K C Chakrabarty: Systemic risk assessment - the cornerstone for the
pursuit of financial stability
Inaugural address by Dr K C Chakrabarty, Deputy Governor of the Reserve Bank of India, at
the International Seminar on "Operationalising tools for macro-financial surveillance: country
experiences", organised by the Financial Stability Unit (FSU), Reserve Bank of India,
Mumbai, 3 April 2012.
* * *
Assistance provided by Ms Dimple Bhandia in preparation of this address is gratefully acknowledged.
First of all, let me extend a warm welcome to all of you to this vibrant city called Mumbai. We,
in India, often call this city the Maximum City - it is undeniably, like the punch line of the
advertisement of a global bank, a city which never sleeps. I hope all of you also take
maximum advantage of your stay here in respect of the deliberations during the seminar and
of the tremendous opportunities for entertainment that this city offers!
The subject of this conference - "Operationalising tools for Macro-financial surveillance" is
indeed very topical. Across the globe, in the wake of the financial crisis, efforts are underway
to alter institutional arrangements to explicitly pursue financial stability as a policy objective
and to put in place a framework for the macro-financial surveillance of the financial system.
At the core of any robust framework for macro-financial surveillance lies a framework for the
identification and assessment of systemic risks. A deeper understanding of systemic risks is
the cornerstone of the policy toolkit for pursuit of financial stability and hence this is the
subject I thought I would dwell upon as I flag off the deliberations during this seminar.
Abstracting from details, the prevalent policy framework prior to the crisis focussed on two
main tenets - a monetary policy focus for achieving price stability and a microprudential
focus for ensuring the health and stability of individual institutions. The crisis turned the
foundations of existing policy frameworks on its head and focussed sharper attention on
systemic risk assessment and on crisis prevention.
Systemic risks - Definition
So what are systemic risks. There is no commonly accepted definition of systemic risk at
present. The precise meaning of systemic risk is ambiguous; it can mean different things to
different people and different definitions have been attempted. The European Central Bank,
for example, defines systemic risks as "risk that financial instability becomes so widespread
that it impairs the functioning of a financial system to the point where economic growth and
welfare suffer materially"1
Over a decade ago, a G10 Report on Consolidation in the Financial Sector (2001) suggested
a working definition, which arguably remains relevant even today: "Systemic financial risk is
the risk that an event will trigger a loss of economic value or confidence in, and attendant
increases in uncertainly about, a substantial portion of the financial system that is serious
enough to quite probably have significant adverse effects on the real economy."
More recently, following the work of the IMF, FSB and BIS for the G202, systemic risk has
been defined as "a risk of disruption to financial services that is caused by an impairment of
all or parts of the financial system and has the potential to have serious negative
consequences for the real economy."
In another case, systemic risks have been defined in terms of a lower "normal" as the risk of
a phase transition from one equilibrium to another, much less optimal equilibrium,
characterized by multiple self-reinforcing feedback mechanisms making it difficult to reverse3.
These are just few of the definitions of systemic risk which abound in literature and amongst
policy makers, though a universally accepted definition remains elusive. Notwithstanding,
there are several perspectives from which systemic risks can be viewed depending on how
the risks originate, how they affect and how they are transmitted across different institutions,
markets, market infrastructure and the real economy. Understanding these different facets of
systemic risks is central to the understanding of systemic risks per se.
One perspective is to describe systemic risk as the risk of experiencing a strong systemic
event i.e. a "big" shock that simultaneously and significantly effects most or all of the
domestic economy. The risks of such a "macro" shock could emanate from an exogenous
shock or could emerge endogenously - from within the financial system or from within the
economy at large.
Viewed from another perspective, systemic risks can be regarded as the risk of contagion.
This is typically defined as the domino effect of a idiosyncratic problem affecting one
institution then affecting other institutions / markets in the cross section. Thus, the failure of a
large bank could cause distress to other institutions connected to it directly or indirectly in a
chain or "knock on" reaction. Systemic risks, viewed from this perspective, were aptly defined
by Governor George of the Bank of England, way back in 19984:
"What we mean by "systemic risk" specifically is the danger that a failure of one
financial business may infect other, otherwise healthy, businesses. This could
happen in either of two ways: first through the direct financial exposures which tie
firms together like mountaineers, so that if one falls off the rock face others are
pulled off too; and second, by contagious panic which sweeps everyone off the
mountain side like an avalanche."
Another facet of systemic risks arises in the context of the build up of widespread imbalances
in the system and could, inter alia, take the form of credit booms, build up of similar third
party exposures, and of maturity and leverage mismatches. When these imbalances unravel,
as they must at some stage, they adversely affect a large section of the financial system. The
more similar the imbalances across institutions, the greater will be the systemic impact of the
"correction".
Evolution of systemic risks
While the recent global financial crisis has brought the concept of systemic risks to the centre
stage, one only has to look back into the history of financial crises to appreciate the fact that
each of these crises were triggered by systemic disturbances in one form or the other. But
while the concept of systemic risks is not new, the concept has evolved over the decades,
growing in complexity and becoming more pervasive over time.
Till the mid-1980s, systemic risks essentially related to systemic disturbances that arose from
bank lending and affected the banking sector. Over the years, different dimensions of
systemic risk were revealed as markets grew and became more integrated; banks' reliance
on funding markets grew; financial intermediation spread from banks to non-banking financial
companies; financial and technological innovation fostered the growth of markets for
derivatives and structured products; and market infrastructure developed with the
introduction of multilateral netting, central counterparty arrangements, etc.
The concept of systemic risk concomitantly broadened along several dimensions to include
non-banks along with banks; to include different kinds of financial activities and exposures in
addition to traditional lending and to focus on interdependencies between market participants
as well as their exposures to common risk factors, including institutions' reliance on core
parts of market infrastructure5.
Appropriately, in this context, is an observation made in an IMF Staff Position note6 in
respect of the financial system prior to the crisis:
"Financial systems and transactions became distorted along several dimensions,
that is, financial system grew highly complex, opaque, over-leveraged and
heavily interconnected; liquidity risk was higher than recognized; large complex
institutions enjoyed the benefits of being "too important to fail" and financial
intermediation has increasingly shifted to the shadow banking sector."
The two dimensions of systemic risks
Cutting across specificities, the different perspectives of systemic risks can be grouped into
two dimensions - a time dimension and a cross sectional dimension.
The time dimension of systemic risks, or what is more commonly known as procyclicality,
relates to the progressive build-up of aggregate risk over time. The second dimension of
systemic risk - common exposures/interlinkages in the cross section focuses on how risk is
distributed within the financial system at any given point in time.
An analytical framework to identify systemic risks must operate in both dimensions.
Assessing systemic risks
As I mentioned earlier, the international financial crisis has refocused policy attention on
systemic risks and forced us all to think much harder - about what systemic risk means, how
it can be measured and what implications does it have for policy. There is a general
consensus that systemic risk was underestimated across the board before this crisis and
also that there is a pressing need to assess and evaluate such risks on an ongoing basis.
Considerable efforts are ongoing, both internationally and amongst systemic regulators
domestically, to develop a framework for assessing systemic risks and for potentially
predicting systemic events. The objective is to put in place an assessment infrastructure
which is capable of raising "flags" i.e., signalling trends that could make markets or countries
vulnerable to unanticipated events.
With the increasing realization that systemic risks per se are generally complex, very often
opaque, and always multifaceted, came the realization that the identification of such risks is
also far from straightforward. It was felt that in order to see "both the forest and trees"7
effectively; there is a need to have a wide range of measures and tools covering different
aspects of systemic risks. The objective is to develop a diagnostic tool that simultaneously
traces the development of macro-financial conditions which pose risks to financial stability
and identifies point in time risk conditions, while also assessing the joint impact of all these
risk factors on systemic stability.
A host of quantitative models attempting to incorporate one or more of these elements have
emerged in the policy and the academic arena since the crisis. The models variously attempt
to quantify the contagion risks in the financial system, to capture distress dependencies
amongst financial institutions or to measure the systemic importance of financial institutions.
Others attempt to develop early warning indicators while yet another class of models aim to
utilize aggregate information from segments of the financial system to develop coincident
indicators of systemic stress. Yet another set of models - the macro stress tests - try to
measure the resilience of the financial system or its key components to various stress factors
by quantifying the link between macroeconomic variables and the health of either individual
financial institutions or the financial sector as a whole.
The emerging models vary in statistical techniques used as well as in the type of available
information used. They range from general equilibrium to game-theoretic models and can be
either comparative static models or dynamic models. Some models attempt to assess
systemic risks using credit risk conditions while others rely on data from financial markets.
The development of these models is in a nascent stage and the learning curve is very steep.
Identifying and assessing systemic risks requires a broad and deep information basis and a
wide range of tools to process the relevant information as well as analytical tools and
techniques. While fertile research on these issues is underway, especially since the crisis,
the progress has been slow given the large mass of uncertainties - both "known" and
"unknown". Let me briefly highlight some of these.
First, while the notion of systemic risks is clear, there is, as yet, as elucidated earlier, no
universally accepted definition of systemic risk. Further, there is little agreement amongst
regulators and academicians about the best way to operationalise a framework for the
identification and measurement of systemic risks. The associated issues are further
complicated by the fact that systemic risks are inherently unobservable. The main factors
resulting in systemic risks - contagion risks, imbalances, etc., are also difficult to observe
and/or quantify. Adding to the difficulties are the facts that interconnections between financial
institutions and correlations of risk factors often tend to behave differently during "peace"
times and during times of "crisis". The emergence of "wrong-way" risks in derivative contracts
wherein counterparty exposures reverse signs under stressed scenarios is a case in point. A
framework for assessment of systemic risks would therefore need to infer or "reverse
engineer" assessments about the build up of systemic risks.
Second, is the now well debated issue of data gaps. To state that better data is required to
support all the critical initiatives underway to identify systemic risks and to put in place a
robust early warning framework is perhaps to state a truism. Regulators require better data at
both the national and international level to ensure that they can recognise and address the
build up of risks in a timely manner. Absent such improvements, new macroprudential
processes will operate in an environment characterised by major gaps in information, and will
remain at significant risk of missing, yet again, emerging vulnerabilities that threaten global
financial stability.
In the recent crisis, the lack of timely and accurate information has arguably proved very
costly. The current data architecture lags well behind the forces driving increased complexity
and globalisation of financial systems, institutions and markets. There is currently little
consistent information on the major bilateral linkages between large financial institutions, and
on their common exposures to, and funding dependencies on, countries, sectors and
financial instruments. Again, there are significant data gaps on funding risks and
dependencies, on leverage, on maturity and liquidity mismatches and on risks exposures
arising from off balance sheet activities. Adding to these are the difficulties in collecting
information from non-bank intermediaries and unavoidable reporting lags.
Associated with the need for plugging of data gaps, is the need to address issues related to
the quality of data. The general concerns about the quality of historical data which are used
in models for the assessment of systemic risks, means that even with a long time series of
data available for some of the models/ indicators for the assessment of systemic risks, it may
be difficult to identify incipient risks/ crises with precision.
There are efforts underway internationally on putting in place a framework to collect, pool
and share relevant data on global financial institutions that would provide authorities with a
clear view of the financial network and a powerful monitoring tool to assist them in their
supervisory and macroprudential responsibilities. However, it appears unlikely that these
informational barriers can be overcome rapidly, and in the interim, assessment of systemic
risks will remain, at the most, a "best" estimate. The role of judgement, therefore, for the
assessment of systemic risks will remain crucial, for the time being, at least.
Third, even though an extensive analytical framework for identification of systemic risks is put
in place, there are challenges in putting together all the "flags" being raised i.e. in connecting
the dots. For instance, many analysts cautioned against "risk concentrations" in U.S.
housing, but there were few suggestions prior to the crisis that this could lead to dire
macroeconomic consequences, particularly at a global level. The risks are even higher
because systemic risk assessment remains an inexact science with considerable scope for
missing signals and raising false alarms, which makes it difficult to spur concrete policy
action especially as such actions often involve taking away the proverbial punch bowl just as
the party is going strong.
These challenges do not imply that technical work on measuring and monitoring systemic
risk should not go forward; only that the task ahead is as large and time consuming as it is
critical. There is, therefore, a need that the momentum set in motion in the wake of the crisis
be maintained. Promising work on measuring systemic risk is, in fact, now in progress - at
international institutions such as the IMF, the Basel Committee for Banking Supervision and
the Financial Stability Board; in central banks and other systemic risk regulators; and in the
academic world; indeed in each of the institutions which all of us collected here today
represent. I had observed that the learning curve with respect to the identification and
assessment of systemic risks is steep. However, treading on these unchartered territories
can become easier and swifter through sharing of experiences and through greater
collaborations. This seminar, a conglomeration of operational mangers/experts on financial
stability management across the globe, I hope, will be a giant step forward in this direction.
The Indian experience
Before I conclude, let me spend a few moments in outlining the framework in place in India
for macroprudential surveillance and for the pursuit of financial stability.
In India, prior to the crisis, no agency was explicitly granted a mandate for financial stability
though the Reserve Bank acted as the implicit systemic regulator for the country. In 2004,
well ahead of the crisis, the Reserve Bank formally added financial stability as a policy
objective, in addition to price stability and growth, in view of the growing size and importance
of the Indian financial sector. The broad compulsions of financial stability have, in fact,
underlined all major policy initiatives of the Reserve Bank especially since the balance of
payment crisis of the early 1990s - much ahead of the articulation of financial stability as an
objective.
The Reserve Bank has, over the years, attempted to address both aspects of systemic risks
- the time dimension (which essentially refers to procyclicality) and the cross sectional
dimension (which refers to interconnectedness) within a macroprudential framework, without
christening these policies as macroprudential policies. Organisational developments within
the Reserve Bank, over the last couple of decades, have also reflected the Bank's
commitment to maintaining financial stability. Two separate Committees of the Reserve
Bank's Central Board, viz., the Board for Financial Supervision (BFS) and the Board for
Payment and Settlement Systems (BPSS), are responsible for focused regulation and
supervision of financial institutions regulated by the Reserve Bank and the payment and
settlement infrastructure, respectively. Towards ensuring a coordinated approach to the
supervision of the financial system, a High Level Coordination Committee on Financial
Markets (HLCCFM) was functional since 1992 with the Governor of the Reserve Bank as
Chairman, and with representations from the sectoral regulators and the Finance Ministry.
The HLCCFM has now been replaced by the Sub-Committee of the Financial Stability and
Development Council (FSDC). The FSDC is an inter agency forum set up in the wake of the
crisis with a specific mandate, inter alia, for systemic financial stability. A Sub Committee of
the FSDC, headed by Governor, Reserve Bank, functions as the primary operating arm of
the FSDC. The Sub Committee has also set up a dedicated Crisis Management Framework
to facilitate the handling of crisis situations, should they arise.
Post the crisis, in July 2009, the Reserve Bank set up a Financial Stability Unit (FSU) with a
mandate to, inter alia, conduct effective macro-prudential surveillance of the financial system
on an ongoing basis to enable early detection of any incipient signs of instability. With the
establishment of the FSU, the Reserve Bank started publication of half yearly Financial
Stability Reports (FSRs) - which now forms a critical tool for the Reserve Bank in its attempt
to communicate the potential systemic risks facing the financial system to all stakeholders of
the system. Somewhat unique, in the Indian context, is the fact that our FSRs are discussed
and deliberated upon in the meetings of the Sub Committee of the FSDC which enables the
views of all the sectoral regulators and the Government on risks to systemic stability to be
incorporated in the FSR. The FSR, thus presents, a holistic assessment of the risks to the
stability of the Indian financial system.
A number of initiatives have been taken to improve the financial stability analytics to take full
account of the different sources of systemic risk. A series of indicators and indices have been
developed to assess the health and resilience of the financial system on an ongoing basis.
Let me discuss some of these very briefly as I am aware that there is a detailed presentation
which will be made on these initiatives during the course of this seminar.
Stability indicators and maps
Stability indicators and maps represent coincident indicators of systemic stress in the
financial system. They are constructed by aggregating information from different segments of
the overall financial system and encapsulating the information in a single statistic which
measures the current state of instability in the financial system.
The Financial Stability Map and Indicator in India depict the overall stability condition in the
Indian financial system. The Financial Stability Indicator is based on the three major
segmental indicators namely, the Macro Stability Indicator, the Financial Markets Stability
Indicator and the Banking Stability Indicator. Each of these indicators is in turn based on
contemporaneous developments in a number of risk factors relevant to the respective
segments. The Financial Stability Indicator is derived using a simple average of macro,
financial markets and banking stability indicators.
Recognising the importance of fiscal health for financial stability, separate Fiscal Vulnerability
and Fiscal Stress Indices have been developed to respectively assess inter-temporal
changes in the vulnerabilities arising from the fiscal conditions and to indicate the likelihood
of crisis like events. A Systemic Liquidity Indicator attempts to gauge the degree of stress in
domestic liquidity conditions and to establish time frames for potential extreme events.
Banking stability measures and Expected Shortfall
Banking stability measures, a cross-sectional econometric framework, capture the distress
dependence among financial firms in a system using stock price data and thereby estimate
the extent to which individual financial institutions contribute to overall systemic risk. These
measures have been used in the Reserve Bank to measure the systemic importance of our
banks through three different, yet, complementary perspectives; viz., (i) common distress of
the financial institutions in a system, (ii) distress between specific institutions, and (iii)
distress in the system associated by distress in a specific institution. A Banking Stability
Index (BSI) is calculated, which captures the expected number of banks to become
distressed given that at least one bank has become distressed. Separate Toxicity and
Vulnerability Indices capture distress between specific institutions while the Cascade Effect
attempts to measure the distress in the system associated with the distress of a specific
institutions. This method is also being used for estimation of Expected Shortfall of assets of
banking system, in a bid to assess what would happen to a bank in an environment of a large
negative shock.
Network Analysis
The intertwined nature of modern financial systems was amply revealed by the recent
financial crisis. Such interconnected and complex financial systems make it particularly hard
to predict the manner in which the cookie will crumble when distress situations emerge.
Network models attempt to capture the intricate structure of linkages between financial
institutions by depicting the causal chains between nodes. The contractual obligations
between financial institutions comprise the bilateral flows of payoffs and determine the extant
network structures. An actual crisis with default of counterparties engenders system wide
feedback loops and can trigger further contingent claims such as on derivatives obligations
and also large losses at default due to collapse in asset markets.
The techniques of network modelling have been used to develop a bespoke financial network
analysis and contagion stress testing platform for the Indian financial system. The analysis
primarily looks into the interconnections that exists between different institutions in the
financial system and tries to identify build up of systemic risk. Graphical network
representations have been developed which are being used to assess the degree of system
level interconnectedness and the stability of the system. A contagion simulator helps in
assessing the possible loss of capital to the financial system due to a random failure of one
or more financial institutions.
Macro financial stress tests
During the recent financial crisis, macro financial stress tests were used by some central
banks as a policy tool to restore market confidence and improve market functioning. Such
stress testing addresses the need to assess the impact of the system wide nature of risk
drivers. Macrofinancial stress testing, quantifies the link between macroeconomic variables
and the health of financial institutions and the financial system, to measure the resilience of
the financial system to various stress factors. In India, we conduct two sets of macro stress
testing exercises at regular periodicities. The first set of stress testing exercises use
multivariate regression tools to evaluate the impact of a particular macroeconomic variable
on the asset quality of banks and its capital adequacy ratio. The second set is based on a
vector autoregressive (VAR) model which assesses the impact of the overall economic
stress situation on the asset quality and capital adequacy of the banking system taking into
account the feedback effect of the macroeconomic performance of the economy on banks'
stability.
Concluding remarks
Let me finish with a final observation. The events of the last four to five years have placed
pursuit of financial stability at the centre stage of policy makers domestically and
internationally. The objective is to put in place a framework for macrofinancial surveillance
which identifies, measures and manages systemic risks, as and when they occur, with a view
to effective crisis prevention. The task is exciting. The challenge is to put in place a set of
riskometers which help identify which of the myriads things that could go wrong in the
financial system and the broader macro economy. For this, we will need both "thermometers"
and "crystal balls" - thermometers to determine risk indicators that, metaphorically, a policy
maker can plug into the financial system to read off its "heat"; and crystal balls to devise
forward looking early warning indicators that - to some extent - permit a glimpse into the
future of financial stability conditions8.
The next two days at hand, as I see from the schedule, will be quite hectic. But, I am sure
that the deliberations in the Seminar will prove to be extremely useful for all the participants
as it should tend to create an inventory of hands-on tools to manage systemic financial
stability. I wish you all an enjoyable stay in Mumbai.