Toward Determining Systemic Importance

Kinlaw, Kritzman, and Turkington introduce a methodology for measuring systemic importance. Investors care about systemic importance because this knowledge may enable them to assess their portfolio’s vulnerability to particular events and, if warranted, to pursue defensive strategies. Policymakers also need this information to ensure that policies and regulations target the appropriate entities and to more effectively engage in preventive or corrective measures when circumstances warrant intervention. The absorption ratio, introduced by Kritzman, Li, Page, and Rigobon in 2011, provides an implied measure of systemic risk based on principal component analysis. The authors extend this methodology to determine an entity’s centrality. Their centrality measure captures an entity’s vulnerability to failure, its connectivity to other entities, and the risk of the entities to which it is connected. They convert this measure of centrality into a measure of systemic importance by conditioning it on periods of high systemic risk. <bold>TOPICS:</bold> <ext-link>Portfolio construction</ext-link>, <ext-link>analysis of individual factors/risk premia</ext-link>, <ext-link>accounting and ratio analysis</ext-link>