Analyzing the Effectiveness of Asset Size to Indicate Systemic Risk

The Situation

In the wake of the 2007-2008 financial crisis, policymakers considered a number of proposals intended to reduce systemic risk posed by financial institutions. One popular proposal would have required financial institutions above a specified asset size to pre-fund a “systemic dissolution fund.”

NERA's Role

A leading property casualty trade association asked NERA to provide an analysis of the effectiveness of this proposal with particular focus on its ability to correctly identify systemically risky institutions. NERA experts -- along with Oliver Wyman Group Partner Dr. John Bovenzi -- authored two white papers demonstrating that reliance on asset size for systemic risk identification would pose several problems and would potentially fail to identify the type of institutions most likely to generate systemic risk. The first white paper showed that use of asset size as a proxy for a firm’s systemic risk would erroneously identity a number of firms as systemically risky while failing to identify certain firms that do pose significant systemic risk. The second white paper discussed the role of financial system interconnectedness in systemic risk. It described the types of connections between various financial firms, including property and casualty and life insurance companies. The paper illustrated that the extent of interconnectedness and hence systemic risk contribution varies by institution type and concludes that an appropriate assessment of interconnectedness is critical for any systemic risk oversight process.

The Result

The trade association used the NERA white papers to help explain their position about financial reform.