Mirror, mirror on the Wall (Street), who was the riskiest of them all?
It was the question at the heart of the global financial crisis, when investors pummeled the shares of companies whose exposures to various investments such as subprime-mortgage-backed securities were unclear, and it is a hot topic in Washington, D.C., as regulators seek ways to prevent another meltdown.
Into the fray have stepped researchers at New York Universitys Stern School of Business. They have devised a ranking of 102 financial institutions, which measures which firm poses the greatest systemic risk to the financial system. In recent weeks, the group has shared its proposal with the Federal Reserve Bank of New York and officials at the International Monetary Fund.
Of course, measuring the impact an individual institution’s financial troubles could have on the overall financial system is tricky because, as the recent global financial crisis showed, systemic risk isn’t always apparent until the entire system is under stress.
The NYU researchers used three different methodologies. First, they looked at 5% of the trading days since the 1960s with the biggest declines and calculated how much each institution’s stock losses contributed to the markets overall decline on those days. Second, they ranked each institution’s risk profile by calculating its losses during those particularly bad days as a percentage of its overall market value. The third measure is likely to prove the most controversial: The group proposes that each financial institution be required to take out an insurance policy that would pay out to the government in the event of a financial crisis.
While not all of the institutions are systemically significant by themselves, they present “red flags” for regulators seeking to identify vulnerable links in the financial system, says Matthew Richardson, one of the projects authors and an NYU finance professor.
To be sure they measured the institutions’ risk before the financial crisis took hold and to test the predictive qualities of their research, the researchers calculated the rankings using data through June 2007.
Predictably, at the top of this first list, an individual institution’s contribution to the stock market decline on those down days, are the biggest financial institutions: No. 1 Citigroup; No. 2 J.P. Morgan Chase; No. 3 Bank of America; No. 4 Morgan Stanley; and No. 5 Goldman Sachs Group. (Look familiar?) At the bottom of the list were Berkshire Hathaway, United Health, Aflac Inc. and US Bancorp.
By the second criteria (stock losses duiring the 5% worst days as a percentage of a company’s overall market value), the top of the list reads: No.1 E*Trade; No. 2 Bear Stearns; No. 3 CB Richard Ellis; No. 4 Lehman Brothers Holdings; No. 5 Morgan Stanley. CIT Group, the small-business lender that recently narrowly escaped bankruptcy, ranked No. 10.
The insurance rates charged would be determined by a complex algorithm measuring an institution’s leverage (or debt load) and the volatility of its share price and how its corelates the overall market losses. As of 2007, the ranking of the highest rates reads like a Wall Street tombstone: No 1 Bear; No 2 Lehman; No. 3 Merrill Lynch; No. 5 Countryside Financial.
Under the NYU plan, rising debt loads and a stock market meltdown would trigger an insurance payout to the federal government to offset the costs of any bail out or other assistance. The idea is that the insurance fees, which could total tens of millions of dollars per firm, would discourage a bank or broker from taking too much risk in the same way that the federal tax on carbon emissions is meant to discourage pollution.
The problem is whether private insurers could afford to provide such systemic risk insurance. “You dont want a situation like [American International Group] where insurers would be writing insurance they cant pay off,” Richardson says.
Next up? Satisfied that they are on to something, the NYU researchers plan to bring the rankings up to date. We eagerly await those new standings.
Below is the 10 riskiest firms as of June 2007 measured by MES. Click here to see the complete list.
|Marginal Expected Shortfall Ranking (%)||Firm||Marginal Expected Shortfall Ranking ($)*|
|1||E* TRADE FINANCIAL CORP||37|
|3||CB RICHARD ELLIS||54|