Higher-Order Exposures

56 Pages Posted: 1 Sep 2021

See all articles by Garbrand Wiersema

Garbrand Wiersema

University of Oxford; University of Oxford - Institute for New Economic Thinking at the Oxford Martin School; University of Oxford - Mathematical Institute

Alissa M. Kleinnijenhuis

Stanford Institute for Economic Policy Research, Stanford University; Institute for New Economic Thinking at the Oxford Martin School, University of Oxford ; Oxford-Man Institute of Quantitative Finance, University of Oxford

Esti Kemp

University of Cape Town (UCT), Students

Thom Wetzer

University of Oxford; University of Oxford, Faculty of Law; Institute for New Economic Thinking at the Oxford Martin School; University of Oxford - Oxford-Man Institute of Quantitative Finance

Date Written: August 30, 2021

Abstract

Traditional exposure measures focus on direct exposures to evaluate the losses an institution is exposed to upon the default of a counterparty. Since the Global Financial Crisis of '07/'08, indirect exposures via common asset holdings are increasingly recognized too. Yet direct and indirect exposures fail to capture the losses that result from shock propagation and amplification following the counterparty's default. In this paper, we introduce the concept "higher-order exposures" to refer to these spill-over losses and propose a way to formalize and quantify them. Using granular data of the South African financial system, we show that higher-order exposures make up a significant part of exposures – particularly during times of financial distress when exposures matter most. We also show that higher-order exposures cannot simply be extrapolated from direct or indirect exposures, since they depend strongly on the network structure and the robustness of individual institutions. Our findings suggest that higher-order exposures should inform the design and calibration of those tools in the regulators' arsenal where exposures matter -- including large exposure limits, capital requirement calibration, stress test design and resolution. Failure to do so may result in both lax ex-ante regulation and ill-informed ex-post handling of financial crises.

Keywords: Financial Exposures, Direct Exposures, Indirect Exposures, Credit Risk, Market Risk, Liquidity Risk, Systemic Risk, Financial Contagion, Multi-Layered Networks, Stress Tests, Prudential Regulation, Macroprudential Policy

JEL Classification: G01, G17, G18, G21, G23, G28

Suggested Citation

Wiersema, Garbrand and Kleinnijenhuis, Alissa M. and Kemp, Esti and Wetzer, Thom and Wetzer, Thom, Higher-Order Exposures (August 30, 2021). Available at SSRN: https://ssrn.com/abstract=3914076 or http://dx.doi.org/10.2139/ssrn.3914076

Garbrand Wiersema (Contact Author)

University of Oxford ( email )

Mansfield Road
Oxford, Oxfordshire OX1 4AU
United Kingdom

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ( email )

Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

University of Oxford - Mathematical Institute ( email )

Andrew Wiles Building
Radcliffe Observatory Quarter (550)
Oxford, OX2 6GG
United Kingdom

Alissa M. Kleinnijenhuis

Stanford Institute for Economic Policy Research, Stanford University ( email )

366 Galvez Street
John A. and Cynthia Fry Gunn Building
Stanford, CA CA 94305
United States

HOME PAGE: http://https://siepr.stanford.edu/people/alissa-kleinnijenhuis

Institute for New Economic Thinking at the Oxford Martin School, University of Oxford ( email )

Oxford
United Kingdom

Oxford-Man Institute of Quantitative Finance, University of Oxford ( email )

Oxford
United Kingdom

Esti Kemp

University of Cape Town (UCT), Students ( email )

Rondebosch
Capetown
South Africa

Thom Wetzer

University of Oxford ( email )

St Cross Building
St Cross Rd
Oxford
United Kingdom

University of Oxford, Faculty of Law ( email )

Oxford
United Kingdom

Institute for New Economic Thinking at the Oxford Martin School ( email )

Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

University of Oxford - Oxford-Man Institute of Quantitative Finance ( email )

Oxford
United Kingdom

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