Co-written by Rob Engle, Nobel Laureate and Director of the Volatility Institute at NYU Stern School of Business
The 2008 financial crisis highlighted the threat of systemic risk: the risk generated by the interconnectedness of financial institutions (FIs). It also emphasised the importance of monitoring FIs that are considered ‘too big to fail’. As a result, financial regulators resolved to monitor the capital levels of Systemically Important Financial Institutions (SIFIs) to make sure they could cope with the risk that a future stress event could cause.
In July 2013, the Financial Stability Board published a list of systemically important banks and insurers based on a range of criteria including size, complexity, and interconnectedness. However, these underlying indicators are only backward-looking, whereas systemic risk is also driven by dynamic and forward- looking factors. New analytical tools based on publicly available market and accounting data are a useful complement to capital requirements that regulators propose.
What is SRISK?
SRISK is a measure developed by the Volatility Institute of the NYU- Stern School of Business, which provides insight into the direction and magnitude of stress events. SRISK measures how much capital an FI would need to raise in order to operate normally when faced with a crisis event (defined as a percentage drop in the global equity market over a certain period). A high value signifies elevated risk in terms of capital shortfall. Each individual firm’s value is determined by its size, leverage and level of interconnectedness, and, in aggregate, SRISK represents a stress test on the financial system.
SRISK in action
Several remarkable political events transpired in the second half of 2016:
- Britain chose to leave the European Union
- Donald Trump won the U.S. presidential election
- The Italians voted ‘No’ in the constitutional referendum
The remaining 2017 political calendar, including the upcoming general election in the United Kingdom and the parliamentary election in France, demonstrates a pressing need to try to forecast the effect these stress events may have on the stability of financial markets. The following examples illustrate how applying SRISK’s methodology makes it possible to quantify the impact of these systemic risk events:
As the first phase of post-Brexit risk peaked at the end of July 2016, of all the financial institutions in Europe, it was the banks which experienced the highest SRISK values. Four of the top ten were British, three were French, and the others were German, Spanish, and Italian. There was greater diversity among U.S. FIs: the top ten consisted of five banks, four insurance firms, and one investment manager.Examining the change in SRISK value between May 2016, the month before the Brexit vote, and the end of July 2016, Lloyds reported the biggest jump, likely due to its level of exposure to the U.K. economy, but insurers AXA and Allianz, and financial services group ING also experienced significant increases. Analysis of the underlying indicators used to measure SRISK revealed the main drivers for these changes were a decrease in equity values and higher risk caused by market volatility and correlation.
Despite the increase in systemic risk following the Brexit vote, U.S. and European FIs showed resilience when coping with the fallout. However, continuing uncertainty around Brexit may generate systemic risk in the future, so it is worth monitoring closely. The General Election on June 8, 2017 will provide insight on the U.K. position going into the Brexit negotiations.
The U.S. presidential election
S&P Global Market Intelligence and the NYU V-Lab measured the change in SRISK values of FIs across the Americas between the end of October 2016 (days before the election) and the start of April 2017. Interestingly, the SRISK value fell for five of the top 10 firms due to a greater increase in market capitalisation relative to risk, while the market value for all 10 firms rose. This was in response to the prospect of deregulation and higher interest rates. Optimism and more risk taking after the election led to elevated trading revenues, possibly explaining why SRISK values for firms like JP Morgan declined significantly.
When the time period was shortened to a month after the election, the results were different. Seven out of the top 10 SRISK contributors were Latin American banks, with five from Brazil. However, by the start of April 2017, just one of these Latin American banks, Bank of Bradesco, was featured in the top ten. It could be argued that Trump’s election didn’t increase systemic risk among FIs in the Americas overall, although the possibility of deregulation in the financial services industry could lead to greater risk in the future.
The Italian referendum
SRISK values peaked a week after the referendum in December 2016 when the total capital shortfall in the Italian banking system hit $147.486 billion. Banca Monte dei Paschi di Siena ranked fourth in systemic risk among Italian firms, primarily due to its very high leverage. This Bank was the only FI to fail the last round of the European Banking Authority stress tests. The SRISK value for the rest of the top ten had improved by the end of the month.The capital shortfall had dropped to pre-referendum levels of $95.541 billion at the beginning of April 2017. However, the top three FIs-- Unicredit, Intesa and Assicurazioni Generali-- accounted for 74% of the total systemic risk in the country, although only Unicredit features on the Financial Stability Board’s SIFI list. While the Italian referendum didn’t have a major impact on systemic risk, the concentration of SRISK among three FIs may be a cause for concern from a domestic standpoint.
The recent and upcoming French elections
The results of the 2017 French Presidential election have significant implications for the global economy and, particularly, for the future of the European Union. Emmanuel Macron’s decisive win on May 7, 2017 may have reduced EU-related risk, as the goals of his administration are to:
- Liberalize the economy via streamlining labour laws and supporting small businesses
- Propose reforms for the governance of a more integrated Eurozone
- Unite a deeply divided country
However, the ability of Macron’s party, En Marche, to reform France will depend on the upcoming legislative election, which will take place in the country on June 11 and 18. Currently, the likelihood of winning an absolute majority for En Marche looks slim, so a coalition will probably be required. A divided government may notably impede Macron’s policy making and implementation, creating risks for France and the Eurozone.
Heightened economic uncertainty pending the outcome of the parliamentary election in June means that SRISK values are expected to change significantly during this period. Close monitoring of SIFI’s SRISK values could provide early indications of impending trouble for markets.
Global political uncertainty has highlighted a need for a forward-looking and dynamic tool, such as SRISK, able to quantify and provide insight into how FIs will contribute to systemic risk.
Our SRISK analysis of Brexit, the Trump election, and the Italian Referendum has shown a temporary but material increase of aggregate systemic risk in the wake of these events. However, with uncertainty remaining over Brexit negotiations, fluid U.S. policy, and the upcoming French legislative election, there is no doubt that SRISK has a valuable part to play in how these political events will impact market stability.
Thank you to our co-author: