Aurora Borealis
1 February 2014 CFA Institute Journal Review

A Survey of Systemic Risk Analytics (Digest Summary)

  1. Marc L. Ross, CFA

Since the 2008–09 financial crisis, risk management has become more critical than ever for the financial services industry. The authors review the landscape of risk analytics, focusing on quantitative measures of systemic risk in economics and finance literature. Their analysis focuses on critical themes in systemic risk measurement and management.

What’s Inside?

The Great Recession of 2007–2009 has given renewed impetus to the study and practice of risk management. The authors endeavor to parse out its key disciplines and offer open-source software implementation guidelines for 31 analytical tools in an effort to promote further analysis and debate on this subject of critical importance.

How Is This Research Useful to Practitioners?

The complex interrelationships of the global financial system are subsumed under the rubric of “financial services” and are of major significance. Indeed, financial services have evolved to a level of granularity and specialization akin to those of the medical and legal professions. The intersection of technology and finance accelerates matters further. The study of risk analytics itself is of sufficient breadth to warrant a comprehensive, yet not exhaustive, survey of its seminal issues and the tools to understand them better, which the authors provide. Recognizing the subject’s complexity, the authors structure the survey to act as an open invitation to further study and research with the provision of MATLAB open-source analytics tools.

The 2010 Dodd–Frank legislation created the Financial Stability Oversight Council (FSOC) and the Office of Financial Research (OFR). The FSOC has as its mandates the identification of risks to financial stability from macroeconomic events or activities of large financial institutions, the promotion of market discipline through the elimination of moral hazard (i.e., the expectation of a bailout), and the response to emerging threats to the stability of the financial system.

Underpinning all of these efforts is an accurate and timely system of risk metrics, the creation and continuous refinement of which is the task of the OFR. The fickle and dynamic nature of the financial system gives rise to numerous risks and, consequently, the need for various measures to address them. The authors endeavor to address the needs of regulators and policymakers in this effort. Although innovation is born of competition, which, in turn, affects profitability, it can spawn unforeseen risks—for example, in mortgage securitization and shadow banking. A lighter regulatory regime can accelerate such risks.

Finally, the trend toward disintermediation found its apex in late 2008, when swathes of the financial system were outside such orderly resolution regimes as the Federal Deposit Insurance Corporation and lender-of-last-resort facilities. Metrics should help financial professionals foresee upcoming trouble and address crises contemporaneously by organizing resources to address them more efficaciously and enforcing accountability and remediation through ex post measures.

Risk managers, policymakers, and regulators will find this survey to be a useful compendium for their work, both as a reference tool and as the impetus for further discussion and analysis in a growing field. Financial practitioners dealing with individual investors will also find the survey useful. Although they are further removed from the bigger-picture issues affecting the global financial system, practitioners and their clients are nonetheless inextricably bound up with such issues. The authors’ work, which is presented in layman’s terms, provides an invaluable perspective.

How Did the Authors Conduct This Research?

The authors’ narrative provides perspective on and analysis of the seminal issues in systemic risk management. They discuss such issues as supervision and research along with data requirements. The appendix contains a detailed review of 31 quantitative measures of systemic risk taken from academic and practitioner literature.

The survey does not purport to be exhaustive. Rather, it reviews recurrent themes on the subject matter and invites further inquiry as evidenced by the inclusion of open-source MATLAB code for the reader’s perusal and investigation. There are six categories of risk issues: (1) macroeconomic measures, (2) granular foundations and network measures, (3) forward-looking risk measurement, (4) stress tests, (5) cross-sectional measures, and (6) measures of illiquidity and insolvency. The final section of the article details the MATLAB program headers for the reader’s reference.

Abstractor’s Viewpoint

Born of a robust regulatory response to the recent financial crisis, the OFR has as its mission the investigation of inflection points—both present and future—that could give rise to additional systemic risk. This article is one such effort. Complexity begets analysis. Recent events have spawned a fecund academic and regulatory response, what the authors term an “embarrassment of riches.” It is on this foundation that the survey is based. Yet the study of past financial calamities on a global scale—not just the recent crises—would also be warranted. History can sow the seeds of progress as well as destruction.

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