Robert C. Merton (2014) - Measuring the Connectedness of the Financial System: Implications for Systemic Risk Measurement and Management

Robert C. Merton (2014)

Measuring the Connectedness of the Financial System: Implications for Systemic Risk Measurement and Management

Robert C. Merton (2014)

Measuring the Connectedness of the Financial System: Implications for Systemic Risk Measurement and Management

Abstract

Macrofinancial systemic risk is an enormous issue for both governments and large asset pools. The increasing globalization of the financial system, while surely a positive for economic development and growth, does increase the potential impact of systemic risk propagation across geopolitical borders, making its control and repairing the damage caused a more complex and longer process. As we have seen, the impact of the realization of systemic risk can be devastating for entire economies. The Financial Crisis of 2008-2009 and the subsequent European Debt Crisis were centered around credit risk, particularly credit risk of financial institutions and sovereigns, and the interplay of the two. The propagation of credit risk among financial institutions and sovereigns is related to the degree of “connectedness” among them. The effective measurement of potential systemic risk exposures from credit risk may allow the realization of that risk to be avoided through policy actions. Even if it is not feasible to avoid the systemic effects, the impact of those effects on the economy may be reduced by dissemination of that information and subsequent actions to protect against those effects and to subsequently repair the damage more rapidly. This paper applies the structural credit models of finance to develop a model of systemic risk propagation among financial institutions and sovereigns. Tools for applying the model for measuring connectedness and its dynamic changes are presented using network theory and econometric techniques. Unlike other methods that require accounting or institutional positions data as inputs for determining connectedness, the approach taken here develops a reduced-form model applying only capital market data to implement it. Thus, this model can be refreshed almost continuously with “forward-looking” data at low cost and therefore, may be more effective in identifying dynamic changes in connectedness more rapidly than the traditional models. This new research is still in progress. The basic approach and the empirical findings are encouraging and it would seem that at a minimum, this approach will provide “good “questions, if not always their answers, so that overseers and policy makers know better where to look and devote resources to discovery among the myriad of places within the global financial system. In particular, it holds promise for creating endogenously specified stress test formulations. The talk closes with some discussion of the importance of a more integrated approach to monetary, fiscal and stability policies so as to better recognize the unintended consequences of policy actions in one of these on the others.

Background reading:

Merton, R.C., 1977, “An Analytical Derivation of the Cost of Deposit Insurance and Loan Guarantees,” Journal of Banking and Finance, vol. 1 (June); pp. 3-11.

Gray, D. F., Merton R. C. and Z. Bodie, 2007, “Contingent Claims Approach to Measuring and Managing Sovereign Credit Risk”, Journal of Investment Management, Vol. 5, No. 4, pp. 5-28.

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