Oops! There is that word **systemic** again

Risk Measurement and Systemic Risk - November 8, 2005

Speech by André Icard, Deputy General Manager of the Bank for International Settlements, at the Fourth Joint Central Bank Research Conference on Risk Measurement and Systemic Risk, European Central Bank, Frankfurt, 8 November 2005

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In addition, the number of counterparties big enough to accommodate our business needs is very limited, especially in the domain of OTC derivatives. As this limits the number of eligible investments and counterparties, the BIS runs significant credit risk and business volume concentrations. In fact, the resulting triangularity between credit quality, liquidity and concentration is exacerbated not only by the growth of our own business volume, but also by the continuing merger activity among issuers and counterparties. As most of you will agree, a situation like this requires careful monitoring and management of the resulting risks; and models alone, though helpful, do not guarantee that we get such a trade-off right. Furthermore, the use of collateral can help mitigate the counterparty risk posed by positions in OTC derivatives, but leaves open a significant part of the risk involved.

The last point is of some importance, as a relatively small number of institutions has become key to the integrity and smooth functioning of quite a number of markets. As these players combine various forms of intermediation activities, on and off balance sheet, it is conceivable that problems in one of these activity areas could affect the activity of other parts of the firm, and thus spread across various markets. Idiosyncratic shocks to key bank or non-bank institutions, particularly when coinciding with systematic factors, could thus become systemic. Indeed, the concentration phenomenon that I identified in the first part of my talk as a feature of the BIS’s risk exposure reappears here as a potential concern about the system’s "plumbing".

While big, Refco was probably not big enough to matter in any systemic sense, and its crucial futures brokerage continued to be operational. But the events surrounding its demise offer a taste of how the proverbial "flap of a butterfly’s wing" could cause repercussions throughout the financial system by affecting parts of the market infrastructure. What if a bigger broker with more of a presence in OTC instruments had been hit by the same event? At the risk of overemphasising the point, I find it relatively easy to imagine that cases involving bigger institutions with more complex net positions would have much broader implications.

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