This definition lends itself to practical risk mitigation applications, as demonstrated in recent research by a simulation of the collapse of the Icelandic financial system in circa 2008.
One argument that was used by financial institutions to obtain special advantages in bankruptcy for derivative contracts was a claim that the market is both critical and fragile.
TBTF can be measured in terms of an institution's size relative to the national and international marketplace, market share concentration, and competitive barriers to entry or how easily a product can be substituted.
Second, the TCTF test is a measure of the likelihood and amount of medium-term net negative impact to the larger economy of an institution's failure to be able to conduct its ongoing business.
[12] The traditional analysis for assessing the risk of required government intervention is the "too big to fail" test (TBTF).
TBTF can be measured in terms of an institution's size relative to the national and international marketplace, market share concentration (using the Herfindahl-Hirschman Index for example), and competitive barriers to entry or how easily a product can be substituted.
A more useful systemic risk measure than a traditional TBTF test is a "too connected to fail" (TCTF) assessment.
An intuitive TCTF analysis has been at the heart of most recent federal financial emergency relief decisions.
TCTF is a measure of the likelihood and amount of medium-term net negative impact to the larger economy of an institution's failure to be able to conduct its ongoing business.
The SRISK Systemic Risk Indicator is computed automatically on a weekly basis and made available to the community.
[21] Manzo and Picca[22] introduce the t-Student Distress Insurance Premium (tDIP), a copula-based method that measures systemic risk as the expected tail loss on a credit portfolio of entities, in order to quantify sovereign as well as financial systemic risk in Europe.
One problem when it comes to the valuation of derivatives, debt, or equity under systemic risk is that financial interconnectedness has to be modelled.
One particular problem is posed by closed valuations chains, as exemplified here for four firms A, B, C, and D: For instance, the share price of A could influence all other asset values, including itself.
are, for instance, defined by a Black-Scholes dynamic (with or without correlations), risk-neutral no-arbitrage pricing of debt and equity is straightforward.
It is known that modelling credit risk while ignoring cross-holdings of debt or equity can lead to an under-, but also an over-estimation of default probabilities.
[26] The need for proper structural models of financial interconnectedness in quantitative risk management – be it in research or practice – is therefore obvious.
[28] Building on Eisenberg and Noe (2001), Cifuentes, Ferrucci, and Shin (2005) considered the effect of costs of default on network stability.
While financially interconnected systems with debt and equity cross-ownership without derivatives are fairly well understood in the sense that relatively weak conditions on the ownership structures in the form of ownership matrices are required to warrant uniquely determined price equilibria,[23][28][30] the Fischer (2014) model needs very strong conditions on derivatives – which are defined in dependence on any other liability of the considered financial system – to be able to guarantee uniquely determined prices of all system-endogenous liabilities.
[23][25] At present, it is unclear how weak conditions on derivatives can be chosen to still be able to apply risk-neutral pricing in financial networks with systemic risk.
Until recently, many theoretical models of finance pointed towards the stabilizing effects of a diversified (i.e., dense) financial system.
Nevertheless, some recent work has started to challenge this view, investigating conditions under which diversification may have ambiguous effects on systemic risk.
[37] Since the banks themselves could not give credit where the risk (and therefore returns) were high, it was primarily the insurance sector which took over such deals.
[43] A key conclusion of the analysis is that the core activities of insurers and reinsurers do not pose systemic risks due to the specific features of the industry: Applying the most commonly cited definition of systemic risk, that of the Financial Stability Board (FSB), to the core activities of insurers and reinsurers, the report concludes that none are systemically relevant for at least one of the following reasons: The report underlines that supervisors and policymakers should focus on activities rather than financial institutions when introducing new regulation and that upcoming insurance regulatory regimes, such as Solvency II in the European Union, already adequately address insurance activities.
However, during the financial crisis, a small number of quasi-banking activities conducted by insurers either caused failure or triggered significant difficulties.
The report therefore identifies two activities which, when conducted on a widespread scale without proper risk control frameworks, have the potential for systemic relevance.
The industry has put forward five recommendations to address these particular activities and strengthen financial stability: Since the publication of The Geneva Association statement, in June 2010, the International Association of Insurance Supervisors (IAIS) issued its position statement on key financial stability issues.
"[44] Other organisations such as the CEA and the Property Casualty Insurers Association of America (PCI)[45] have issued reports on the same subject.
[citation needed] On the other hand, the same effect was measured in presence of a banking oligopoly in which banking sector was dominated by a restricted number of market operators encouraged by their market share and contractual power to set higher loan mean rates.
[citation needed] Banks are the entities most likely to be exposed to valuation risk as a result of their massive holdings of financial instruments classified as Level 2 or 3 of the fair value hierarchy.
In February 2020 the European Systemic Risk Board warned in a report that substantial amounts of financial instruments with complex features and limited liquidity that sit in banks' balance sheets are a source of risk for the stability of the global financial system.