Mirror, mirror on the wall — who’s really the riskiest of them all?

This — in case you were wondering — is a list of what some academics see as today’s most systemically risky financial firms in the US:

The list has been compiled on VoxEu.org by Viral Acharya, Thomas F. Cooley, Robert Engle and Matthew Richardson, all of whom argue that while measures such as the Volcker Rule — as enforced under the Financial Stability Oversight Council — represent important steps in curbing systemic risk in the financial system the most important step of all is still the identification of risky firms.

In this domain, they say, the Council’s initial proposals have missed a key issue.  The extent of correlation between the risk of a firm and the whole financial sector. As they note:

Their primary focus on firm size and firm capital (based on current risk assessments) misses this entirely.

But to correctly identify systemically risky firms , one needs first to be clear about what constitutes systemic risk though:

A natural assumption is that systemic risk emerges when the aggregate financial sector falls short of capital, and that the costs of this risk increase with the magnitude of the shortfall. Given this assumption, everything follows. Economic theory provides a precise measure of systemic risk for a financial firm (see for example Acharya 2010a, 2010b). It consists of two parts. First, the costs to society of a systemic crisis measured per dollar of capital shortage in entire financial sector, times a second part which is the firm’s anticipated contribution to the capital shortage in that sector.

Which leads to:

Then, the Systemic Risk Contribution, SRISK%, is the percentage of financial sector capital shortfall that would be experienced by this firm in the event of a crisis. Firms with a high percentage of capital shortfall in a crisis are not only the biggest losers in a crisis but also are the firms that create or extend the crisis. This SRISK% is the NYU Stern Systemic Risk Ranking of the US Financial sector.

While the list at the beginning of the post reflects the academics’ current SRISK% estimation of the most risky firms in the United States, the model can also be applied historically. In that case:

As an illustration, applying these methods in July 2007, of the top 10 systemic firms, Citigroup, Merrill Lynch, Freddie Mac, Lehman Brothers, Fannie Mae and Bear Stearns all show up. By March 08, AIG, Bank of America and Wachovia enter into the top 10 rankings.

On a current basis though, the most interesting finding is that the biggest contributor to risk by a wide margin is Bank of America, while the top five riskiest firms account for over 70 per cent of the risk.

What’s more, Citigroup and AIG still rank at number two and number five “even if their immediate problems may have been resolved through government backstops.”

A fact which hardly puts the prospect of an AIG 2.0 on the back burner for long.

Related links:
Overseeing systemic risk - VoxEu.org
You couldn’t make this up, Hartford Financial edition – FT Alphaville
An update on America’s riskiest banks – FT Alphaville