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Interconnected systems key to assessing systemic risk in banking sector: DTCC

FINANCIAL networks tend to be robust yet fragile, absorbing shocks up to a certain tipping point, beyond which they spread risks rather than contain them, according to the Depository Trust & Clearing Corporation (DTCC).

In its white paper entitled "Understanding Interconnectedness Risk", DTCC said these interconnections - the network of credit exposures, trading links and other relationships and dependencies between financial agents - serve as a conduit for contagion and have proven to propagate shocks beyond their original impact, amplifying them in the process

"The impact of the failure of a large interconnected entity can spread rapidly and extensively across the financial system, to the point where it can cause worldwide financial instability," according to the report.

This was evident in the collapse of Lehman Brothers in September 2008, which triggered the worst financial crisis since the Great Depression. The initial crisis originated in the US subprime mortgage-backed securities and collateralised debt obligations markets, but quickly affected market participants around the world through a complex web of direct and indirect links.

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The risk of contagion generally increases with the size of the shock and the centrality of the affected entities; all else being equal, the more central the location of a failing node, the greater the likelihood of contagion.

It noted that some research has suggested that networks with a moderate level of interconnectedness may be the most resilient ones.

"That said, studies on the relationship between a network's interconnectedness and its ability to withstand shocks also suggest that many other factors come into play, including the type of financial shocks, the maturity structure of banks' liabilities, existence of information problems and other financial frictions," it said.

DTCC said risk management practitioners may benefit most from incorporating interconnectedness analysis into everyday risk management activities, to enhance systemic resilience, both for individual organisations and for the financial industry as a whole.