Managing systemic risk from the perspective of the financial network under macroeconomic distress

FSI Papers
October 2012

Introduction

The recent global financial crisis has emphasized the importance of managing systemic risk, which disrupts the financial system and has a significant adverse impact on the real economy. Recently, the interconnectedness of financial institutions has been identified as a critical source of systemic risk. Financial sector supervisors realise that any systemic event carries contagion effects and conventional supervisory approaches at the level of an individual bank are insufficient. They now have initiated great efforts to assess financial system vulnerabilities arising from interconnectedness and to mitigate the impact of contagion.

This paper proposes an enhanced methodology to assess contagion risk arising from financial connections across financial firms. The methodology addresses the following three questions:

(1) How does the failure of some financial institutions impact other financial institutions?

(2) What are the key exposures that create systemic risk?

(3) How much must inter-financial institution exposures be reduced in order to prevent extensive spillovers and how much additional capital is needed for the same purpose?

Recently, various methods to measure and reduce systemic risk have been developed from the interconnectedness perspective. It is believed that the balance sheet-based network analysis can offer an intuitive and practical look in explaining default contagion effects arising from interconnected financial linkages.