The Economist blog, Free Exchange has an entry summarizing a new paper from the National Bureau of Economic Research which attempts to measure systemic (system-wide) risk in the finance and insurance sector. The research illustrates that the monthly returns from hedge funds, banks, brokers and insurance company’s have become more and more interrelated. Over the last ten years the increasing interconnectivity between the industries has increased the level of system wide risk.
It would appear that the number of connections has ebbed and flowed over time. Below two charts from the above mentioned research paper, Econometric Measures of Systemic Risk in the Finance and Insurance Sectors by Billio, Getmansky, Lo and Pelizzon point to the fact that there were less connections from 1999-2001 (left picture) than there were from 2006-2008 (right picture). The first period was after the collapse of the hedge fund Long Term Capital Management (LTCM) in 1998. The failure of LTCM affected global markets and impacted a majority of the big investment banks of the day. It also illustrated just how interconnected these banks were via the LTCM and how susceptible they were to the failure to just one counter party. An excellent account of LTCM’s rise and fall was penned by Roger Lowenstein in his book When Genius Failed: The Rise and Fall of Long Term Management.