Systemic risk thinking ought not to stop at financial firms. Certain non-financial firms are special as well
The 2008 crisis brought a fresh focus upon “systemic risk". Before the crisis, regulators aimed to lower the chances that a financial firm will fail. But that did not ensure the safety of the entire financial system. One element of the problem was that the failure of certain firms had consequences beyond themselves. These were the systemically important financial institutions (SIFIs). Systemic risk management focuses on treating these firms differently in two ways. First, micro-prudential norms for SIFIs must be set in such a way that these firms have lower chances of failure than others. Second, there must be well thought out and special mechanisms for resolution of these firms when they get into distress.
In India today, the Financial Stability and Development Council (FSDC) is tasked with systemic risk monitoring. In the new draft law proposed by the Financial Sector Legislative Reforms Commission, the work of FSDC includes identifying SIFIs (section 295), in a transparent manner (section 299), and enhanced micro-prudential regulation for SIFIs (section 141 and 261). When a version of this draft law is enacted, it will require corresponding institutional capacity to carry out this mandate.
Researchers have developed an array of statistical tools to identify SIFIs. Simple measures include identifying SIFIs by size and inter-connectedness. For example, Lehman Brothers was extremely inter-connected during the crisis. Some methods are based on how much the stock price of one firm affects another. Others are based on the value at risk (VaR) concept such as the “marginal expected shortfall" (MES) and the “conditional VaR" (CoVaR). However, each method identifies different firms in the list of SIFIs. In a recent research paper, “A systematic approach to identify systemically important firms" (http://goo.gl/qRDMhe), we analyse Indian data and offer two innovations. The first innovation lies in drawing information from different methods into a single measure called the systemic risk index (SRI) which yields an unambiguous ranking of firms as SIFIs.
We use historical Indian data to calculate and use SRI to identify the list of ten SIFIs every quarter from 2006 to 2012, with interesting results. For instance, while both ICICI Bank Ltd and State Bank of India (SBI) had relatively similar SRIs in the April-June 2008 quarter, the gap widened in the next quarter. The lower SRI for SBI may have been a reflection of the “flight to quality" of capital in the form of deposit movement from the private to the public sector banks during a phase when public confidence in private banks had fallen dramatically.
The second innovation is that we calculate the SRI for non-financial firms as well. Generally, systemic risk analysis focuses only on financial firms, as it is felt that only financial firms can be so inter-connected that their failure imposes important ramifications on the overall economy and society. However, it is possible that the failure of a big (non-financial firm) borrower could bring down a few banks and, in turn, have further consequences. For instance, it is worth asking if the failure of Maruti Suzuki India Ltd could bring down an entire ecosystem of firms that are connected to Maruti?
In order to explore this conjecture, we extend our analysis to cover all firms. Non-financial firms with large SRI values could be termed as systemically important non-financial firms (SINFIs). In the Indian economy, we find several non-financial firms in the top SRI ranks. For example, real estate and infrastructure firms such as DLF Ltd and GMR Infrastructure Ltd have high SRIs from 2009 onwards. DLF had the third highest SRI in October-December 2009, and has been in the list of top 20 firms since then.
This suggests that systemic risk thinking ought not to stop at financial firms. Certain non-financial firms are special; their failure can have substantial consequences for the economy. This raises questions about what financial regulation can do about these risks, as financial regulators cannot ask non-financial firms to take on reduced risk. However financial regulators are not entirely powerless in the presence of SINFIs. While lending to or taking over-the-counter exposure to an SINFI, a financial firm can be asked to set aside higher amounts of capital.
A key strength of SRI is that it uses multiple measures of systemic risk. In the future, new methods for identifying SIFIs will undoubtedly arise since a sophisticated financial system produces a great deal of valuable information, and SRI will be able to incorporate these as well. As an example, actively traded corporate bonds and credit default swaps generate new information about credit risk. When India undertakes financial reforms and more markets become active, new information will become available. These new data resources will also create new measures of systemic risk. All these developments can then be readily incorporated into SRI.
Systemic risk analysis is a frontier of financial regulation. It has become the fourth pillar of financial policy along with the traditional pillars of consumer protection, micro-prudential regulation and resolution. SRI helps the analysis by identifying SIFIs, as well as by pointing out the possible role of SINFIs in contributing to the systemic risk of the economy.
Rohini Grover and Susan Thomas are, respectively, research scholar and assistant professor at the Indira Gandhi Institute for Development Research.