Systemic Wrong-way Risk

Michael Pykhtin and Alexander Sokol

This article was first published as a chapter in Managing systemic exposure (2nd edition) on August 14, 2013, by Risk Books.

The financial crisis of 2007–09 emphasised the importance of measuring and managing counterparty credit risk (CCR) for all market participants.¹¹A comprehensive overview of CCR can be found in Canabarro and Duffie (2003), Cesari et al (2010), Gregory (2012) or Pykhtin (2011). The collapse of Lehman Brothers and other major financial institutions during the crisis showed that even the largest financial institutions can fail. The default of Lehman Brothers’ vividly illustrated that the failure of a large financial institution can cause a major impact on world markets and the global economy. In the wake of the crisis, the Basel Committee on Banking Supervision (2010) introduced the notion of the systemically important financial institution (SIFI). Under the Basel III framework issued in response to the crisis, SIFIs will be the subject of an additional capital surcharge above the minimum capital requirements. This new regulatory standard will provide an additional measure of safety with respect to the default of a SIFI.

In this chapter, we will discuss a