by Don Alexander, MBA
Associate, RSD Solutions Inc.
Viral Acharya, Robert Engle & Matthew Richardson, members of the faculty at NYU Stern School, provide an update on their work on systemic risk in a short VOXEU communique (dated 14th March). The authors discuss their method to estimate capital that a financial firm would need to raise if we have another financial crisis.
The effective regulation of banks requires identification of systemically important institutions. The measure of capital shortfall is based on publically available information and is conceptually similar to the stress tests conducted by European and US regulators.
The authors note three potential approaches: (1) how much capital is required for an orderly rescue; (2) what is required for an orderly liquidation of systemically important institutions; and lastly, (3) how to regulate institutions according to their economic impact. The authors prefer the latter where effective and efficient regulation requires the identification of systemically important financial institutions.
A definition from Federal Reserve Governor Daniel Tarullo (2009): “Financial institutions are systemically important if the failure of the firm to meet its obligations to creditors and customers would have significant adverse consequences for the financial system and the broader economy.” The definition makes two points: (1) what happens to the institution when it cannot perform its function due to a capital shortfall; and (2) systemic risk matters when there is an impact on the broader economy. Systemic risk should not be described as a firm’s failure per se, but the firm’s contribution to system-wide failure. The real systemic risk of the firm is a function of the social cost of a crisis per dollar of capital, the probability of a crisis, and the capital shortfall of the firm in a crisis.
The authors provide a methodology to estimate the capital shortfall of a financial institution from its various business activities in the event of another financial crisis. The expected capital shortfall captures in a single measure the important characteristics of systemic risk: size, leverage and interconnectedness. All of these characteristics capture widespread losses in the financial sector are reflected in the capital shortfall and also provide information of the co-movement of a firm’s assets with the aggregate financial sector.
The information is based on public financial information and provides timely, accurate estimates compared to the time consuming methodology of the BIS-type stress tests. The reader is referred to their VOXEU column and their NYU website.
A key lesson from this approach for risk management is that a simple, well thought out methodology, that is not time consuming, can provide the same answers as a more-complex approach. However, the value of the results is limited by the quality of the input data. The potential under-reporting of risk exposure, such as under Basel III, may not appear in the calculations.
For more on this, follow the link: www.voxeu.org/index.php?q=node/7722
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