A Systematic Approach to identify Systemically

Important Firms : A Summary

Rishabh Shukla
Since the 2008 crisis, there has been a growing interest in measuring systemic
risk in the financial sector, as prudential regulation of individual financial
firms did not prove adequate to manage the risk posed by the financial sector
to the economy. In such a scenario it is wise to identify systemically important
financial firms (SIFIs) as it enables policy-makers to choose the most suitable
government intervention when such a firm approaches failure.
The paper by Agarwal, Arora et.al (2013) identifies systemically important
financial firms (SIFIs) in India using three measures which are grounded in
quality datasets, namely Granger Causality (GC), Marginal Expected
Shortfall (MES) and Conditional Value at Risk (Co-VaR). The paper also
proposes a Systemic Risk Index (SRI), an aggregate measure of systemic risk
based on average of percentile rankings on individual measures.
Granger causality (GC) measures the degree of interconnectedness between
firms and also the direction of causality of their relationship. Greater the
number of inter-connections, more likely will a firms failure cause a systemic
shock. Marginal Expected Shortfall (MES) measures the market capitalization
that a firm stands to lose on the worst performing days of the market. Greater
the MES of a firm, more vulnerable it is to a crisis. Co-VAR measures the
marginal contribution of a firm to the overall level of systemic risk of the
market.
The systemic risk index (SRI) is computed for a firm i by calculating GC,
MES and Co-VAR at sample time period t. The percentile rank of each firm is
then calculated on the basis of each measure. The average of these percentile
ranks are then obtained for each firm at each time period to obtain the SRI.
The differences between rankings based on different measures is thus
eliminated and a unique set of SIFIs is determined for a given time period.
The paper calculates SRI for the 50 largest firms listed on the NSE for each
quarter from July 2006 to October 2012, including both financial and
non-financial firms. The paper also evaluates the SRI for the 25 largest banks
in the country. The firms with higher SRI are systemically riskier compared to
the lower ranked firms.

The hypothesis that the paper then tests is whether the measures capture
some or all facets of systemic risk. If they do, then theyll have significantly
different values in the pre-crisis period compared to the crisis period, since
systemic risk increases during the time of a crisis. The hypothesis is tested
using the test of difference in medians between two periods using the
Wilcoxon-Mann-Whitney test.
The paper finds that GC and MES rise significantly between the pre-crisis
period, the crisis period and the post-crisis period while co-VAR falls
significantly in the post-crisis period, implying that it could be a lead indicator
of rise in systemic risk; thereby acting as an early warning signal. The median
GC of the banks is higher compared to the 50 largest firms, implying a higher
degree of interconnectedness among the major banks compared to the average
firm. Since the median MES, as a fraction of GDP, is found to be higher
during the crisis period compared to the post-crisis period, banking sector is
likely to contribute a larger portion to the systemic risk during the crisis
period compared to periods with low systemic risk.
By ranking of the firms by averaging the SRI in each quarter within a period,
it is found that ICICI Bank was the most SIF during the crisis period. If the
top 20 SIFs are calculated by averaging the GC, MES, SRI or co-VAR, the
number of financial firms vary across measures. However, the largest number
of financial firms among the top 20 are identified during the crisis across all
measures, with SRI identifying the most number of financial firms across all
periods (pre, during and post crisis).
The paper also finds that non-financial firms may cause systemic risk to
spread during a crisis due to the exposure of commercial banks to such firms
through bank loans. For example, during Jul-Sep 2008, DLF, a real estate firm
with a market cap under 4% of GDP, similar to HDFC Bank during that
quarter, had a higher MES than HDFC, however the bank was more
inter-connected (higher GC).
An extension of the paper could identify SIFs in different industry sectors. If
the systemically important sectors have a concentration in the loan portfolio of
the banking sector, it could serve as a useful input for better risk management
of the banking firm and also the sector at large.