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Regulators Need New Ways to Measure Collective Risk, IMF Says

The International Monetary Fund said regulators need new ways to measure the risk of a financial shock before they can try to prevent future meltdowns and it proposed three ways to monitor warning signs of broad-based problems.

The IMF said international banking standards have improved when it comes to monitoring individual banks and financial firms, under the Basel III capital framework. The next challenge will be developing a way to monitor group risks to head off a broad financial collapse, the Washington-based lender said in its Global Financial Stability Report, released today.

The fund recommended that financial authorities consider how they will monitor and rein in systemic risk, perhaps through taxes, fees or a capital surcharge. Any of the three methods could be used to develop regulatory tools, said the report, which didn’t endorse a single policy path or evaluate which would be cost-effective to implement.

Systemic liquidity risk is “the risk that multiple institutions may face simultaneous difficulties in rolling over their short-term debts or in obtaining new short-term funding through widespread dislocations of money and capital markets,” the IMF said. “More needs to be done.”

When adding a surcharge or tax on liquidity risk, regulators should try not to double-charge big banks, said Laura Kodres, chief of the IMF’s global stability analysis division, at a news conference today. She said banks that raise more capital, increasing their solvency, probably should see their liquidity-related requirements decrease accordingly.

Stress Tests

Stress tests are one of the IMF’s three proposed frameworks for evaluating systemic risk. This method is the most familiar to regulators and also “the one that is easiest to implement in the short run,” the IMF said.

Stress tests work by assessing a bank’s vulnerability to an economic or financial industry shock. The IMF’s method would also assess the risk of liquidity shortfalls and transmission of liquidity woes to other firms.

A second framework is a Systemic Liquidity Risk Index that would attempt to measure the simultaneous tightening of liquidity and funding conditions in global markets. This includes looking for “arbitrage violations,” or when financial conditions appear to be hampering normal market operations.

This index could assess covered interest rate parity in currency markets and swap spreads in interest-rate markets. For bond markets it could look at the difference between credit default swaps and the implied credit spreads on cash bonds.

The IMF’s proposal for this index includes 36 metrics in three securities markets at various maturities. It is “straightforward to compute” and can be used to monitor trends.

Systemic Risk

The third proposed framework is a Systemic Risk-Adjusted Liquidity model. It would use contingent claims analysis to measure liquidity risk.

This method could look at the probability that an individual company might experience a liquidity shortfall, quantify that shortfall, and then look for spillover effects. It uses Basel III’s proposed “net stable funding ratio” as a starting point and adds other levels of analysis.

The model “has the advantage of using daily market data and standard risk-management methods to translate individual contributions to systemic risk into a macroprudential measure,” the IMF said. For the model to work, it would be important to have an accurate measure of liquidity risk as a starting point, the IMF said.

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