Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey: New Methods Aim to Identify Systemic Financial Risks

April 21, 2009

  • Policymakers must address threats to financial system
  • Systemic risks must be identified, measured
  • IMF develops measures to gauge when events become systemic

The global crisis has highlighted that further progress is needed to identify and address systemic risks—those that threaten the financial system rather than individual financial institutions or markets.

New Methods Aim to Identify Systemic Financial Risks

Decision to allow Lehman Brothers collapse may have aggravated global systemic financial crisis already in making (photo: Nicholas Roberts/AFP)

GLOBAL FINANCIAL STABILITY REPORT

But before policymakers can take steps to mitigate systemic risks, those risks must be identified and measured, new IMF research says.

The IMF’s Spring 2009 Global Financial Stability Report devotes a chapter to some recent research by staff in the IMF’s Monetary and Capital Markets department aimed at identifying and measuring systemic events, focusing on the current crisis but also extending the analysis to earlier episodes of financial stress. In particular, IMF economists devised ways to help policymakers determine when problems in financial institutions, and markets more broadly, are likely to become “systemic.”

Being able to identify systemic events at an early stage enhances policymakers’ ability to take necessary steps to contain the crisis. Similarly, being able to detect when those pressures may be easing would help authorities decide when to initiate exit strategies. Because there are many facets to and causes of systemic risks, a range of measures are presented to help discern when events become systemic. The Group of Twenty industrial nations called for enhanced surveillance of potentially systemic events in its April 2, 2009 communique.

Reliable indicators

The economists discovered that some of the basic information that has typically been used to identify a financial institution’s vulnerability is less useful than other measures in determining which financial institutions proved vulnerable in the current crisis. For the sample of global financial institution examined, leverage ratios and return on assets proved the most reliable indicators, while capital-asset ratios and nonperforming loan data lacked predictive power.

Several techniques also analyze forward-looking market data for groups of financial institutions to detect whether and when systemic risks became apparent. Market-based measures that are able to capture joint tail risks—the extreme risk that many financial institutions become distressed simultaneously—seem to have given prior indications of impending stress for the overall financial system.

Proxies for “market conditions,” such as variables used to measure investors’ risk appetite, that influence (and reflect) the risks facing financial institutions are also examined to capture the bigger picture of system-wide stress. The signaling capacity of these indicators is explored by observing whether and when they moved from low, to medium, and to high volatility “states,” with the high state associated with systemic crisis.

Several measures suggest that the U.S. decision to allow the investment bank Lehman Brothers to collapse on September 15, 2008, aggravated what appeared to be a global systemic financial crisis already in the making.

Major stress events

The various techniques used in the chapter clearly identify as systemic major stress events, such as those associated with the assisted merger of Bear Stearns and JPMorgan, as well as the Lehman Brothers failure. Some indicators, signaled rising systemic pressures as early as February 2007. However, advance notice of systemic stress using market-based data can be relatively brief.

The analysis presented could help calibrate the additional contribution of a financial institution to systemic risk, depending on the state of global markets (as reflected, for example, by the level of global liquidity and interest rates, the degree of volatility and uncertainty in capital markets, and the general price of risk).

The tools presented in the chapter could be useful to financial regulators as the basis for additional regulatory measures to encourage behavior that mitigates systemic risk. In particular, macroprudential regulation should aim to require institutions to enhance their stress tests and hold additional capital to take account of the build-up of systemic risk and their contribution to it.

The key policy implications drawn from the analysis are:

• Policymakers should monitor a wide range of market indicators tuned to systemic risk and combine these indicators with more thorough information from financial institutions, because the practical utility of measures to identify systemic risk depends on ability to reliably predict stress events, which may only become apparent concurrently in some cases,.
• More public information on key data— especially on off-balance derivative exposures and measures of market liquidity—is needed.
• Policymakers should develop comprehensive contingency plans that can be implemented quickly if needed, because of the difficulties in predicting systemic events. Having such a scheme in place may help diminish uncertainty, which is often a key factor in the transition of a “contained” financial crises to one that is systemic.

Comments on this article should be sent to imfsurvey@imf.org