The Depository Trust & Clearing Corporation

Given this inherent complexity in defining interconnectedness, we begin by providing readers a broad taxonomy of categories according to research by The Depository Trust & Clearing Corporation (“DTCC”) that may assist firms in applying interconnectedness analysis to their respective organizations or other analytical endeavors.

Direct and Indirect Financial Connections:⁹

• Lending relationship between two firms
• Derivatives contract between two firms
• Trading relationships between firms and financial market infrastructures
• Links between various financial market infrastructures
• Liquidity providers
• Exposure to common assets/securities
• Investment counterparties
• Mark-to-market losses
• Margin calls and haircuts on collateral
• Intra-financial system liabilities
• Intra-financial system assets
• Shadow banking activities

Operational Connections:

• Vendors and other critical third-party suppliers
• Settling banks
• Clearing banks
• Custodians
• Data providers

Basel Committee on Banking Supervision

Global regulators such as the Basel Committee on Banking Supervision have agreed on five categories (listed in the following Table 15.1) for measuring the systemic importance of Global Systemically Important Banks (G-SIBs). Subsequently, the Fed adopted this methodology to determine which U.S. banks are G-SIBs. The methodology gives an equal weight of 20% to each of the five categories of systemic importance, which are: size, cross-jurisdictional activity, interconnectedness, substitutability/financial institution infrastructure, and complexity. For purposes of this chapter, we focus primarily on two of these five categories: (i) interconnectedness, which attempts to measure a G-SIB's financial interconnectedness; and (ii) substitutability, which focuses on critical services provided by the G-SIBs to the industry. See Chapter 9 for details and a listing of current G-SIBs.

1. Size: Measured through total exposures. This is a more comprehensive measure than total assets, and it is measured consistently across jurisdictions, whereas the measurement of assets varies with national accounting standards.
2. Interconnectedness: Measured through a bank's intra-financial system assets, intra-financial system liabilities, and total securities outstanding.
3. Substitutability: The extent to which a bank provides important financial infrastructure that would be difficult to replace if the bank were to fail. It is measured through payments activity, assets under custody, and underwriting activity.
4. Complexity: Measured through a bank's over-the-counter derivatives activity, trading and available-for-sale assets, and holdings of less liquid assets.
5. Cross-jurisdictional activity: Measured through a bank's foreign claims and total cross-jurisdictional liabilities.

According to a detailed systemic risk survey conducted jointly by Deloitte and SIFMA (June 2010), the factors identified by Basel are largely in line with the views of the broader market. The survey found that factors typically included in a definition of systemic risk include: size (of an individual financial institution or a combination of smaller firms); interconnectedness; and the potential for underlying issues, such as complexity and leverage, exposure concentrations, erosion of market practices, marketplace bubbles, and the potential of a failure (of a systemically important firm or group of firms) to serve as a trigger event that may impact the broader real economy. When considering the complexity of the global financial system, it is essential that key drivers of systemic risk are identified. Knowing these drivers will enable a systemic risk regulator to identify, measure, and monitor systemic risk events across the entire financial services system.

Office of Financial Research

The OFR describes interconnectedness as the failure of a bank to meet payment obligations to other banks, which can accelerate the spread of a financial system shock if the bank is highly interconnected. The OFR has adopted Basel's five-part methodology for assessing a bank's degree of systemic importance.

One of the OFR's many different measures of the systemic risks posed by large banks includes a bank's total claims on the financial system, its total liabilities to the financial system, and the total value of debt and equity securities issued by a bank. For the first two of these indicators, the financial system includes banks, securities dealers, insurance companies, mutual funds, hedge funds, pension funds, investment banks, and central counterparties.

Table 15.2 illustrates the OFR's annual ranking of G-SIBs' systemic importance based upon the five equally weighted measures described earlier.¹¹

Another measure of a bank's systemic risk performed by the OFR includes analysis conducted of the public sections of the eight U.S. G-SIBs' living wills. To minimize the risk of costly bank bailouts in the future, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) requires every bank holding company with $50 billion or more in assets to prepare a resolution plan, or living will. Living wills describe how a failing bank would wind down. Each of the individual living wills for the eight U.S. G-SIBs differs somewhat in terms of format and content. However, most contain enough standardized information to allow the OFR to conduct analysis across banks and across time. One such category is called “complexity” and measures the number of core business lines, material legal entities, and critical operations of each bank, which can serve as measures of complexity and provide an indication of the ease by which each bank could be resolved.

The next category of complexity measured by the OFR is a study of the layers of corporate structure within the U.S. G-SIBs. According to the OFR, multiple layers of corporate structure can make orderly resolution of a bank more difficult. In this study, the average subsidiary is 4 to 6 layers below the parent and in some cases 20 layers below.

Another measure employed by the OFR is called intra-firm interconnectedness, which quantifies the total number of internal connections with other material legal entities within each organization. It also measures the total number of membership each G-SIB maintains in financial market utilities (FMUs), which provide payment, clearance, and settlement services to banks. This is deemed important as FMUs require G-SIBs to post collateral to them on a regular basis, and they also maintain certain early termination rights, both of which can complicate the resolution process.

CPMI IOSCO Principles

As covered in Chapter 8 of this book, CPMI IOSCO publishes a set of 24 principles for financial market infrastructures which recognizes that interconnectedness among FMIs may foster knock-on effects throughout the financial system in a stress event, thereby impacting participants and markets across the FMIs. Specific examples include:

• Principle 3: Framework for the comprehensive management of risks directs FMIs to regularly review the material risks they bear from and pose to other entities because of interdependencies (such as other FMIs, settlement banks, liquidity providers, and service providers) and develop appropriate risk management tools to address these risks.
• Principle 20: FMI links directs FMIs to identify, monitor, and manage sources of risk arising from the links it has established with other FMIs. An example of an FMI link is a connection established between central securities depositories (CSDs) for purposes of enabling participants of one CSD to access the services of and securities maintained in another CSD.

The Depository Trust & Clearing Corporation

In this section, we will explore an approach proposed by DTCC that financial firms may employ to initiate their own risk analysis, consisting of the following elements:¹²

• Make a comprehensive inventory of external entities on which your firm relies.
• Determine which interconnections are critical to your business.
• Quantify your critical interconnections, if practical.
• Assess in detail how an impaired interconnection could affect specific areas of the firm.
• Identify highly interconnected entities and assess the potential impact of their failure on your business entity.
• Manage exposures to interconnected entities holistically.
• Cooperate across departments.
• Take a gradual approach.

Let's explore each of these elements.

Make a comprehensive inventory of external entities on which your firm relies: Most financial institutions rely on adequate funding and liquidity, credit, access to markets and market infrastructures, as well as the provision of reliable and timely data—among many other processes. External entities that provide or support these services represent external interconnections to your firm. Given that insolvencies occur at a legal entity level, intragroup dependencies between distinct legal entities should also be represented as external interconnections.

Determine which interconnections are critical to your business: Use the following criteria to assess the level of criticality of your interconnections:

• Severity: How severely might an impaired or failed interconnection impact your firm, its clients, shareholders, regulators, or other stakeholders?
• Time sensitivity: How long would it take for a failed interconnection to have a considerable impact?
• Substitutability: How easily and quickly could you switch to a suitable replacement?

Quantify your critical interconnections if practical: Quantifying interconnections can be useful as a straightforward and objective way to aggregate, rank, and assess the related risks. It may also help prioritize risks and monitor their evolution over time. That said, operational interconnections with providers of data and other financial services may be harder to quantify than those with borrowers/lenders, trade counterparties, and funding providers. Therefore, interconnections should be quantified as appropriate depending on the circumstances and the effort involved in doing so.

Assess in detail how an impaired interconnection could affect specific areas: Depending on the circumstances, the failure of an interconnected entity may cause a credit or trading loss, but it may also cause a loss of revenue, affect funding, or have a different type of impact altogether. In assessing the effect of an impaired or failing interconnection, it may be more appropriate to consider peak volumes and associated risks, rather than average values.

Identify highly interconnected entities and assess the potential impact of their failure on your business entity: While the analysis described earlier is valuable, its real power lies in the aggregation of risks across areas that may be simultaneously affected by a single failure. The failure of a highly interconnected entity may have a combined effect—for instance, by simultaneously causing credit losses while affecting your firm's funding as well as your access to other financial services. While each of these impacts may be manageable individually, their combined effect may not be.

Manage exposures to interconnected entities holistically: Given the potential combined effect of the failure of a highly interconnected entity, it is important to manage the associated risks holistically. Among other things, that means that concentration risk should be managed not only by assessing the relative exposures to funding, trading, credit, and other counterparties in isolation, but also in its entirety across these various areas. Stress tests and scenario analyses can be very valuable in this respect, provided they explicitly incorporate these forms of interconnectedness.

Cooperate across departments: Organize cross-functional risk reviews and discussions to make interconnectedness awareness an integral part of your organization's risk management culture. Interconnectedness analysis should complement other disciplines, not replace them.

Take a gradual approach: As is the case for other risk management disciplines, interconnectedness analysis is an iterative process—start small and expand gradually. Periodically assess in which areas you may need to become more sophisticated.