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Toward Determining Systemic Importance - Mark Kritzman (19 Sept 2012)
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Toward Determining Systemic Importance - Mark Kritzman (19 Sept 2012)

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This is a joint event with the CFA. The speaker, Mark P. Kritzman, is a Senior Lecturer in Finance at the MIT Sloan School of Management. ...

This is a joint event with the CFA. The speaker, Mark P. Kritzman, is a Senior Lecturer in Finance at the MIT Sloan School of Management.

In this presentation, Mark introduces his methodology for measuring systemic importance. The absorption ratio provides an implied measure of systemic risk. It is then extended to determine an entities centrality – this centrality measure capture’s an entity’s vulnerability to failure, its connectivity to other entities, and the risk of the entities to which it is connected.

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Toward Determining Systemic Importance - Mark Kritzman (19 Sept 2012) Toward Determining Systemic Importance - Mark Kritzman (19 Sept 2012) Presentation Transcript

  • Toward Determining Systemic ImportanceWill KinlawMark KritzmanDavid TurkingtonUniversity of Edinburgh Business School 19 September 2012 1
  • STATE STREET ASSOCIATESWhy it is difficult to observe systemic risk directly• Securitization obscures connections among stakeholders.• Private transacting leads to opacity.• Complexity reduces clarity.• “Flexible accounting” also hides financial linkages.• Even if we could identify the relevant linkages, they do not remain constant. Slide 2 of 39
  • STATE STREET ASSOCIATESThe absorption ratio• The absorption ratio equals the fraction of the total variance of a set of assets explained or “absorbed” by a finite number of eigenvectors.• A high absorption ratio implies that markets are compact or tightly coupled.• Compact markets are relatively fragile in that shocks propagate more quickly and broadly than when markets are loosely linked. Slide 3 of 39
  • STATE STREET ASSOCIATESThe absorption ratio i1 n E 2 AR  i  j1 N A 2 j AR: Absorption ratio N: number of assets n: number of eigenvectors used to calculate AR  E : variance of the i-th eigenvector, sometimes called eigenportfolio 2 i  A : variance of the j-th asset 2 j Slide 4 of 39
  • STATE STREET ASSOCIATES The absorption ratio for U.S. equities* Absorption ratio S&P 500 Absorption ratio S&P 500 1.3 1800 1600 1.2 1400 1.1 1200 1 1000 0.9 800 600 0.8 400 0.7 200 0.6 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011* We estimate the covariance matrix and eigenvectors of MSCI USA industry returns using a 500-dayrolling window. Variances are estimated from exponentially decaying returns with a one-year half life.We set n equal to 10 eigenvectors. Results from 1/1/1998 through 11/30/2011. Source: State Street Global Markets Slide 5 of 39
  • STATE STREET ASSOCIATES Absorption ratio, drawdowns, and returns* Fraction of drawdowns preceded by a spike in AR 1% Worst 2% Worst 5% Worst 1 Day 70% 70% 62% 1 Week 73% 73% 67% 1 Month 92% 90% 75% Annualized return after extreme AR 1 Sigma Increase 1 Sigma Decrease Difference 1 Day -6.1% 7.5% -13.6% 1 Week -6.1% 7.5% -13.5% 1 Month -4.9% 5.7% -10.6%* Spike = 1 standard deviation outlier of (15-day moving average of AR minus 1-year moving average ofAR) divided by standard deviation of 1-year AR. Results from 1/1/1998 through 11/30/2011. Source: State Street Global Markets Slide 6 of 39
  • STATE STREET ASSOCIATES Absorption ratio as a market timing signal* Trading rule Performance (1/1/1998 through 11/30/2011) Stock/Bond Systemic Risk Index Exposure Dynamic 50/50 -1σ ≤ ∆Index ≤ +1σ 50 / 50 Return 9.15% 5.72% ∆Index > +1σ 0 / 100 Risk 11.30% 10.14% ∆Index < -1σ 100 / 0 Return/Risk 0.81 0.56 Max. Drawdown 12.83% 26.26% Turnover 111% n/a Trades/year 2.2 n/a* We compute a standardized shift to construct this trading rule. We first compute the moving average ofthe Systemic Risk Index over 15 days and subtract it from the moving average of the index over one year.We then divide this difference by the standard deviation of the index over the one-year time period. Source: State Street Global Markets Slide 7 of 39
  • STATE STREET ASSOCIATES Absorption ratio stock exposure Stock Exposure S&P 500 Stock Exposure S&P 500 300% 1800 1600 1400 200% 1200 1000 800 100% 600 400 200 0% 0 Jan-04 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Slide 8 of 39Source: State Street Global Markets
  • STATE STREET ASSOCIATES How is the absorption ratio different from average correlation? Absorption Ratio versus Average Correlation Absorption Ratio versus Average Correlation Average Correlation Period 1 Correlations Standard Absorption Ratio Assets 1 2 3 4 Deviations 1 1.00 0.12 -0.01 0.01 35.16% 2 0.12 1.00 -0.04 -0.03 35.07% Period 1 3 -0.01 -0.04 1.00 0.82 4.95% 4 0.01 -0.03 0.82 1.00 5.02% Period 2 Correlations Standard Period 2 Assets 1 2 3 4 Deviations 1 1.00 0.64 -0.05 -0.01 34.46% 2 0.64 1.00 -0.05 -0.03 34.04% 0 0.2 0.4 0.6 0.8 1 3 -0.05 -0.05 1.00 0.03 4.92% 4 -0.01 -0.03 0.03 1.00 4.88%Source: State Street Global Markets Slide 9 of 39
  • STATE STREET ASSOCIATES Absorption ratio performance versus average correlation Return-to-risk (1/1/1998 through 11/30/2011) 1.0 0.81 0.8 0.6 0.56 0.53 0.4 0.2 0.0 AR filter Static (50/50) Average correlation filter Turnover: 111% n/a 139%* We compute a standardized shift on each metric, using the same parameters, to construct trading rules. Source: State Street Global Markets Slide 10 of 39
  • STATE STREET ASSOCIATES Absorption ratio performance versus average correlation Absorption ratio Static (50/50) Average correlation 450 400 350 300 250 200 150 100 50 0 Jul-99 Jul-04 Jul-06 Jul-98 Jul-00 Jul-01 Jul-02 Jul-03 Jul-05 Jul-07 Jul-08 Jul-09 Jul-10 Jan-11 Jul-11 Jan-98 Jan-00 Jan-01 Jan-03 Jan-05 Jan-07 Jan-10 Jan-99 Jan-02 Jan-04 Jan-06 Jan-08 Jan-09Source: State Street Global Markets Slide 11 of 39
  • STATE STREET ASSOCIATES The normal distribution: one-week U.S. equity returns -18% -16% -14% -12% -10% -8% -6% -4%Source: State Street Global Markets Slide 12 of 39
  • STATE STREET ASSOCIATES Conditional U.S. equity volatility: next month Annualized out-of-sample U.S. equity volatility with 1-day lagSource: State Street Global Markets Slide 13 of 39
  • STATE STREET ASSOCIATESThe absorption ratio and volatilityWe identify the 10% most volatile 30-day periods of the MSCI All Country World Equity Index. We synchronize the volatile periods andmeasure the median standardized shift of the global absorption ratio leading up to, during, and following these periods of volatility. Slide 14 of 39
  • STATE STREET ASSOCIATESThe absorption ratio and financial turbulence dt = (yt - µ)Σ-1(yt - µ)′ dt = vector distance from multivariate average yt = return series  = mean vector of return series yt Σ = covariance matrix of return series yt• We measure financial turbulence as a condition in which asset prices behave in an uncharacteristic fashion, given their historical pattern of behavior. This includes extreme price moves, decoupling of correlated assets, and convergence of uncorrelated assets.• Differences from historical averages capture the extent to which one or more return was unusually high or low.• Multiplying by the inverse of the covariance matrix makes the measure scale independent and captures interaction of assets.• Post multiplying by the transpose of differences converts the vector to a single number. Slide 15 of 39
  • STATE STREET ASSOCIATESThe absorption ratio and financial turbulenceWe identify the 10% most turbulent 30-day periods in global equities, as measured from industries of the MSCI All Country WorldEquity Index. We synchronize the turbulent periods and measure the median standardized shift of the global absorption ratio leadingup to, during, and following these periods of high turbulence. Slide 16 of 39
  • STATE STREET ASSOCIATESOther markets• We have applied the same model with the same calibration to other markets: – The global stock market – The European Monetary Union stock market – The Australian stock market – The Canadian stock market – The German stock market – The Japanese stock market – The UK stock market – 16 Emerging market stock markets – US risk factors (market neutral) – US stock market sectors (market neutral) – EMU stock market sectors (market neutral)• In all cases the results were qualitatively similar. Slide 17 of 39
  • STATE STREET ASSOCIATES The absorption ratio as a measure of intrinsic systemic risk • We construct an absorption ratio based on the returns of eight asset classes • Then, we measure the risk of a typical institutional portfolio following both high and low systemic risk • The allocation for this portfolio is shown at rightSource: State Street Global Markets Slide 18 of 39
  • STATE STREET ASSOCIATES The absorption ratio as a measure of intrinsic systemic risk Low intrinsic systemic risk High intrinsic systemic risk 9.5% 9.7% 10.1% Subsequent 8.3% 8.3% 7.9% annualized volatility Next 3 months Next 6 months Next 12 months Subsequent 1% VaR* Results from 2/21/1996 through 3/30/2011.Source: State Street Global Markets Slide 19 of 39
  • STATE STREET ASSOCIATES The absorption ratio as a measure of intrinsic systemic risk Average volatility Volatility increase of increase across asset portfolio classes* 1998-present 1.2x 1.3x 2007-2009 1.4x 1.7x * Portfolio-weighted average* Results from 2/21/1996 through 3/30/2011.Source: State Street Global Markets Slide 20 of 39
  • STATE STREET ASSOCIATESWhy is systemic importance important?• Investors care about systemic importance in order to assess their portfolios’ vulnerability to shocks and to pursue defensive tactics if needed.• Policymakers need this information to ensure that policies and regulations target the appropriate entities and to engage in preventive or corrective measures more effectively. Slide 21 of 39
  • STATE STREET ASSOCIATESAsset centralityWe construct a measure of asset centrality, which captures:• an asset’s vulnerability to failure• how broadly and deeply an asset is connected to other assets in the system• the riskiness of the other assets to which it is connected. Slide 22 of 39
  • STATE STREET ASSOCIATES Asset centrality   n  EVi j   AR j    N   EVk j Normalized component j 1   “weights” in each eigenvector Asset Centrality i   k 1  n  AR j j 1Asset Centrality i = the centrality score for asset i AR j = the absorption ratio of the j-th eigenvector (percentage of variation explained) EVi j = the absolute value of the exposure of the i-th asset within the j-th eigenvector n = the number of top eigenvectors to include in the calculation N = the total number of assets Slide 23 of 39
  • STATE STREET ASSOCIATESAsset centrality: an intuitive interpretation• If we were to use only the first eigenvector to compute asset centrality, this would be the same technique used in Google’s PageRank algorithm.• We instead chose to use several eigenvectors in the numerator of the absorption ratio because in many instances – perhaps most – several factors contribute importantly to market variance. Slide 24 of 39
  • STATE STREET ASSOCIATES Multiple eigenvectors contribute importantly to variance Explanatory power of the top eigenvectors (US financials absorption ratio based on individual stock returns) 70% 60% 50% 40% 30% 20% Principal eigenvector 10% Eigenvectors 2 through 10 0% 1991 1992 1993 1995 1996 1999 2000 2002 2003 2004 2006 2007 2010 1994 1997 1998 2001 2005 2008 2009Source: State Street Global Markets Slide 25 of 39
  • STATE STREET ASSOCIATES Centrality percentile ranks for selected US industries Construction Materials Oil and Gas Commercial Banks 30% 100% 100% 20% 80% 80% 10% 0% 60% 60% 1999 2003 2005 2009 1997 2001 2007 2011 1997 1999 2001 2003 2005 2007 2009 2011 1997 2001 2003 2007 1999 2005 2009 2011Source: State Street Global Markets Slide 26 of 39
  • STATE STREET ASSOCIATES US sector centrality percentile ranksConsumer Discretionary 0.9 Consumer Staples 0.8 Energy 0.7 Financials Health Care 0.6 Industrials 0.5 Information Technology 0.4 Materials 0.3 Telecom Services 0.2 Utilities 0.1 1997 1999 2001 2003 2005 2007 2009 2011Source: State Street Global Markets Slide 27 of 39
  • STATE STREET ASSOCIATESSystemic importance Systemic importance equals the asset centrality percentile rank conditioned on high systemic risk. Slide 28 of 39
  • STATE STREET ASSOCIATES US Sector systemic importance Average Top sectors when standardized shift > 1 percentile rank Energy 85 Financials 75 Telecommunication Services 64 Information Technology 62 Health Care 46 Consumer Staples 43 Consumer Discretionary 39 Materials 35 Industrials 34 Utilities 30Source: State Street Global Markets Slide 29 of 39
  • STATE STREET ASSOCIATES Top 10 systemically important US industries Average Top industries when standardized shift > 1 percentile rank Diversified Financial Services 95 Capital Markets 94 Software 92 Commercial Banks 91 Communications Equipment 90 Oil, Gas & Consumable Fuels 90 Computers & Peripherals 90 Real Estate Investment Trusts (REITs) 87 Pharmaceuticals 85 Industrial Conglomerates 85Source: State Street Global Markets Slide 30 of 39
  • STATE STREET ASSOCIATES Top 10 systemically important US financial stocks Average Top stocks when standardized shift > 1 percentile rank Citigroup 98 Bank of America 97 JP Morgan Chase 96 American International Group 96 Fannie Mae 93 Morgan Stanley 92 American Express 92 Merrill Lynch 91 Bank One (Acquired) 91 Goldman Sachs 89Company names provided above are for illustrative purposes only and do not represent an analysis of the merits of investing insuch companies.Source: State Street Global Markets Slide 31 of 39
  • STATE STREET ASSOCIATES Lehman Brothers centrality score through time 15-Sep-08, 89% 100% 80% 60% 40% 20% 0% 1997 1999 2002 2004 2005 2007 1998 2000 2001 2003 2006 2008Source: State Street Global Markets Slide 32 of 39
  • STATE STREET ASSOCIATES Daily volatility over the past 500 days Lehman Brothers (left-hand axis) 8% Top Eigenvector (Lehman removed, right-hand axis) 25% 7% 20% 6% 5% 15% 4% 3% 10% 2% 5% 1% 0% 0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 1996 1997 1998 1999Source: State Street Global Markets Slide 33 of 39
  • STATE STREET ASSOCIATES Comparison to the Financial Stability Board methodology Our methodology Financial Stability Board Systemic importance scores are derived from Systemic importance scores are calculated by securities price movement, using principal weighting a range of fundamental factors or component analysis. This technique indicators, often from company balance sheets. The captures: indicators used (and their weightings) are:1 • an institution’s vulnerability to failure, • Cross-jurisdictional claims (10%) • Cross-jurisdictional liabilities (10%) Data and • how broadly and deeply an institution is connected • Total exposures as defined by Basel III leverage (20%) calculation to other institutions in the system, and • Intra-financial system assets (6.67%) • Intra-financial system liabilities (6.67%) • the riskiness of the other institutions to which it is • Wholesale funding ratio (6.67%) connected. • Assets under custody (6.67%) • Payments cleared and settled via systems (6.67%) • Values of underwritten debt & equity trans. (6.67%) • OTC derivatives notional value (6.67%) • Level 3 assets (6.67%) • Trading book value and avail. for sale value (6.67%) Timeliness One week delay Two year delay 21 Basel Committee on Banking Supervision, “Global systemically important banks, Assessment methodology and the additional loss absorbencyrequirement,” Bank for International Settlements, July 2011.2As noted in: Financial Stability Board, “Policy Measures to Address Systemically Important Financial Institutions,” 4 November, 2011, November 2011values were based on data as of the end of 2009. Slide 34 of 39Source: State Street Global Markets, Financial Stability Board
  • STATE STREET ASSOCIATES Top 25 systemically important financial institutions (as of Dec 2009) Financial institutions Rank Financial institutions (cont’d) Rank Bank of America 1 UBS 14 JP Morgan Chase 2 ING 15 Wells Fargo 3 AXA 16 Citigroup 4 Unicredit 17 Barclays 5 Mitsubishi UFJ FG 18 Royal Bank of Scotland 6 Credit Suisse 19 HSBC 7 Met Life 20 Lloyds Banking Group 8 Prudential Financial 21 BNP Paribas 9 Societe Generale 22 Goldman Sachs 10 AIG 23 Morgan Stanley 11 Deutsche Bank 24 Santander 12 Credit Agricole 25 US Bancorp 13 Also appears on the FSB’s list of 29 systemically important institutionsCompany names provided above are for illustrative purposes only and do not represent an analysis of the merits of investing insuch companies.The universe is based on the MSCI Developed World Financials Sector index constituents as of November 2011. We removed companies from the RealEstate industry group as well as 22 companies that did not have a long enough stock price data history to include in our study. Slide 35 of 39Source: State Street Global Markets, Financial Stability Board
  • STATE STREET ASSOCIATES Stratification of the top 25 institutions compared to the full universe as of November 25, 2011 Regional Representation (%) 0 Asia Pacific 23 Industry Representation (%) 68 12 Europe Insurance 38 31 32 16 North America Diversified Financial Services 39 11 52 Commercial Banks 41 Market Cap Representation (%) 0 Consumer Finance 28 2 50 billion USD or larger 8 20 Capital Markets 72 14 10-50 billion USD 36 0 Thrifts & Mortgage Finance 0 1 5-10 billion USD 21 0 1-5 billion USD 33 Top 25 (%) 0 32 1 billion USD or smaller North America All (%) 2 39 68 EuropeThe universe is based on the MSCI Developed World Financials Sector index constituents as of November 2011. We removed companies from the Real 38Estate industry group as well as 21 companies that did not have a long enough stock price data history to include in our study. Slide 36 of 39Source: State Street Global Markets 0 Asia Pacific
  • STATE STREET ASSOCIATES 11th – 25th most systemically important global financial institutions as of November 25, 2011 Global financial institution Rank Societe Generale 11 Unicredit 12 Morgan Stanley 13 Goldman Sachs 14 ING 15 AXA 16 Intesa Sanpaolo 17 BBV Argentaria 18 UBS 19 Credit Suisse 20 Credit Agricole 21 Deutsche Bank 22 Allianz 23 MetLife 24 US Bancorp 25Company names provided above are for illustrative purposes only and do not represent an analysis of the merits of investing insuch companies. Slide 37 of 39Source: State Street Global Markets
  • STATE STREET ASSOCIATES Top 10 systemically important global financial institutions as of November 25, 2011 Global financial institution Rank Bank of America 1 Citigroup 2 JP Morgan Chase 3 Wells Fargo 4 BNP Paribas 5 Santander 6 Lloyds Banking Group 7 Barclays 8 HSBC 9 Royal Bank of Scotland 10Company names provided above are for illustrative purposes only and do not represent an analysis of the merits of investing insuch companies.Source: State Street Global Markets Slide 38 of 39
  • STATE STREET ASSOCIATESThank you Slide 39 of 39