Modeling and Measuring Systemic Risk

The 2007–8 financial crisis and its aftermath illustrated the fundamental shortcomings of the existing regulatory and policy-making approaches to recognize and mitigate systemic risk in financial markets and thereby maintain the stability of the economy. Ten years later, we still have no comprehensive framework to monitor/mitigate systemic risk and lack reliable and efficient methods to predict and avoid financial crises. Mainstream research and practice in this field focus on extending existing theories and regulatory approaches to cover the newly recognized phenomenon of systemic risk. Those theories and approaches, however, were developed for the purpose of regulating a traditionally structured banking industry in which the principal business consisted of aggregating small deposits into secured collateral consumer loans. The systemic risk models in the literature do not address modern financial systems, which are complex interconnected sets of institutions with numerous interacting channels for activities that even the exposed banks themselves, let alone regulators and policymakers, may not be able to observe.

We propose a novel mathematical framework to model financial markets as complex systems of economic interactions and contractual and legal obligations aiming to understand, measure and mitigate systemic risk exposure of economy from the perspective of the policymakers and regulators. The proposed mechanism aims to exploit the systemic structure of contractual dependencies of the financial institutions in a competitive market where banks maximize their individual share of the financial market/profit. To do so, we need to develop an economy of such financial systems capturing the market dynamics and consistent with legal rules and regulatory frameworks.

The resulting model should be a reasonable basis to define a measure of systemic risk associated with each financial institution. Ideally, the model will also be a framework for developing alternative regulatory methods to mitigate aggregate systemic risk exposure of the economy, subject to minimum regulatory and economic intervention and an economy of fixed size. We aim to show that, our methodology is a plausible and efficient framework to design better regulatory alternatives than the existing ones.