Ilin, T. and Varga, L. (2014), The uncertainty of systemic risk

Thomas Ilin, PhD student, Email: thomas.ilin@cranfield.ac.uk, Dr Liz Varga, Principal Research Fellow, Director Complex Systems Research Centre, Email: liz.varga@cranfield.ac.uk

www.cranfield.ac.uk/som

An actionable definition of systemic risk in financial services validated using data from the Icelandic financial system failure

$

PARTICIPANT(regulated)

$

PARTICIPANT(unregulated)

$

CENTRAL AUTHORITY

FINANCIAL SERVICE

PRODUCTS

LOANDEPOSIT

DEBTSETTLEMENT

SECURITYFUND

$$

SOVEREIGNGDP % Treasury Budget

LENDING (LL) / BORROWING (LB)TAKING (DT) / PLACING (DP)ISSUING (DI) / HOLDING (DH)

RETIRING (DR) / DISCHARGING (DD)TENDERING (ST) / ACQUIRING (SA)

RECEIVING (FR)

Activities

Regulated Participant Data

ProfitAssetsLiquid-AssetsLiabilitiesFines… etc

LENDING (LL) / BORROWING (LB)TAKING (DT) / PLACING (DP)ISSUING (DI) / HOLDING (DH)

RETIRING (DR) / DISCHARGING (DD)TENDERING (ST) / ACQUIRING (SA)

RECEIVING (FR)

Activities

Unregulated Participant Data

ProfitAssetsLiquid-AssetsLiabilities… etc

PROVIDING (FP)

Activities

LL / LB, DT / DP

Fine Policy % of Assets

Central Authority Data

Fine RateRatiosInterest RatesLiquid-Assets… etc

FP / FR FP / FR

RATING AGENCY

Strategy:MAX-REGULATION MIN-REGULATION

Strategy:GROW-PROFITSGROW-ASSETS

REDUCE-LIABILITIESMAINTAIN-LIQUIDITY

BALANCE

Strategy:GROW-PROFITSGROW-ASSETS

REDUCE-LIABILITIESMAINTAIN-LIQUIDITY

BALANCE

Fine Policy

Strategy:PROVIDE-LIQUIDITY

DO-NOTHING

Product Data

FunctionHoldings TotalBids Open TotalOffers Open Total… etc

Fine

SIMULATION MODEL CONTENTS:COUNTRY (x1)SOVEREIGN (x1)CENTRAL AUTHORITY (x1)RATING AGENCY (x1)FOREIGN PARTICIPANT (x1, sized as a multiple of native participants)PARTICIPANT - regulated (x1 < configurable <= x100)PARTICIPANT - unregulated (x1 < configurable <= x100)SIFS (2 per 6 functions = 12)

% GDPSovereign Data

Treasury BudgetFine PolicyCountry-GDP.. etc

$

FOREIGNPARTICIPANT

Acquisition

DI / DHDR / DDST / SA INTERNATIONAL

MARKET

DI / DHDR / DDST / SA

KEY:

Reference

Value flow

Participation

Detail

$

FOREIGNPARTICIPANT

Acquisition

RegulatoryBudget

Financial service activity-types (SIFS Supply / Demand)

Financial service activity-types (SIFS Supply / Demand)

Macroeconomicevents

Distress is created by exogenous causes, and operationalized in the system.

Systemic behaviour is manifested as external effects, sometimes causing further distress.

SIPs – Systemically important Participants (e.g. banks, intermediaries, counterparties).SIFS – Systemically important Financial Services (e.g. short-term funding from money-markets).

* Behaviour can also be: Contagious, Dispersive, Convergent, Expansive, Divergent, Optimal.

Global Financial System operations

In response to increasing distress, local operational efforts of SIPs become focused on certain SIFS (e.g. getting short-term funding).A

B

effectscauses

F

Distress is propagatedsystem-wide as problems in the execution-level activities of SIPs in overall supply vs

demand for certain SIFS. (e.g. lack of short-term funding).

Failed*

D

E Which becomes emergentoperational behaviour.

C

Distress is increased by endogenous causes within the system’s operations.

stability

instability

effects ofinstability

Purpose of research: to explain phenomena that emerge in the operational behaviour paradigm of the global financial system (Fig 1). Outcomes: •  a metric of systemic risk of failure (Fig. 2) •  validation using data from the Icelandic financial crisis

2000-2009 (Fig. 3) •  multidisciplinary theory of systemic risk using a cusp-

catastrophe type (static 3d) model (Fig. 4a for the surface and Fig. 4b with base from Fig. 4a and time in the z axis)

•  a dynamical complex system model responding to collective participation behaviour (Fig. 5a for conceptual model and Fig. 5b for the agent based model )

Fig. 1 Operational behaviour paradigm of systemic failure

Source: Extracted from the reported accounts of all 51 financial institutions in the Iceland database of Bankscope.

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009tot_profit_act 1,656,700 4,312,100 8,403,100 2,276,100 6,020,600 3,549,845,139 239,599,662 206,412,248 -1,953,841,290 -607,881,900tot_assets_act 451,393,500 924,935,100 981,676,800 565,522,000 2,939,201,500 15,999,713,336 7,811,197,543 10,435,219,325 4,996,139,748 3,887,703,500tot_liabilities_act 468,318,500 939,790,100 995,786,700 570,690,500 3,044,863,900 16,654,898,860 8,383,680,300 11,465,867,885 5,574,049,530 4,318,728,400tot_liquid_act 231,931,800 330,242,100 363,716,300 103,713,500 691,861,200 1,525,669,113 2,581,366,364 4,860,068,189 2,374,534,591 1,734,561,200tot_securities_act 53,084,900 74,062,800 67,007,000 17,630,800 407,113,000 12,681,175,749 1,712,223,256 2,715,050,572 1,093,228,923 774,386,700tot_debt_act 202,975,600 557,257,400 572,129,000 437,710,500 1,951,623,900 7,215,230,684 4,429,202,641 4,835,106,317 3,480,337,873 3,811,485,100tot_loans_act 0 0 0 0 250,700,200 354,177,740 934,168,278 999,915,622 332,978,327 323,283,500tot_deposits_act 92,725,900 138,312,400 136,906,900 5,807,700 136,177,400 342,577,782 511,286,489 1,081,272,784 688,948,932 362,818,900

-5,000,000,000

0

5,000,000,000

10,000,000,000

15,000,000,000

20,000,000,000

ISK

tho

usan

dsNational Systemic Failure Summary - Iceland Actual Financials

(total levels among all operational participants in each year)

Foreignacquisitions.

High ratio and level of assets in traded

international securities.

Relief Euphoria Frustration Euphoria Relief

Prolific new issuance of long-term debt securities on foreign markets.

Banking system collapsed. State restructured remaining banks and allowed them to default on their external debt.

Liberalisation of the Icelandic financial sector and privatisation of domestic banks completed.

Negative reports by rating agencies limited access to international securities markets.

FearDatapoints:Sentiment:

1 2 3 4 5 6

Fig. 3 Iceland financial system failure analysis (2000-2009)

What is systemic risk? Systemic risk is the risk of a systemic event in a system that produces an altered or damaged transitional system that is functionally impeded, which in the extreme may no longer be capable of functioning (authors’ summary of Zigrand, 2014).

Fig. 4b A cusp catastrophe-type model of the global financial system

Fig. 5a Conceptual model of agent-based model

So what The method proposed here offers a way of diagnosing when the global financial system is approaching a state of operational crisis, and understanding how that outcome could generally be avoided. Impact Mitigating falls in lifetime income of working age adults of $150,000 on average estimated for the 2008 global financial crisis

PotentiallyCatastrophic

SystemicFidelity

SystemicFailureset

Divergent

Contagious

Optimal

Contagious Dispersive

Dispersive

Divergent

Optim

al

0%

When shifts in the system’s operational state over time are projected from the three-dimensional surface of behaviour Bt onto this two-dimension control surface of focus F, and then are described by extensions to the concepts of divergence and hysteresis from catastrophe theory, they provide a categorisation of operational behaviour.

Hysteresis

y

100%

% of systemicallyimportantfinancial services(SIFS) that arethe focus ofconcentrations insupply intentions

x100%

% of systemically importantfinancial services (SIFS) that arethe focus of concentrationsin demand intentions

( )failF

( )F

The two-dimensional control surface F of overall focus on intended supply relative to demand

Fig. 5b Part of agent-based model dashboard (time on horizontal axis) showing phenomena/system level demand, supply and satisfaction

100%

0%

yx

100%

z

The two-dimensionalcontrol surface Ft of overall operational focus on intended

supply relative to demand

The three-dimensional surface Btof all previous and predicted operational states at time t. This surface represents the operational behaviour topology, in which each coordinate point (x, y, z) =bt∈Bt is a potential overall operational effectiveness at time t. Then a current operational state at t is defined by a single point on this surface and a state category derived from its placement in a region of Bt.

Bifurcation set(shadow of the fold

on the control surface), which isalso a catastrophic contagion set

SystemicFailure

set

Singularity

Cusp(can fold

either way)

Progressive contagion set for y(supply)

Cross-sectional cut in surface Bt

Catastrophicfailure of the

system

Systemic risk mitigation effect

Progressive contagion set for x (demand)

100%% of all available systemically important financial services that achieve a minimum level of overall supply satisfaction of demand