Understanding Systemic Risk in Global Financial Markets

An accessible and detailed overview of the risks posed by financial institutions

Understanding Systemic Risk in Global Financial Markets offers an accessible yet detailed overview of the risks to financial stability posed by financial institutions designated as systemically important. The types of firms covered are primarily systemically important banks, non-banks, and financial market utilities such as central counterparties. Written by Aron Gottesman and Michael Leibrock, experts on the topic of systemic risk, this vital resource puts the spotlight on coherency, practitioner relevance, conceptual explanations, and practical exposition.

Step by step, the authors explore the specific regulations enacted before and after the credit crisis of 2007-2009 to promote financial stability. The text also examines the criteria used by financial regulators to designate firms as systemically important. The quantitative and qualitative methods to measure the ongoing risks posed by systemically important financial institutions are surveyed.

• A review of the regulations that identify systemically important financial institutions
• The tools to use to detect early warning indications of default
• A review of historical systemic events their common causes
• Techniques to measure interconnectedness
• Approaches for ranking the order the institutions which pose the greatest degree of default risk to the industry

Understanding Systemic Risk in Global Financial Markets offers a must-have guide to the fundamentals of systemic risk and the key critical policies that work to reduce systemic risk and promoting financial stability.

Preface xiii

Acknowledgments xvii

About the Authors xviii

Chapter 1 Introduction to Systemic Risk 1

What Is Systemic Risk? 2

Systemic Risk Drivers 3

Why Systemic Risk Must Be Understood, Monitored, and Managed 5

Chapter 2 How We Got Here: A History of Financial Crises 9

Common Drivers of Historical Crises 10

Bursting of Asset Bubbles 10

Banking Crises 14

Sovereign Debt Crisis 15

International Contagion 18

Chapter 3 The Credit Crisis of 2007–2009 24

Planting the Seeds of a Bubble: The Early 2000s 25

Wall Street’s Role 27

The U.S. Government Takeover of the GSEs 30

The Tipping Point: Lehman Brothers’ Failure 32

Aftermath of the Credit Crisis 35

Cost of Government Bailouts 37

Chapter 4 Systemic Risk, Economic and Behavioral Theories: What Can We Learn? 44

Minsky Three-Part Model 45

Debt Deflation Cycle 46

Benign Neglect 47

Behavioral Theories 48

Risk Aversion Bias 49

Asset Prices 50

Homogeneous Expectations versus Heterogeneity 51

Anchoring Heuristic 52

Excessive Optimism 52

Familiarity Bias 53

Fallacy of Composition 53

Fight or Flight 53

Chapter 5 Systemic Risk Data 59

Key Data Attributes 60

Key Policy Changes to Address Data Gaps 60

Data Sources 63

Data Collection Challenges and Remaining Gaps 63

Move Toward Standardization: Legal Entity Identifier Initiative 68

Chapter 6 Macroprudential versus Microprudential Oversight 73

A Comparison of Macroprudential versus Microprudential 74

Microprudential Policies 74

Macroprudential Policies 76

A Historical Perspective on Macroprudential Tools 77

Choice of Macroprudential Policy Tools 79

Chapter 7 Introduction to the U.S. Regulatory Regime 84

Who Are the Regulators? 84

U.S. Regulatory Approaches 86

Comparison of U.S. versus International Financial Regulatory Regimes 87

Introduction to the Dodd-Frank Act 90

Chapter 8 Introduction to International Regulatory Regimes 97

The Financial Stability Board 97

The Basel Accords 99

The European Systemic Risk Board 99

Principles for Financial Market Infrastructures 102

Chapter 9 Systemically Important Entities 107

Introduction to Systemically Important Entities 107

Classification of Entities as Systemically Important by the FSOC 108

Bank SIFIs 110

Nonbank SIFIs 110

SIFMUs 112

Globally Systemically Important Banks 112

Total Loss-Absorbing Capacity (TLAC) Requirements 114

Broad Impact of Financial Stability Requirements 117

Chapter 10 The Volcker Rule 120

Introduction to the Volcker Rule 120

The Volcker Rule: Details 122

Prohibition of Proprietary Trading 123

Prohibition of Ownership or Sponsorship of Hedge Funds and Private Equity Funds 123

The Volcker Rule and Systemically Risky Nonbank Financial Companies 123

Activities That Are Permitted Despite the Volcker Rule 124

Implementation of the Volcker Rule 125

Volcker Rule: Criticism 126

Chapter 11 Counterparty Credit Risk 130

Overview of Derivative Securities 130

Counterparty Exposure 133

How Counterparty Credit Risk Is Managed 136

Collateral 136

Netting 136

Central Counterparties 139

Counterparty Credit Risk and Systemic Risk 142

Chapter 12 The Dodd-Frank Act and Counterparty Credit Risk 147

Measuring Counterparty Exposure in the OTC Derivatives Market 147

Overview of Historical Data 149

The Evolution of the U.S. Regulatory Approach toward OTC Derivatives 152

Key Provisions of Title VII of the Dodd-Frank Act 153

Mandatory Clearing 154

Execution Platforms and Data Repositories 154

Registration Requirements 155

The Push-Out Rule 155

The End User Exemption 155

Criticism of Title VII of the Dodd-Frank Act 155

Chapter 13 The Basel Accords 159

What Are the Basel Accords? 159

The Approach of the Basel Accords 160

Basel I 161

Basel II 163

Pillar 1: Minimum Capital Requirements 163

Pillar 2: Supervisory Review 164

Pillar 3: Market Discipline 165

Basel II. 5 165

Basel III 165

The Continuing Evolution of the Basel Accords 166

Chapter 14 Lender of Last Resort 169

Lender of Last Resort Concept 169

Henry Thornton, Walter Bagehot, and Alternative Views 170

The Fed’s Role in the Great Depression 172

The Credit Crisis of 2007–2009 173

Chapter 15 Interconnectedness Risk 177

A Case Study of Interconnectedness 178

Interconnectedness Categories 179

The Depository Trust & Clearing Corporation 180

Post-Crisis Regulatory View of Interconnectedness 181

Basel Committee on Banking Supervision 181

Office of Financial Research 182

CPMI IOSCO Principles 184

An Approach to Analyzing Interconnectedness Risk 185

The Depository Trust & Clearing Corporation 185

Chapter 16 Conclusion: Looking Ahead 190

It’s Not a Question of If, but When, Where, and How 192

A Summary of Global Surveys 192

Sources of Systemic Risk 193

Preparing for the Next Crisis 194

Appendix: Systemic Risk Models 198

Structural versus Reduced-Form Credit Models 198

Contingent Claims and Default Models 199

Merton versus Garch 204

Studies in Support of Merton 205

Macroeconomic Measures 210

Probability Distribution Measures 211

Illiquidity Measures 214

Counterparty Risk Measures 215

Behavioral Models 217

Solutions to the Knowledge Check Questions 223

Index 239

ARON GOTTESMAN is Professor of Finance and the chair of the Department of Finance and Economics at the Lubin School of Business at Pace University. He is widely published in academic journals and is the author of Derivatives Essentials: An Introduction to Forwards, Futures, Options, and Swaps.

MICHAEL LEIBROCK is managing director, chief systemic risk officer, and head of Counterparty Credit Risk for The Depository Trust & Clearing Corporation (DTCC). He serves as chair of DTCC’s Model Risk Governance Committee and co-chair of the Systemic Risk Council, and is an active speaker globally on the topics of systemic and credit risk.

Systemic risk is the risk that developments in the financial system will disrupt financial stability and the economy. While systemic risk has been a central concern since the Credit Crisis of 2007–2009, the history of finance shows that financial crises occur frequently and threats to financial stability are constant, requiring careful monitoring and management of systemic risk. Understanding Systemic Risk in Global Financial Markets is your in-depth primer on the core principles and dynamics of systemic risk that comes complete with a real-world approach to managing it.

In a brilliant presentation specifically designed for accelerated learning, two thought leaders from academia and business take you on an enlightening exploration of the prime drivers of systemic events—through such historic happenings as the Dutch Tulip Crisis, South Street Sea Bubble, the Great Depression, and the Credit Crisis of 2007–2009 — to offer an advantageous perspective on how these drivers influence banks and other financial institutions designated as systemically important. Without presuming any advanced background in mathematics, straightforward explanations illuminate theories in both economics and human behavior that contribute to financial crises in an attempt to understand the impact of potential events in the future. Through the unique lens this guidebook offers, you can clearly see the interconnectedness financial firms have with each other and the rest of the world, while gaining:

• A practical understanding of how to monitor and analyze real-world conditions to mitigate impact from a systemic crisis
• A firm grasp of U.S. financial regulation, including the Dodd-Frank Act, as well as key international regulators and standards such as the Financial Stability Board and the Basel Accords
• Cutting-edge insight into the latest ways data is now used to effectively monitor systemic financial risks

Understanding Systemic Risk in Global Financial Markets gives you the perspective and hands-on skillset to effectively monitor and respond to events that can threaten financial stability.