Assessing Systemic Risk

New York University's Stern School of Business hosted a conference yesterday to discuss how systemic risk should be addressed under the Dodd-Frank Act.  One of the presenters at the conference, Stanford Finance Professor Darrell Duffie, proposed a new approach for identifying systemic risk.  Here's some detail on his proposal as reported by Bloomberg.

The world’s largest banks and investment firms should undergo quarterly stress tests to identify risks that could sink the financial system, according to a proposal by Stanford University finance professor Darrell Duffie. “I’m not talking about the ordinary, matter-of-course, risk management of institutions. We’re looking at what are the sources of risk and how are they flowing through the system. We want to connect the dots.”

Duffie calls his plan “10-by-10-by-10” because it’s based on 10 financial firms undergoing 10 stress tests that expose the banks’ 10 largest trading partners. For example, institutions would be tested on their ability to withstand the default of a single firm that they do business with, an idea replicating the 2008 Lehman bankruptcy.

“The objective is to alert regulators and the public to potential sources of financial instability before they reach dangerous levels,” Duffie wrote in a paper outlining the proposal. The tests, which would be adjusted over time to cover different scenarios, could flush out new systemically important firms as they arise, Duffie said. Central bankers could opt to conduct some of the stress tests using average financial numbers over a given timeframe “to mitigate period-end ‘window dressing,’” Duffie said. Regulators should also audit the way the banks measure the data they present, he said.

More specifics about the Duffie proposal are contained in his working paper, "Systemic Risk Exposures: A 10-by-10-by-10 Approach." By his own admission, Duffie notes that this proposal merely represents a first step for regulators to begin to analyze systemic risk. There are shortcomings to the proposal such as the current lack of data as well as the potential to exclude other entities that may pose risks to the system. However, the regulators must begin somewhere and this approach is a practical method for assessing systemic risk.