The impact of systemic risk depends very much on the collective behavior of financial institutions and their interconnectedness as well as on the interaction between financial markets and the macro-economy. Elements of interconnectedness can generally be measured by consideration of counterparty risks related to a financial institution's activities. Knowing the interconnectedness of a financial institution could enable a systemic risk regulator to determine how many additional failures could be caused by the failure of an individual firm.1
The theme of interconnectedness is still in its nascent stages, having garnered broad attention by the financial industry, regulators, and academia only since the Credit Crisis. The reason for the latter is attributable largely to lessons learned from the failure and/or government bailout of financial firms such as Lehman Brothers Inc. and American International Group in 2008.
As interested parties analyzed the risks posed by these firms during the Credit Crisis, it became very clear that the real risks posed to the global financial system did not only originate from the stand-alone size or direct counterparty exposures posed by such firms. Instead, it was only after the massive size and complexity of the direct and indirect financial, operational, and legal connections of Lehman and AIG became more clear that the true systemic impact of these firms became evident. As discussed in detail in ...