Correlatedness and interconnectedness risks in bank failures

The conventional wisdom on systemic risk in banking is that the size of institutions is the risk propagation mechanism. Accordingly, the failure of a very large financial institution, who is one of the largest counterparties or whose holdings are likely to constitute a significant share of the market for a particular financial instrument, pose prohibitive risks. Regulators across the world have therefore designated certain institutions, based on their asset size, as “systemically important financial institutions” (SIFIs) who pose a too-big-to-fail (TBTF) risk.

In a recent paper, two economists from the Minneapolis Fed, refute this conventional wisdom, arguing that policy makers intervene to rescue big banks “not simply because they are too big” but “because the potential systemic costs resulting from the bank failure are considered too big”. They point to similarity in risk profiles of asset portfolios held by the institutions, or correlatedness, as the risk propagation mechanism. Regulators intervene when the “aggregate assets of threatened financial institutions are sufficiently large to represent a substantial risk to the broader economy should those institutions fail”. They write,

Proponents of bank size limits as a solution to the moral hazard problem induced by bailouts implicitly assume that the combined portfolio of a collection of smaller banks will be less risky than the portfolio of a large bank of equivalent size. This assumption is unwarranted, we contend. In fact, the very prospect of government bailouts creates an incentive for banks—regardless of size—to take on highly correlated risks, which, in turn, raises the likelihood of financial crisis. … the anticipation of bailouts creates incentives for banks to herd in the sense of making similar investments. This herding behavior makes bailouts more likely and potential crises more severe.

So their prescription for regulators,

What truly matters to the well-being of the broad economy is not the risk profile of any given bank portfolio, large or small, but the risk profile of the entire banking system. Regulators therefore need to understand what kinds of events are likely to threaten a significant fraction of the aggregate assets of the entire banking system, rather than concentrate (as current policies do) on a limited number of large banks. In particular, they must focus on how the portfolio of the entire banking system is exposed to such events. Regulation of a given bank then should deal with whether that particular bank’s behavior is mitigating or aggravating the risk exposure of the entire system. In brief, we need stress tests of the entire banking system, not just of individual banks.

While the authors are right to point to the importance of correlatedness over size, they overlook the role of another contributor, interconnectedness in assets or liabilities among institutions. Accordingly, in the US, AIG’s failure to honor its over-the-counter CDS obligations threatened a large number of institutions, especially pension funds, holding that asset. Similarly, the failure of Lehman froze the money market mutual funds which had investments in institutions like Lehman. Taken together, correlatedness and interconnectedness in asset/liability portfolios are a more reliable measure of systemic risk that mere size. 

Regulators ought to focus on measures of correlation and interconnection and put in place counter-cyclical macro-prudential measures, central clearing houses for standardized OTC derivatives with higher and variable margin requirements, and greater information sharing on exposures of individual institutions to mitigate the risks arising from them. Merely focusing on size would be tantamount to missing the woods for the trees.