Interconnectedness : mapping the shadow banking system

Systemic risk is the risk of collapse of the financial system resulting from inter-linkages, such that the failure of individual entities or the collapse of an individual market can cause a cascading failure. The essence of systemic risk is interconnectedness. Theory gives some guidance: if negative shocks are small, a more densely connected financial network spreads risk and enhances financial stability. But beyond a certain point, dense interconnections support transmission and propagation of shocks, hence a more fragile financial system. Direct interconnectedness may arise from counterparty relationships and exposures, whether on the asset or the liability side. Indirect interconnectedness may arise when entities have common exposures, so that if one is forced into fire sales, the fall in asset prices affects the balance sheets of others. Indirect interconnectedness is also a feature of collateral chains, in which entities that have no direct relationship are nevertheless linked because one holds collateral originating from the other. Reputational risk can also connect an entity whose reputation suffers a blow (e.g. suspicion of illegal activity) to others believed to share similar characteristics, though they have no direct institutional or transactional relationship. In many such cases, there may be a danger of contagion. Particular concerns arise in derivatives markets, securities financing transactions (SFTs), wholesale funding markets, leveraged open-ended funds doing significant maturity or liquidity transformation, and central counterparties. In all these cases, the first step must be to get data that document the interconnectedness. This amounts to "mapping" the shadow banking system, i.e. documenting and analysing interconnectedness. That is essential to advance our understanding not only of shadow banking, but also of the overall environment within which Capital Markets Union (CMU) is to progress.The ADEMU Working Paper Series is being supported by the European Commission Horizon 2020 European Union funding for Research & Innovation, grant agreement No 649396