The Depository Trust and Clearing Corporation (DTCC) recently issued a whitepaper explaining the risk of interconnectedness in the financial world. DTCC notes that “risk managers can no longer view financial firms as stand-alone entities because, in reality, they are now a diverse set of interconnected components that distribute risk and are exposed to it, oftentimes in ways that are not transparent or expected.” The paper suggests that the interconnectedness of the financial system means that “firms must do more than monitor and mitigate these risks – they also need to focus on building resiliency so they can detect potential systemic shocks before they strike or recover from them as quickly as possible.”
DTCC defines “interconnectedness” as “the network of credit exposures, trading links and other relationships and dependencies between financial agents.” The paper notes that entities can become directly interconnected by lending to each other or through contractual obligations, or indirectly interconnected by investing in the same asset. However, DTCC notes that interconnectedness is not all negative. In some instances, “these intra-financial and/or legal linkages help dampen shocks by distributing and dispersing their impact throughout the financial system” and in others they “have proven to propagate shocks beyond their original impact, amplifying them in the process.”
The paper summarizes studies conducted on interconnectedness as “financial networks tend to be robust yet fragile, meaning they absorb shocks up to a critical tipping point, beyond which they spread risk rather than contain it.” Research finds that a middle-level of interconnectedness may be optimal so that institutions are connected sufficiently to channel shocks “to a sufficiently large number of risk-absorbing” entities, but not so densely connected as to tip the scale. The paper suggests that, due to difficulties in determining the optimal level of interconnectedness, “policymakers have mainly focused on introducing rules aimed at increasing the resilience of the most interconnected – and most systemically important – financial institutions.”
Regulators and policy makers are actively seeking to measure interconnectedness to assess systemic importance of individual institutions. The paper cites a recent report from the Office of Financial Research which finds U.S. banks JPMorgan Chase and Citibank atop the list of global systemically important banks (G-SIBS) in terms of interconnectedness. Another OFR study found that seven of eight U.S. G-SIBS had a high financial connectivity index, or the “fraction of a firm’s liabilities that are held by other financial institutions,” and that five of the eight had showed a high level of contagion risk, or the risk that “an adverse shock at one financial institution can have negative consequences for others.”
The paper suggests that interconnectedness should be considered as a part of everyday risk management. Doing so “promotes holistic thinking,” “clarifies the boundaries between actionable and inherent risks,” can help develop more broad-based solutions, and can help risk managers “to recognize core competencies outside of their own walls.” It suggests the following guidelines for analyzing interconnectedness risk:
- Make a comprehensive inventory of external entities on which you rely
- Determine which interconnections are critical to your business
- Quantify your critical interconnections if practical
- Assess in detail how an impaired interconnection could affect specific areas
- Identify highly interconnected entities and assess the potential impact of their failure on your business in its entirety
- Manage exposures to interconnected entities holistically
- Cooperate across departments and
- Take a gradual approach.