The discipline of risk management has become more complex and diverse than ever, driven in large part by new regulatory mandates, an explosion of technological and financial innovation and the growing interconnectedness of global markets.
DTCC’s recent white paper “Understanding Interconnectedness Risk,” offers six key takeaways to help risk managers gain a deeper understanding of all the risks they face as well as the intricate spider’s web of interconnections they create.
1. What is financial interconnectedness and why does it matter?
Financial interconnectedness is the network of credit exposures, trading links and other relationships and dependencies between financial agents. Interconnectedness matters because it serves as a conduit for contagion. The impact of the failure of a large interconnected entity can spread rapidly and extensively across the financial system, to the point where it can cause worldwide financial instability.
2. Types of financial interconnectedness
Firms can be interconnected directly (e.g., through interbank loans) or indirectly (e.g., if they are exposed to common assets).
3. Studies on interconnectedness key
Financial networks tend to be robust yet fragile, absorbing shocks up to a critical tipping point, and spreading risk beyond this threshold. The failure of a centrally located node tends to increase the likelihood and extent of contagion. Some research suggests that networks with a moderate level of interconnectedness may be the most resilient ones.
Related: DTCC’s Practical Guidelines for Analyzing Interconnectedness Risks
4. Policy implication
Regulators have made progress in understanding and addressing interconnectedness within the global financial system. Rather than curbing interconnectedness directly, they have chosen to emphasize measures designed to increase the resilience of highly interconnected – and systemically important – financial institutions.
5. Implications for risk management practitioners
While additional research may help deepen our insight into certain risk dynamics, risk management practitioners may benefit most from incorporating an interconnectedness lens into everyday activities. This can meaningfully contribute to enhancing systemic resilience, both for individual organizations and for the financial industry as a whole.
Subscribe to DTCC Connection for news on DTCC initiatives to mitigate risk and reduce costs for the global financial services industry and exclusive commentary from DTCC senior executives on a broad range of issues impacting global markets: http://www.dtcc.com/dtcc-connection/sign-up.html