SWP1: Systemic Risk Identification in Securities Markets

IOSCO Research Department: Staff Working Paper 2012/1 July 2012 1 Systemic Risk Identification in Securities Markets Werner Bijkerk, Rohini Tendulkar, Samad Uddin, Shane Worner This staff working paper should not be reported as representing the views of IOSCO. The views expressed in this staff working paper are those of the author(s) and do not necessarily represent those of IOSCO, its members or its policy. Staff working papers describe research in progress by the author(s) and are published to elicit comments and to further debate. Comments can be sent to research@iosco.org. IOSCO Research Department: Staff Working Paper 2012/1 July 2012 2 I. Introduction The financial crisis highlights the need to identify and monitor systemic risk in the securities markets, before we can manage it. In this context, IOSCO has adapted its Mission and Goals; added two principles regarding the identification and management of systemic risk to its IOSCO Objectives and Principles of Securities Regulation1; developed high level guidance in its Methodology for Assessing Implementation of the IOSCO Objectives and Principles of Securities Regulation; published an exploratory paper that discusses the tools securities regulators can use in mitigating systemic risks;2 and produced a Securities Markets Risk Outlook that discusses some of the major potential systemic risks arising from the securities markets.3 Adding to this body of work, this Consultation Paper outlines a systematic approach to assist securities market regulators specifically, in the identifying and monitoring of systemic risks and risk build-up in entities, market infrastructures, products and activities. The “system” presented in this report relies on a list of practical and concrete indicators and offers a flexible and coherent process within which to use them.4 Ultimately, the system will serve a dual purpose in (1) providing a standardized approach to systemic risk identification and monitoring across jurisdictions and (2) guiding data collection. As well as securities regulators, this system may prove beneficial to IOSCO, other organizations with an interest in financial stability and researchers. This report does not attempt a literature review as comprehensive reports offering such analysis are already in the public domain.5 Rather this report attempts to take one step further towards building a practical methodology for identifying and measuring systemic risk in securities market by outlining a practical approach and testing its potential value using case studies (see annexes). Of course, since there is no precedent or existing methodology available for systemic risk identification in securities market, a system like this can only be thoroughly tested in practice. The paper is structured as follows. Section 2 outlines the various elements of this system. Section 3 provides a step-by-step application of the system. Appendix 1 presents the case studies on financial entities (LTCM hedge fund) and products (unit linked products in the Netherlands). Appendix 2 gives a full list of indicators that can be used within the system. 1 IOSCO, Objectives and Principles of Securities Regulation, 2010, Principles 6 and 7 https://www.iosco.org/library/pubdocs/pdf/IOSCOPD323.pdf 2 IOSCO, Mitigating Systemic Risk – A Role for Securities Regulators, 2011 3 This Outlook will be produced annually by the Research Department of IOSCO. 4 The list of indicators identified by the system should be expanded, refined and adapted by regulators for use in their own markets. Furthermore, data will need to be gathered for the selected indicators and analysed. 5 See for example Dimitrios Bisias, Mark Flood, Andrew W. Lo, Stavros Valavanis, A Survey of Systemic Risk Analytics, Office of Financial Research, Working Paper 1, January 5 2012; Bernd Schwaab, Siem Jan Koopman, Andre Lucas, “Systemic Risk Diagnostics: Coincident Indicators and Early Warning Signals”, Working Paper Series, No. 1327, April 2011. IOSCO Research Department: Staff Working Paper 2012/1 July 2012 3 II. Describing the System This systemic risk identification system has five main elements: 1. Multi-level Indicators – micro, macro and thematic The aim of this system is to encourage the use and development of indicators that are practical6, coincidental, forward looking and dynamic. The indicators are divided first into macro level and micro level indicators. The macro level indicators help to provide signalling on emerging risks stemming from the broader environment, such as the macro-economy, the political and regulatory environment, technology and socio-economic trends. The