DTCC is involved in several internal and external initiatives aimed at addressing concerns related to financial interconnectedness. Internal efforts focus primarily on enhancing DTCC’s resilience in the face of interconnectedness risk, while external initiatives are designed to help mitigate industry-wide systemic risks.
In its white paper, “Understanding Interconnectedness Risk”, released October 12, DTCC proposes a list of practical guidelines for analyzing interconnectedness risks in the securities industry:
1. MAKE A COMPREHENSIVE INVENTORY OF EXTERNAL ENTITIES ON WHICH YOU RELY
Most financial institutions rely on adequate funding and liquidity, credit, access to markets and market infrastructures, as well as the provision of reliable and timely data – among many other processes. External entities that provide or support these services represent external interconnections to your firm. Given that insolvencies occur at a legal entity level, intra-group dependencies between distinct legal entities should also be represented as external interconnections.
2. DETERMINE WHICH INTERCONNECTIONS ARE CRITICAL TO YOUR BUSINESS
Use the following criteria to assess the level of criticality of your interconnections:
- Severity – how severely might an impaired or failed interconnection impact your firm, its clients, shareholders, regulators or other stakeholders?
- Time sensitivity – how long would it take for a failed interconnection to have a considerable impact?
- Substitutability – how easily and quickly could you switch to a suitable replacement?
3. QUANTIFY YOUR CRITICAL INTERCONNECTIONS IF PRACTICAL
Quantifying interconnections can be useful as a straightforward and objective way to aggregate, rank and assess the related risks. It may also help prioritize risks and monitor their evolution over time. That said, operational interconnections with providers of data and other financial services may be harder to quantify than those with borrowers/ lenders, trade counterparties and funding providers. Therefore, interconnections should be quantified as appropriate depending on the circumstances and the effort involved in doing so.
4. ASSESS IN DETAIL HOW AN IMPAIRED INTERCONNECTION COULD AFFECT SPECIFIC AREAS
Depending on the circumstances, the failure of an interconnected entity may cause a credit or trading loss, but it may also cause a loss of revenue, affect funding or have a different type of impact altogether. In assessing the effect of an impaired or failing interconnection, it may be more appropriate to take into account peak volumes and associated risks, rather than average values.
Related: Understanding Interconnectedness Risks: 6 Key Takeaways
5. IDENTIFY HIGHLY INTERCONNECTED ENTITIES AND ASSESS THE POTENTIAL IMPACT OF THEIR FAILURE ON YOUR BUSINESS IN ITS ENTIRETY
While the analysis described above is valuable in its own right, its real power lies in the aggregation of risks across areas that may be simultaneously affected by a single failure. The failure of a highly interconnected entity may have a combined effect – for instance, by simultaneously causing credit losses while affecting your firm’s funding, as well as your access to other financial services. While each of these impacts may be manageable individually, their combined effect may not be.
6. MANAGE EXPOSURES TO INTERCONNECTED ENTITIES HOLISTICALLY
Given the potential combined effect of the failure of a highly interconnected entity, it is important to manage the associated risks holistically. Among other things, that means that concentration risk should be managed not only by assessing the relative exposures to funding, trading, credit and other counterparties in isolation, but also in its entirety across these various areas. Stress tests and scenario analyses can be very valuable in this respect, provided they explicitly incorporate these forms of interconnectedness.
7. COOPERATE ACROSS DEPARTMENTS
Organize cross-functional risk reviews and discussions to make interconnectedness awareness an integral part of your organization’s risk management culture. Interconnectedness analysis should complement other disciplines, not replace them.
8. TAKE A GRADUAL APPROACH
As is the case for other risk management disciplines, interconnectedness analysis is an iterative process – start small and expand gradually. Periodically assess in which areas you may need to become more sophisticated.
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