Assessing the Systemic Implications of Financial Linkages

Abstract

The rise in the complexity and globalization of financial services has contributed to stronger interconnections or linkages. While more extensive linkages contribute to economic growth by smoothing credit allocation and allowing greater risk diversification, they also increase the potential for disruptions to spread swiftly across markets and borders. In addition, financial complexity has enabled risk transfers that were not fully recognized by financial regulators or by institutions themselves, complicating the assessment of counterparty risk, risk management, and policy responses. Thus the importance of assessing the systemic implications of financial linkages.

This chapter illustrates the type of methodologies that can provide some prospective metrics to facilitate discussions on systemic linkages and, specifically, the “too-connected-to-fail” problem, thereby contributing to enhanced systemically focused surveillance and regulation.

Though these methodoloies have limitations, together they represent a set of valuable surveillance tools and can form the basis for policies to address the too connected- to-fail problem, specifically in two areas:

• Perimeter of regulation. To maintain an effective perimeter of prudential regulation without stifling innovation, the tools provided in the chapter could help address questions such as whether to limit an institution’s exposures, the desirability of capital surcharges based on systemic linkages, and the merits of additional liquidity regulations.

• Information gaps. The chapter also discusses the importance of filling existing information gaps on cross-market, cross-currency, and cross-country linkages to refine analyses of systemic linkages. Closing information gaps would require improved data collection procedures and impose additional demands on financial institutions, but would be a far better alternative to waiting until a crisis ensues to obtain information as events unfold.

Keywords: financial crisis, interconnectedness, network analysis, corisk, default intensity, perimeter of regulation, information gaps

JEL Classification: G20, G18, F36