SYSTEMIC RISK EXPOSURES AND LOSSES
The systemic risk losses are defined by analyzing the systemic interaction between the risk factors of particular market sectors, counterparty ratings as well as the sector and idiosyncratic behavior characteristics linked to financial contracts.
The unexpected systemic events of the financial contracts, derived from the systemic risk, define the exposures to systemic losses expressed as losses in value, income and liquidity.In marketplace lending, even though lenders bear all the risk of the loans they fund on lending platforms, the sector may create potential systemic exposures that might become significant. If the sector achieves a significant degree of market share—such as $1 trillion in originations by 20206—then it could become systemic. The fact that returns are satisfactory with few losses under ideal conditions is no guarantee that this will continue under stress conditions. It is therefore sensible to look into exposures and their impact on the financial system beyond individual counterparties.
A high correlation among markets and high degrees of sector sensitivities of the counterparties indicate that the probability of increasing the amount of contacts that are under systemic risk is higher. Even a portfolio where the majority of the interconnected counterparties have low probability of downgrades or resulting default events, under stress conditions, systemic risk losses can be high. This is due to the fact that a small number of counterparties and markets could be vulnerable to stress conditions and thus could directly impact the correlated counterparties and markets that both impact the financial events of the linked financial contracts. Especially when securitizations of marketplace loans increase in size, some investors or funds may concentrate large exposure to the asset class. Because marketplace borrowers may act similarly under stress, such a concentrated exposure might become extremely volatile very quickly.
Even a financial entity in the shadow banking sector can become systemic and may need capital injections if a rescue mission is necessary. For instance, the hedge fund Long-Term Capital Management (LTCM), after celebrating returns in the first three years, lost billions in just a few months following the 1997 Asian financial crisis and 1998 Russian financial crisis, and eventually required financial intervention by the U.S. Federal Reserve. Even though funds investing in marketplace loans are still nowhere near the size of LTCM at its peak, the danger for concentration by an unregulated entity exists.The credit spreads together with the market curves are used to calculate the value and the expected cash flows, expressed as value and liquidity exposures of the financial instruments. In fact, these exposures can be distinguished as the ones where counterparties are holding and the ones that are exchanged. The former indicates the implications in losses of the portfolio value and liquidity in case the counterparty defaults or downgrades. The latter, that is not always available, indicates the degree of systemic exposure and interdependency between the counterparties. For instance, in a portfolio with governmental bonds, the information referring to both types of exposures is available.7
Future exposures can be defined based on stochastic process analysis or deterministic assumed market and credit risk factors. Any fluctuation of the exposures due to market volatilities is also considered to define the degree of haircut applied in future exposures. Haircuts can also be used to define the collaterals provided for absorbing future systemic losses. Future systemically correlated exposures are used to estimate the potential systemic losses.
Finally, it is important to bear in mind that the consideration of gross exposures could help to avoid the implications from general and/or specific wrong way risk discussed in Chapter 10.
11.4