A camera catches a column of hand-written numbers as Sir David Attenborough narrates:
Here, in the unforgiving embrace of the high peaks, a ghost of finance moves, the systemic risk, a creature so rightfully vilified its very existence seems a threat to our way of life. For years, we have tracked it, a patient hunter in its own right, yet it is I who has been the hunted, a mere shadow in its vast and shaky domain.
Now, through the crisp, frigid air, a flash of counterparty default, a moment of profound stillness as it halts, its powerful frame perfectly outlined on the calculator.
It is a scene that has unfolded for decades, driven by the frantic pace of tech bubbles and housing booms, a breathtaking testament to the contagion of hype and the sheer, unyielding power of exposures.
Okay, okay, I admit that I like cinematic drama and reading through a new working paper on higher-order exposures from the European Central Bank (ECB), I just might have been carried away.
The working paper concludes that neither direct exposures through a financial institution’s counterparties in loans and other asset holdings, nor indirect exposures through market value changes in portfolios overlapping with other banks, fully capture a bank’s credit risk.
In a case study of the South African banking sector, the working paper shows that higher-order exposures, defined as the contagion of credit losses, can pose a substantial systemic risk.
Alas, if Bank A defaults, Bank B can be:
-
Directly exposed through loans to and investments in Bank A.
-
Indirectly exposed through the fire sale of Bank A’s assets, lowering the mark-to-market value of Bank B’s holdings of the same assets.
-
Higher-order exposed through contagion within overlapping portfolios, counterparties, and shareholders.
So, even if Bank B has no business with Bank A, it can still be hit by the depressing ripple effect of Bank A’s demise. Or as the wise bots on the internet say:
“Systemic risk is the risk of a domino effect, where the failure of one institution or market spreads to others due to interconnections, resulting in a loss of confidence, a reduction in credit, and a severe economic downturn.”
The brilliance of the ECB paper is that it finds a way to quantify systemic risk, which can justify a bit of the worrywart streak in bank regulators.
However, the quantification itself relies on a rare and exclusive access to very detailed information about the interconnectedness of South African banks, something that is difficult to replicate, let alone operationalize, elsewhere.
Thus, while systemic risk is real, its practical measurement still largely eludes us, and yet, when we catch glimpses of it, we shall continue to be both fascinated and cautioned by it.
Regitze Ladekarl, FRM, is FRG’s Director of Company Intelligence. She has 25-plus years of experience where finance meets technology.
This article is part of the FRG Risk Report, published weekly on the FRG blog. To read other entries of the Risk Report, visit frgrisk.com/category/risk-report/.