HANDBOOK ON SYSTEMIC RISK

Edited by

J E A N - P I E R R E F O U Q U E University of California, Santa Barbara

J O S E P H A . L A N G S A M University of Maryland, College Park

g|| CAMBRIDGE |̂>P? UNIVERSITY PRESS

Contents

Contributors page xv Introduction xx

PART I: DATA: THE PREREQUISITE FOR MANAGING SYSTEMIC RISK 1 Data for Systemic Risk 3 H. V. Jagadish

1 Systemic Risk Information Requirements: Current Environment, Needs, and Approaches for Development 9 Edward T. Hida II I.1 Introduction 9 1.2 Purpose 10 1.3 Overview of types of systemic risk information required 10 1.4 Overview of the financial landscape 14 1.5 Observations on the state of financial data within financial

institutions 24 1.6 The challenge ahead for systemic risk information collection 28 1.7 Paths for collection of systemic risk information 30 1.8 Conclusions 32 Bibliography 36

2 Aligning Models and Data for Systemic Risk Analysis 37 Roger M. Stein 2.1 Introduction 37 2.2 Data aggregation and statistical inference: at what level of

detail should data be collected? 42 2.3 Data linkage 45

v

VI Contents

2.4 Aligning data and models 51 2.5 A brief comment on confidentiality, anonymization and the

role of consortia 56 2.6 Conclusion 60 Bibliography 62

3 Applying FpML 66 Andrew Jacobs and Marc Gratacos 3.1 Introduction 66 3.2 Inside FpML 72 3.3 Application to systemic risk 87 3.4 Conclusions 91 Bibliography 92

4 Data Integration for Systemic Risk in the Financial System 93 Arnon Rosenthal and Len Seligman 4.1 The systemic risk data integration challenge 93 4.2 Data integration task model 100 4.3 Standards for data exchange 102 4.4 Tools for reconciling heterogeneity 110 4.5 Research questions 115 4.6 Conclusions 120 Bibliography 121

5 Semantics in Systemic Risk Management 123 Mike Atkin and Mike Bennett 5.1 Dealing with semantics 125 5.2 Creating an ontology 132 5.3 Semantic technology applications 142 5.4 Operational data 144 5.5 Summary 145 5.6 The financial industry business ontology 147 5.7 FIBO and systemic risk 153 Bibliography 158

PART II: STATISTICS AND SYSTEMIC RISK Statistics and Systemic Risk John Liechty

161 163

Contents vii

6 Statistical Assessments of Systemic Risk Measures 165 Carole Bernard, Eike Christian Brechmann and Claudia Czado 6.1 Introduction and background on systemic risk 165 6.2 CoVaR 167 6.3 Marginal Expected Shortfall 170 6.4 Other tail dependence measures 173 6.5 Conclusions & alternative systemic measure 176 Bibliography 178

7 Regime Switching Models and Risk Measurement Tools 180 John Liechty 7.1 Introduction 181 7.2 Using regime shifting models with historical data 182 7.3 Using forward-looking data 187 7.4 Conclusions 188 Bibliography 189

PART III: MEASURING AND REGULATING SYSTEMIC RISK 191 Measuring and Regulating Systemic Risk 193 Viral V. Acharya

8 Measuring Systemic Risk 196 Viral V. Acharya, Christian Brownlees, Robert Engle, Far hang Farazmand, and Matthew Richardson 8.1 The Dodd-Frank Wall Street reform and Consumer Protec­

tion Act 198 8.2 Evaluation of the Dodd-Frank Act 203 8.3 NYU Stern systemic risk rankings 208 Bibliography 224

9 Taxing Systemic Risk 226 Viral V. Acharya, Lasse Pedersen, Thomas Philippon, and Matthew Richardson 9.1 Systemic risk and the financial crisis of 2007 to 2009 226 9.2 Regulating systemic risk 229 9.3 The Dodd-Frank Wall Street reforms and Consumer Protec­

tion Act of 2010 235 9.4 A tax on systemic risk 241 9.5 Summary 244 Bibliography 244

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247 249 251 254 266

270 278 281

283 285

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287 288 291 294 297 299 302 303

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306 309 316 323 324

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327 333 345

Contents

Analyzing Systemic Risk of the European Banking Sector Viral V. Acharya and Sascha Steffen 10.1 Introduction 10.2 Methodology - measuring systemic risk 10.3 Data and summary statistics 10.4 Measuring systemic risk of European banks 10.5 Responses to the financial crisis of 2007-2009 10.6 After the crisis is before the crisis - the sovereign debt crisis

of 2010 10.7 Conclusion Bibliography

PART IV: NETWORKS Networks: Introduction Rama Cont

Network Models and Systemic Risk Assessment Helmut Elsinger, Alfred Lehar and Martin Summer 11.1 Introduction 11.2 A network model of interbank exposures and contagion risk 11.3 Estimating network exposures 11.4 Creating loss scenarios 11.5 Clearing in the interbank market 11.6 Empirical findings 11.7 Extensions Bibliography

Strategic Interactions on Financial Networks for the Analysis of Systemic Risk Ethan Cohen-Cole, Andrei Kirilenko and Eleonora Patacchini 12.1 Financial networks and systemic risk 12.2 Diffusion-like processes over networks 12.3 An empirical application: the CME market 12.4 Conclusions and policy implications Bibliography

Network Structure and Systemic Risk in Banking Systems Rama Cont, Amal Moussa and Edson B. Santos 13.1 Introduction 13.2 The network structure of banking systems 13.3 Systemic risk and default contagion

Contents IX

13.4 Is default contagion a significant source of systemic risk? 351 13.5 What makes an institution systemically important? 355 13.6 Does one size fit all? The case for targeted capital requirements 361 Bibliography 365

PART V: SYSTEMIC RISK AND MATHEMATICAL FINANCE 369 Systemic Risk and Mathematical Finance 371 Ronnie Sircar

14 Firms, Banks and Households 372 L. C. G. Rogers and P. Zaczkowski 14.1 Introduction 372 14.2 Modelling assumptions 374 14.3 Summary 385 14.4 Examples 387 14.5 Numerical results 390 Bibliography 400

15 An Agent-Based Computational Model for Bank Formation and Interbank Networks 401 Matheus R. Grasselli and Omneia R. H. Ismail 15.1 Introduction 401 15.2 The pre-banking society 404 15.3 Introducing banks 410 15.4 Interbank market 416 15.5 Communities of correlated preferences 423 15.6 Conclusions and further directions 428 Bibliography 430

16 Diversification in Financial Networks may Increase Systemic Risk 432 Josselin Gamier, George Papanicolaou and Tzu-Wei Yang 16.1 Introduction 432 16.2 A bistable mean-field model for systemic risk 433 16.3 Review of some models for systemic risk 439 16.4 Summary and conclusion 442 Bibliography 442

17 Systemic Risk Illustrated 444 Jean-Pierre Fouque and Li-Hsien Sun 17.1 Introduction 444 17.2 Stability illustrated by simulations 446 17.3 Mean-field limit 449

xii Contents

23.5 Risk 636 23.6 Rationality 640 23.7 Sentience 645 23.8 Interactions 648 23.9 Policy implications 652 23.10 Conclusion 655 Bibliography 659

24 Bubbles, Crises, and Heterogeneous Beliefs 663 Wei Xiong 24.1 Historical bubbles 664 24.2 Limits of arbitrage 674 24.3 Heterogeneous beliefs 677 24.4 Resale option theory of bubbles 682 24.5 Credit cycles 692 24.6 General equilibrium models with heterogeneous beliefs 696 24.7 Welfare analysis with distorted beliefs 701 24.8 Summary and future directions 704 Bibliography 706

25 Systemic Risk and Sentiment 714 Giovanni Barone-Adesi, Loriano Mancini and Hersh Shefrin 25.1 Introduction 714 25.2 Behavioral asset pricing theory and sentiment 719 25.3 Estimating the empirical SDF 723 25.4 Sentiment and the financial crisis 726 25.5 External measures of sentiment 734 25.6 Sentiment, systemic risk and leverage 736 25.7 Conclusion 739

PART IX: REGULATION 743 Regulation: Introduction 745 Gary Stern and Ron J. Feldman

26 The New Financial Stability Framework in Europe 748 Carsten Detken and Per Nymand-Andersen 26.1 The new European approach to systemic risk 749 26.2 The new European systemic risk framework 753 26.3 The ECB approach to systemic risk 755 26.4 Global markets require a global approach to risk. 766 26.5 Conclusion 768 Bibliography 771

Contents xiii

Sector-Level Financial Networks and Macroprudential Risk Analysis in the Euro Area 775 Olli Castren and Ilja Kristian Kavonius 21A Introduction 775 27.2 Description of the data 111 27.3 The network of balance sheet exposures for the aggregate

Euro area financial system 111 27.4 Derivation of the risk-based balance sheets 781 27.5 Propagation of shocks in the risk-based financial network 786 27.6 Concluding remarks 788 Bibliography 789

Systemic Risk Early Warning System: A Micro-Macro Prudential Synthesis 791 Mikhail V. Oet, Ryan Eiben, Timothy Bianco, Dieter Gramlich, Stephen J. Ong, and Jing Wang 28.1 Introduction 792 28.2 EWS elements 796 28.3 Risk model and results 801 28.4 Discussion and implications 812 28.5 Conclusions and future work 828 Bibliography 843

PART X: COMPUTATIONAL ISSUES AND REQUIREMENTS 847 Computational Issues and Requirements: Introduction 849 Richard Byrne

Enabling Data Analysis for Addressing Systemic Risk 852 Eric Hughes, Arnon Rosenthal, Charles Worrell 29.1 Challenges in analyzing systemic risk 852 29.2 Approaches that support analysis 853 29.3 Analysis approaches 862 29.4 Discussion and future research 866 Bibliography 868

Operational Considerations in an Analytic Environment for Systemic Risk 869 Charles Worrell, Samar Guharay, Matt McMahon, Len Seligman, and Rajani Shenoy 30.1 Introduction 869 30.2 Controlling the frame of reference 870

xiv Contents

30.3 Managing the data environment 871 30.4 Model hosting and execution environment 874 30.5 Comparison and measurement across disparate models 875 30.6 Aggregation of risk components 877 30.7 From analysis to decisions 879 Bibliography 880

31 Requirements for Systemic Risk Management in the Financial Sector 882 Alan J. King, Donna N. Dillenberger, Aviv Orani, Francis N. Parr, and Gong Su 31.1 Introduction 882 31.2 History 884 31.3 Modern mortgage market 884 31.4 Network and counterparty risk 890 31.5 Requirements for broad scope risk 892 31.6 Integrated risk analytics 895 31.7 Reference data 901 31.8 Risk analytics services 907 31.9 Summary 910 Bibliography 911

PART XI: ACCOUNTING ISSUES 913 Accounting and Systemic Risk: An Introduction 915 Trevor S. Harris Bibliography 917

32 Accounting's Role in the Reporting, Creation, and Avoidance of Systemic Risk in Financial Institutions 918 Trevor S. Harris, Robert Herz and Doron Nissim 32.1 Introduction 918 32.2 Some basics of accounting and financial reporting 921 32.3 Accounting for systemic risk 924 32.4 Accounting for different asset and liability classes 926 32.5 Accounting, pro-cyclicality and systemic risk: summary

thoughts 957 32.6 Single firm versus systemic risk 961 32.7 Concluding remarks 962 Bibliography 963