Systemic Risk and

Interconnectedness for Interconnectedness for

Banks and InsurersMary A. Weiss, Ph.D.

SAFE-ICIR Workshop

Goethe University Frankfurt

May 2014

What is interconnectedness?

Working definition of interconnectedness:

Interconnectedness is an assessment of the

potential impact of a company’s financial distress

on the broader economyon the broader economy

Interconnectedness arises from actual – and perceived–

complex webs of contract relationships across financial

institutions.

Approaches to Measuring Systemic

Risk and Interconnectedness

Two sets of tools used in cross-

sectional dimension:

1. Network analysis1. Network analysis

2. Market-based indicators

Network Analysis

Allen and Gale (2000)

model of financial networks

liquidity shocks having domino effect

Interbank deposits are primary mechanism of liq. Shock

Complete vs Incomplete Networks

Moral of lesson: Diversification

Gai, Haldane and Kapadia (2010)

Shocks propagate in network structures in which some financial institutions more interconnected than others.

Contagion more likely at higher levels of connectivity

“shock transmitters” vs “shock absorbers”

Regulators care about shock transmitters.

Network Analysis: Unexplored Issues

1. Focus on nodes and not on edges of financial networks

2. Detailed and comprehensive data requirements

3. Determinants of network formation (in first place) are

unknown.unknown.

4. Don’t know how networks change in event of new

information or stress events

5. Don’t know the conditions that lead to formation of

fragile/robust networks.

Market-Based Indicators

Two types of Market-Based Indicators:

One set concerned with size of financial distress

Other set concerned with analysis of market information

econometrically

Market-Based Indicators:

Potential Size of Financial Distress I

Several factors related to likelihood of major financial

dislocation:

1. Degree of correlation among holdings of financial

institutions

2. How sensitive institutions are to changes in market prices 2. How sensitive institutions are to changes in market prices

and economic conditions

3. How concentrated the risks are among the financial

institutions

4. How closely linked institutions are with each other and the

rest of the economy

Market-Based Indicators:

Potential Size of Financial Distress II

Three primary measures used to measure

systemic linkages:

Adrian and Brunnemeier (2010)

Conditional Value at Risk: (CoVaR) and ΔCoVaRConditional Value at Risk: (CoVaR) and ΔCoVaR

Acharya et al. (2011)

Systemic Expected Shortfall (SES)

Huang, Zhou, and Zhu (2011)

Distress Insurance Premium (DIP)

Market-Based Indicators:

Potential Size of Financial Distress III

Measures can be implemented with data publicly available on a

high frequency basis

Limits need to rely on detailed (confidential) supervisory data

Forward-looking and reflect investors’ assessment of the

financial health of specific institution

Reflect domestic and global policy actions to contain risk.

Market-Based Indicators:

Observations and Issues

1. Measures cannot be used to determine causability

2. Do not provide a scale for interpreting results as high, medium, or low systemic risk

3. Not clear how financial distress can be mapped into outcomes for broader economy (such as decrease in GDP).

4. Don’t consider whether failure of firm can be absorbed by 4. Don’t consider whether failure of firm can be absorbed by rest of economy

5. Don’t indicator whether competitors can fill in void

6. Don’t measure how important services of the financial institution (e.g., insurers) are to rest of the economy

7. Market based measures cannot be used if stock price data unreliable or institution not publicly traded

8. Have short horizon as early warning indicator of financial distress

Market-Based Measures:

Econometric Approaches

Billio et a. (2012)

hedge funds, banks, brokers, and insurers

Use principal components analysis

used to estimate the number and importance of common factors driving returns of financial institutionsinstitutions

Use Granger causality

pairwise Granger causality tests used to identify network of statistically significant Granger-causal relations among institutions.

Suffer from most of same drawbacks as first set of market-based indicators, but appear to have good “out of sample” properties.

Chen et al. (2013) also use Granger causality

Overall Comments about Systemic Risk

and Interconnectedness Measurement

Don’t know how complementary these measures

are to each other.

Given confidentiality domestic financial network

studies, almost no empirical work has been done

to study relationship between network and price-

based measures.

Insurance-Banking

Interconnectedness I

Quantitative studies of insurance-banking

interconnectedness

Institutional studies of insurance-banking

interconnectedness

Insurance-Banking Interconnectedness:

Quantitative Studies of Interconnectedness I

Billio et al. (2012)

Hedge funds, banks, insurers, and brokers become more interrelated over recent years

Banks and insurers more important to interconnectedness than brokers and hedge fundsfunds

By insuring financial products, writing CDS and engaging in derivatives and investment management, insurers became more part of interconnected system

Chen et al. (2013)

Use spread on CDS for 11 insurers and 12 banks

Dominating influence is that of banks affecting insurance companies.

Insurance-Banking Interconnectedness:

Quantitative Studies of Interconnectedness II

Acharya et al. (2010)

Inference is that if insurer has large systemic expected

shortfall (SES) when other financial institutions

do, it is interconnected.

Insurers least systemically risky compared to depository Insurers least systemically risky compared to depository

institutions and securities dealers and brokers.

AIG more systemic than Berkshire-Hathaway

Top 3 insurers in terms of systemic risk were heavily

involved in providing financial guarantees for

structured products (Genworth, Ambac, and

MBIA)

Insurance-Banking Interconnectedness:

Quantitative Studies of Interconnectedness III

Baluch, Mutanga, and Parsons (2011)

Significant correlation between banking and insurance sectors and finds correlation increased during crisis period.

Greatest impact of crisis on:

1. specialist finance guarantee insurers1. specialist finance guarantee insurers

2. insurers heavily engaged in capital market activities

3. bancassurers

4. credit and liability insurers (to lesser extent).

Conclude that systemic risk is lower in insurance than banking but grown due to increasing linkages with banks and non-traditional insurance activities.

Insurance-Banking Interconnectedness:

Quantitative Studies of Interconnectedness IV

Park and Xie (2013)

Focus on interconnectedness between U.S. primary insurers and their reinsurers. They look at

whether a reinsurer downgrade is associated with a primary insurer downgrade (yes it is)

whether a reinsurer downgrade is associated with whether a reinsurer downgrade is associated with primary insurer reduction in stock price (yes it is)

the likely impact of major global reinsurer insolvencies on the U.S. property-casualty insurance industry.

Even under extreme assumption of 100% reins. recoverable default by one of the top three global reinsurers, only about 2% of insurers would be downgraded, and one percent would become insolvent.

Insurance-Banking Interconnectedness:

Institutional Studies of Interconnectedness

Cummins and Weiss (2013); Geneva Association (2010)

Argument that insurance-banking interconnectedness studies

should focus on business activities of insurers

Business activities may be core insurance activities or non-core Business activities may be core insurance activities or non-core

(possibly banking) activities

Distinction important from regulatory perspective.

It is important to distinguish among business activities

otherwise regulatory arbitrage through the migration of risky

business activities from highly regulated institutions to less

regulated institutions would be likely.

Future Research Topics

1. How can regulation be designed so that systemic risk is mitigated?

2. Does new regulation such as Solvency II contribute to systemic risk

as discussed in academia and practice?

3. How can regulatory arbitrage be avoided practically?

4. Even if systemic risk relatively low in traditional insurer activities,

indirect contagion risk such as reputational risks have not been indirect contagion risk such as reputational risks have not been

considered.

5. What is the contribution of derivatives and other innovative

products from the field of alternative risk transfer?

6. Need explanation of how regression variables used to explain

systemic risk measures are related to reduced output in economy.

7. Is it sufficient to rely on stock price information to measure an

interconnection?

Conclusion

From Billio et al., p. 555

“As long as human behavior is coupled with free enterprise, it is

unrealistic to expect that market crashes, manias, panics,

collapses, and fraud will ever be completely eliminated from our

capital markets. The best hope for voiding some of the most capital markets. The best hope for voiding some of the most

disruptive consequences of such crises is to develop methods

for measuring, monitoring, and anticipating them. By using a

broad array of tools for gauging the topology of the financial

network, we stand a better chance of identifying “black swans”

when they are still cygnets.”

.

Thank you!Thank you!

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• Campbell, S., Research Agenda for Measuring Interconnectedness. Powerpoint presentation.

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