DTCC Connection

Jan 27, 2016 • DTCC Connection

Responding to the Risk of Financial Interconnectedness

Regulators and risk managers look beyond initial post-crisis insights to understand systemic vulnerabilities and enhance resilience

Responding to the Risk of Financial Interconnectedness
Andrew Gray, DTCC Managing Director, Group Chief Risk Officer

By Andrew Gray
DTCC Managing Director, Group Chief Risk Officer

Financial markets have always been interconnected, but advances in technology and globalization have increased the complexity of today’s network. While these connections have created unprecedented levels of efficiency, risk diversification and many other advantages, they also have the potential to amplify financial shocks and spark contagion across marketplaces globally.

The 2008 crisis highlighted this risk as the collapse of one financial institution rippled through markets worldwide, affecting thousands of entities and ultimately threatening global financial stability. It underscored not just how devastating the impact of the failure of a large financial institution can be, but also how the ensuing effects can unfold in ways that are utterly unpredictable.

A wave of studies undertaken after the crisis sought to better understand risks related to financial interconnectedness. These studies revealed that financial networks tend to be robust yet fragile, absorbing shocks up to a critical tipping point, beyond which they spread risk rather than contain it. They also suggested that, if a financial entity fails, the risk of contagion generally increases with the size and systemic importance of the failing entity.

Emphasis on Resilience
While these high-level insights help to frame the problem conceptually, they don’t necessarily offer sufficient guidance on how to use this information at a more practical level. It is equally hard to pinpoint at what level a network may become “too interconnected” or determine which critical linkages have become too fragile.

That is why many regulators have focused on emphasizing measures designed to increase the resilience of highly interconnected — and systemically important — financial institutions, rather than curbing interconnectedness directly. Risk managers are also looking to incorporate interconnectedness insights into their practices.

One area where firms can start is with a map of connections across their enterprises. Take an inventory of all the external entities on which your firm relies, attempt to quantify to the extent practical the risk associated with each link and determine which ones are most critical. Explore how an impaired interconnection could affect specific areas of your firm’s operation. Identify highly interconnected entities and assess the potential impact of their failure on your business in its entirety. Stress tests and scenario analyses are also very valuable tools for this assessment.

Given the interconnectedness of financial entities, many experts agree that joint industry exercises offer tremendous value in strengthening industry resiliency. By testing a network’s ability to respond to incidents, and by allowing players to practice the execution of their procedures and see how they interact with the policies of other participants in the simulated event, firms can assess and enhance their preparedness in the face of a number of systemic threats.

LEIs and Trade Repositories
There are a number of industry initiatives underway that will help mitigate systemic risk by providing more transparency. Two examples are the creation and assignment of globally accepted legal entity identifiers (LEIs) and the establishment of derivatives trade repositories around the world.

LEIs, a unique ID associated with a single corporate entity, enable firms and regulators to better understand exposures of key market participants, individually and at a global level. LEIs also help risk managers better understand counterparty exposures.

Trade repositories have provided regulators with new insights into derivatives trading, providing greater transparency into the local derivatives market and counterparty risk. While significant progress has been made on LEIs and trade reporting, more work remains given the scale and global nature of these efforts.

Interconnectedness is a critical area that has grown in importance as markets have become more global and more connected. Market participants should incorporate interconnectedness analysis into their risk management frameworks to identify areas of potential vulnerability and respond to it now in order to strengthen resilience across the global financial markets.

This article first appeared on the Global Alliance of Risk Professionals (GARP) on Wednesday, January 13, 2016.

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