The traditional method of identifying financial institutions that pose a systemic risk to the global economy takes too long, which makes the resulting data irrelevant, according to United States asset manager Windham Capital Management.
"Securitisation, private transacting, complexity and 'flexible' accounting prevent us from directly observing the many explicit linkages of financial institutions," Windham chief investment officer Mark Kritzman said at a recent CFA Institute presentation in Sydney.
"For example, there is a lot of private transacting, so these connections don't ever occur on anybody's radar screen.
"I don't think that investors would have continued to purchase insurance from IAG had they noticed how much insurance IAG had written."
By the time the complex networks were untangled and the complex accounting was examined, the analysis of connections would be stale, Kritzman said.
As an alternative method, Kritzman and his colleagues developed a measure of implied systemic risk called the absorption ratio.
The ratio is calculated by taking the fraction of the total variance of a set of asset returns explained or 'absorbed' by a fixed number of eigenvectors.
"We infer how systemic the markets are from the behaviour of security prices," Kritzman said.
"The absorption ratio captures the extent to which markets are unified or tightly coupled."
When markets were tightly coupled they were more fragile in the sense that shocks travelled more quickly and more broadly, he said.
Back-testing the method showed the most significant US stock market drawdowns were preceded by spikes in the absorption ratio.
But the method can also be used to create a list of the most systemically important companies in the world.
At recent summits, the G20 country leaders asked the Financial Stability Board to come up with a list of systemically important financial institutions.
"It took the Financial Stability Board two years to come up with their list," Kritzman said.
"We can do it in a day."
The absorption ratio method produced a nearly identical list of 30 companies, with the major differences stemming from the fact the list included insurance companies, which the Financial Stability Board list did not.
A more recent analysis of the market showed Bank of America to be the most systemically important institution, followed by Citigroup and JP Morgan.
The list of 30 companies did not include any Australian institutions.
"Sorry, but you guys are not systemically important," Kritzman said.
The method could also measure the intrinsic systemic risk of a portfolio, he said.
But he also pointed out further research needed to be done to make it function as a practical early-warning system.
Last month, Kritzman, Windham senior research associate Yuanzhen Li and their co-authors Sebastien Page and Roberto Rigobon won the Journal of Portfolio Management Outstanding Article Award for their work on systemic risk, honouring innovative research and practice in portfolio management.
