IMF: Prevent Institutions Becoming Too Connected to Fail

By Marco Espinosa-Vega
IMF Monetary and Capital Markets Department

April 21, 2009 

Lessen risk of domino effect from financial institution's failure

Difficult to gauge when institution's linkages could pose threat

IMF suggests ways to tell when such linkages could become systemic 

The current financial crisis has underscored the problem of an institution that is too connected to be allowed to fail because it is linked to so many other financial institutions.

Its demise could thus trigger catastrophic failures within the financial sector and possibly in other sectors of the economy, the IMF warns in new research. 

A chapter of the April 2009 Global Financial Stability Report (GFSR) says the growing complexity and globalization of financial services can contribute to economic growth by smoothing credit allocation and risk diversification, but they can also exacerbate the too-connected-to-fail problem. For instance, they can lead to situations where an institution’s miscalculations of its risks could lead to its demise, spawning a large number of failures of financial institutions, liquidity squeezes, and even severe capital losses in the financial system. Indeed, the ongoing crisis has shown how financial innovations have enabled risk transfers that were not fully recognized by financial regulators or by institutions themselves. 

Because governments will likely intervene to keep afloat an institution that is considered too connected to fail, they are extending an implicit safety net. But this sends the wrong message because it provides incentives for investors and managers of other institutions to also take excessive risks. 

“Disaster myopia”

Some policymakers have long recognized this problem and to lessen the risk that institutions become too connected to fail have called for oversight and regulation focused on the system not just individual institutions. However, it is easy to ignore such admonitions when times are good, because the probability of an extreme (tail) event seems remote—a phenomenon dubbed “disaster myopia.” Moreover, it is difficult to monitor the linkages that lead to the too-connected-to-fail problem. Yet to make systemic-focused oversight a reality—the type of surveillance G-20 nations called for in the communiqué following their April 2 summit—methodologies that allow policymakers to observe information on potentially systemic linkages must be developed. 

In the GFSR, IMF economists and a Stanford professor feature methodologies that can shed light on when direct and indirect financial linkages can become systemic. Specifically, the authors present complementary approaches to assess financial sector systemic linkages, including:

• The network approach, which tracks the reverberation of a credit event and a liquidity squeeze throughout the system.
• The co-risk model, which exploits market data to assess systemic linkages at an institutional level and is an important method of assessing the markets’ perception of how much more tightly the fortunes of financial institutions are linked together during stress times.
• The default intensity model, which measures the probability of failures of a large fraction of financial institutions (default clustering) as a result of both direct and indirect systemic linkages.

Each approach has its limitations, but together they can provide invaluable surveillance tools and can form the basis for policies to address the too-connected-to-fail problem. More specifically, these approaches can help policymakers to assess direct and indirect spillovers under extreme events, identify information gaps to be filled to improve the precision of this analysis, and provide concrete metrics to assist in the reexamination of the perimeter of regulation. 

As the authors explain, policymakers and regulators are grappling with how to maintain an effective, yet as unobtrusive as possible, perimeter of prudential regulation—that is, which institutions should be included and which need not be at various levels of regulation. Regulators should have the tools to determine which institutions are affected during plausible rounds of contagion and thus determine different levels of oversight and prudential restrictions.

Liquidity risk insurance

Information on systemic linkages could help address such questions as whether to limit an institution’s exposures, the desirability of capital surcharges based on systemic linkages, and the merits of introducing a liquidity risk insurance fund. The improvements in centralized clearing mechanisms currently underway, could provide a means to reduce counterparty risk and the potential systemic implications of financial linkages. 

The GFSR chapter stresses the importance of filling information gaps on cross-market, cross-currency, and cross-country linkages to refine analyses of systemic linkages. Closing information gaps would require additional disclosures; access to microprudential data from supervisors; more intensive contacts with private market participants; improved comparability of cross-country data; and better sharing of information on a regular and ad-hoc basis among regulators. Although these measures could impose additional demands on financial institutions, they are a far better alternative to waiting until a crisis begins and information become apparent as events unfold. 

Because it is virtually impossible for a country by itself to undertake effective surveillance of potentially systemic linkages, the IMF should assume a more prominent global financial surveillance role.