New Framework for Measuring Resilience of Financial Systems

Now that the conventional models and tools for managing financial markets have been found lacking, a new working paper* from Harvard Business School examines another approach based on measuring institutions’ sensitivity to external shocks.

Vulnerability of a national economy to volatility in the global markets for credit, currencies, commodities, and other assets has become a central concern of policymakers, the authors say. “The responsibility for managing these risks at the national level often is given to the central bank. However, the conventional models and analytical tools used by central banks today are ill suited for analyzing these types of risk.”

The paper proposes a new approach to improve the way central banks can analyze and manage the financial risks of a national economy. It is based on the modern theory and practice of contingent claims analysis (CCA), which is successfully used today at the level of individual banks by managers, investors, and regulators. When applied to the analysis and measurement of credit risk, CCA is commonly called the Merton Model.

The basic analytical tool is the risk-adjusted balance sheet, which shows the sensitivity of the enterprise’s assets and liabilities to external “shocks.”

At the national level, the sectors of an economy are viewed as interconnected portfolios of assets, liabilities, and guarantees—some explicit and others implicit. Traditional approaches have difficulty analyzing how risks can accumulate gradually and then suddenly erupt in a full-blown crisis.

The authors say CCA approach is well-suited to capturing such “non-linearities” and to quantifying the effects of asset-liability mismatches within and across institutions. Risk-adjusted CCA balance sheets facilitate simulations and stress testing to evaluate the potential impact of policies to manage systemic risk.

In addition to their traditional focus on inflation and output, central banks are increasingly focusing on the resilience of the national financial system. The CCA framework provides a forward-looking market-based set of indicators to measure the vulnerability of various sectors of the economy and is well-suited to capturing nonlinearities and to quantifying the effects of asset-liability mismatches within and across institutions.

The paper starts with a simple framework of CCA balance sheets for four key sectors (sovereign, financial, corporate, and household sectors). It also describes how the sectoral CCA balance sheets can be constructed and linked together.

*New Framework for Measuring and Managing Macrofinancial Risk and Financial Stability
Dale F. Gray, Robert C. Merton, Zvi Bodie

Comments

[PastTense:]

"Vulnerability of a national economy to volatility in the global markets for credit, currencies, commodities, and other assets has become a central concern of policymakers"

What countries have policymakers strongly concerned about these issues? Certainly not the U.S. where the central concerns of policymakers is just doing whatever the special interest groups want.

2008 Oct 05 01:45 AM