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The Journal of Risk Finance
The structural fragility of financial systems: Analysis and modeling implications for
early warning systems
Dieter Gramlich, Mikhail V. Oet,
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JRF
12,4 The structural fragility
of financial systems
Analysis and modeling implications
270 for early warning systems
Dieter Gramlich
Baden-Wuerttemberg Cooperative State University, Heidenheim, Germany, and
Mikhail V. Oet
Federal Reserve Bank of Cleveland, Cleveland, Ohio, USA
Abstract
Purpose – Lessons from the most recent financial crisis show specific vulnerabilities of financial
markets due to weaknesses in the structure of the financial system (structural fragility). As the
literature points out, the impact of systemic risk can be closely related to issues of concentration
(“too big to fail”) and dependency (“too connected to fail”). However, different structural variables
are emphasized in various ways, and most authors analyze each variable separately. This raises the
questions of how structural fragility, as a cause of systemic distress, can be assessed more
comprehensively and consistently, and what the implications are for modeling it within an integrated
systemic risk framework. This paper seeks to address these issues.
Design/methodology/approach – On the basis of theoretical considerations and in the light of
current transformations in financial markets, this paper explores elements of structural fragility and
the requirements for modeling them.
Findings – The paper suggests an extended approach for conceptualizing structural fragility,
evaluates directions for quantifying structural issues in early warning systems (EWSs) for systemic
crises, and lays a theoretical groundwork for further empirical studies.
Originality/value – The need for supervisory actions to prevent crises is urgent, as is the need for
integrating structural aspects into EWSs for systemic financial crises. Since a significant aspect of a
financial firm’s risk comes from outside the firm, individual institutions should understand and
monitor the structural aspects of the various risk networks they are in.
Keywords Financial market vulnerability, Systemic risk, Systemic risk capital, Financial markets,
Banks
Paper type Conceptual paper
1. Structural fragility as an element of systemic risk

Up until now, early warning systems (EWSs) for systemic financial crises have
concentrated primarily on external shocks from macroeconomic conditions and their
transmission within financial markets (Borio and Drehmann, 2009)[1]. The EWSs
literature discusses the structure of the financial system and its capacity to absorb or
amplify exogenous shocks, but scarcely considers it as a risk determinant in itself[2].
However, the recent crisis showed the vulnerability of banks that results from their
The Journal of Risk Finance connectivity with other banks and as well as the amplification mechanisms caused
Vol. 12 No. 4, 2011
pp. 270-290
q Emerald Group Publishing Limited
1526-5943
The views expressed in this paper are those of the authors and not necessarily those of the
DOI 10.1108/15265941111158460 Federal Reserve Bank of Cleveland, the Board of Governors, or the Federal Reserve System.
by co-movements in the system. Thus, there is evidence that intrinsic weakness Early warning
(structural fragility) may itself be a risk factor and can contribute to problems arising systems
from exogenous effects, making the system even less resilient and shock-absorbent.
Emphasizing the strengths and weaknesses of systemic structures is not only a major
concern for financial supervisory authorities. Since a significant aspect of a financial
firm’s risk comes from outside the firm, an institution that is trying to manage its own
exposure should understand and monitor the structural aspects of the various risk 271
networks it is in. As the European Central Bank (ECB, 2009, p. 127) points out, systemic
risk management must assess, mitigate, and control risk on a macrofinancial level. In this
regard, the banking system at the center of financial markets may be thought of as a
portfolio of financial firms, managed by banking regulators (Lehar, 2005). At a given point
in time, the stability of the portfolio is conditioned by the resilience of single firms and the
robustness of the relationships among them. However, individual firms’ resilience and
inter-relationships can be highly dynamic, particularly under uncertain market
conditions. Thus, the supervisory approach to structural stability focuses on two
objectives: first, the stability of the portfolio through the resilience of single firms and the
robustness of their inter-relationships; and second, on the system’s dynamic properties, for
example, its reactions to worsening conditions and its capacity for structural innovation.
As the most recent crisis shows, supervisory risk/return management of bank
portfolios should concentrate more on ex ante actions and crisis prevention. Once a crisis
has emerged, it is much more difficult to restore the system’s stability and to limit the
negative impact of the crisis. Regarding structural stability, ex ante supervisory risk
management must focus on building stable systemic structures and reducing the risk of
internal weaknesses. At the same time, the system must also be resilient with regard to
external macroeconomic factors and able to absorb shocks from outside without
spillover of these factors into the real economy. Given the dynamics of financial markets
and transformations within the system, it is, particularly desirable that macroprudential
oversight include both the awareness of upcoming structural changes and the ability to
assess their impact on systemic stability.
Against this background, the purpose of the paper is to provide an extended
framework for assessing and modeling structural aspects of financial markets.
Regarding the theoretical precedent of this extension, the critical questions are:
Q1. What elements of financial market structure contribute to systemic risk and
how can they be incorporated into a structural fragility framework?
Q2. In the light of structural characteristics and current transformations in
financial markets, what are the requirements for modeling structural fragility?
What particular requirements come from policymakers’ objectives and
regulatory needs?
Q3. How do existing models respond to these requirements, and what directions
should future modeling research take?
In answering the above questions, we develop the outline of an extended model for
assessing structural fragility in the financial system. The results are important for the
construction of an EWSs and for a regulatory policy that is better adjusted for including
changes in systemic structures. The results may also serve to guide supervisory policies
at the onset – and in the course – of financial crises.
JRF 2. Financial market structure and stability
12,4 2.1 Systemic financial risk
The assessment of systemic risk in financial markets is based on a definition of systemic
risk and an assumption about its causes[3]. Concepts of financial stability are discussed
in Bårdsen et al. (2008, pp. 12-14), which points out that the definition of systemic risk
varies and depends largely on the objectives of the definition. Fundamentally,
272 a definition of systemic risk must involve the degree of distress associated with systemic
crises and the underlying distress-generating mechanism. From a supervisory point of
view, systemic risk may be considered as the risk of correlated defaults of financial
institutions, primarily affecting the system’s risk capital and liquidity, with subsequent
negative feedback effects on real markets.
Theoretical precedents typically discuss exogenous factors – such as shocks from
the macroeconomic environment and the mismatch between economic and financial
variables – as the main drivers of systemic financial risk. More recently, a number of
papers recognize that certain endogenous processes within microfinancial factors, such
as contagion, confusion, or panic, and the markets’ structural pattern also have
significant influence on systemic stress. We regard the financial system’s structure as
the organizational pattern of financial markets created by the number and type of
market players and the nature, direction, and intensity of their interactions[4]. However,
the recent literature does not answer the question of whether these endogenous factors,
in themselves, constitute a set of independent risk categories or are engaged in a
simultaneous, mutually modifying interaction with the exogenous risk factors.
The interaction between financial institutions leads to specific systemwide effects
and is quite distinct from the explanations that can be obtained by simply summing up
the risks and behavior of individual banks. In particular, there are effects for the
compensation or concentration of risk. For example, the fire sale of assets may be an
adequate method of liquidity management on an institutional level, but not if all banks
sell at the same time. Hoarding money may be beneficial on a microfinancial level, but
will dry up liquidity on a macro level. Whereas this emphasizes actions and reactions of
institutions in the presence of risk, the extent to which institutions are exposed to the
same type of risk must be considered a determinant of systemic risk as well. In addition,
the system’s overall capacity to withstand risk depends on risk capital and liquidity as a
function of the capital and funding interrelations among individual financial institutions
(Figure 1).
Against this background, the concept of structural fragility (structural instability)
refers to the vulnerability of the financial system that results from the organizational
pattern of the system itself[5]. The “structural stability” and “structural fragility”
Systemic risk exposure Systemic risk management

= f(risk similarities/risk differences = f(risk compensation/risk amplification
with regard to the common risk effects resulting from the similarity of
exposure of institutions) institutions’ risk management)
Systemic risk capital and liquidity

= f(risk capital and liquidity
Figure 1. stabilizing/destabilizing effects of the
Constituents relatedness of institutions)
of systemic risk
Note: f = function of
concepts are, implicitly, inversely related, as are the concepts of “financial stability Early warning
conditions” and “financial stress conditions.” Structural fragility increases the risk of systems
internal breaks and intensifies financial markets’ sensitivity to internal and external
shocks. In addition, the structure of the financial system reduces its capacity for risk
mitigation, particularly:
. its ability to absorb or amplify stress factors; and
.
the speed and magnitude of adjusting to these factors. 273
2.2 Transformation of financial markets

Recent research provides evidence of structural patterns for systemic risk. This is
closely related to transformations in financial markets and their impact on the resiliency
of the system[6]. Giesecke and Kim (2009, pp. 2-24) conclude that past research mostly
focused on “observable” factors (such as default spreads and the yield curve) as
explanation for systemic risk, whereas “non-observable” factors, such as spillovers into
financial markets, have more recently proved to have a strong impact in times of stress.
Although the new behavior of financial markets may be partly attributable to
innovations in products and processes, the transition in financial regulation has led
to increased liberalization of markets as well as stronger regulatory requirements. Borio
(2007, pp. 2-6) sees transformations as related to financial liberalization, invention of new
products, entry of new players, and appearance of new risk classes.
From the perspective of US financial markets, there is evidence of changes in the
system’s international and national patterns. For example, lending from abroad
amounted to 21.7 percent of gross domestic product (GDP) in 1998 and increased to
68.9 percent in 2008 (Figure 2). Although within the financial sector, the ratio of financial
assets to total financial assets decreased for funds (from 36.6 to 27.6 percent) and
insurance companies (from 11.7 to 9.2 percent), the ratio increased for mortgage and
asset-backed security pools (from 10.7 to 14.5 percent) and commercial banks (from
17.7 to 21.6 percent) (Figure 3). The extension of global markets and the homogenization
of the legal framework have increased similarities across institutions and regions, but
reduced the potential for diversification and intensified procyclicality. Allen and Gale
(2007, p. 19) refer to structural changes, observing that whereas formerly market
behavior was the cause of problems and regulation was its solution, structural stress
recently seems to come from moral hazard implied by governmental behavior, and
market forces seem to be the remedy.
International debt and US GDP (trillions USD)

25
20 6.04
US - International debt
15 3.75 securities
0.69 US - Loans from offshore
10 1.21 banks
14.20
5 US GDP
8.75
Figure 2.
0
1998 2008 International debt and
US GDP, 1998 and 2008
Source: Data from: BIS (2009) and IMF (2009b)
JRF US financial assets (trillions USD)
12,4 140
16.78
120 9.02
5.70 Other
100 13.42
Mortgage and ABS pools
17.16 Insurances
274 80
7.37 Commercial banks
3.41
3.70 Funds (pension, mutual)
60 5.64
11.64 62.54 US nonfinancial sectors
40 Rest of the world
38.91
20
Figure 3.
16.90
Total financial assets 0 5.41
on the US markets, 1998 2008
1998 and 2008
Source: Data from: Federal Reserve Board (2009)
Hendricks et al. (2007) and King et al. (2006) provide evidence of new instruments
and market mechanisms. They conclude that the dynamics and complexity of financial
markets have been induced primarily by the transition from bank-based to
market-based systems. Most changes are linked to technological and regulatory
developments that lead to financial innovation. The changes have been accompanied by
a more flexible and richer set of financial products, and the speed of financial
information and the complexity of products have increased as well. The growing volume
of structured products and derivatives, in particular, have affected the information and
timeliness requirements for assessments of counterparty risk and analysis of risk/return
profiles for market participants. The growth of financial products in the USA, based
mainly on derivatives, climbed from a nominal value of $33.0 trillion in 1998 to
$200.4 trillion at the end of 2008 (Figure 4).
The rising number of traded assets and their pricing on a mark-to-market model,
mostly on the basis of net present-value calculations and uncertain forecasts,
US banks (NA′s) total derivatives and assets

200
160 US NA′s total derivatives

US NA′s total assets
120
80
40
0
Figure 4.
Dec-98
Jun-99
Dec-99
Jun-00
Dec-00
Jun-01
Dec-01
Jun-02
Dec-02
Jun-03
Dec-03
Jun-04
Dec-04
Jun-05
Dec-05
Jun-06
Dec-06
Jun-07
Dec-07
Jun-08
Dec-08
US banks’ total
derivatives and
assets 1998-2008
Source: Data from: OCC (2009)
has increased the opaqueness of financial products and the volatility of their prices. Early warning
In addition, this volatility is reflected in accounting systems that increasingly are based systems
on market prices and disclose results with short-term frequency. The International
Monetary Fund (IMF, 2008) claims that fair values, as the principal elements of a
mark-to-market accounting system, are highly susceptible to changing interest rates
and credit spreads. Whereas financial innovations increase flexibility and efficiency, the
wide scope and complexity of these products also lead to further opaqueness and 275
volatility. Bliss and Kaufman (2006) analyze this ambiguity in the context of trading and
netting credit derivatives in the highly concentrated US market. Their conclusion is that
although risk is mitigated from a single institution’s perspective, risk-transfer
instruments may increase systemic risk from a macro perspective. This is, particularly
relevant if – as is the case for credit derivatives within the US banking system – the
market is concentrated in only five counterparties covering almost 100 percent of the
interbank credit derivatives market (Figure 5).
2.3 Elements of structural fragility

A broad strand of the literature is concerned with exploring linkages between banks[7].
Some authors emphasize the relationship between banks and regulatory institutions,
while the connectivity of other financial firms, such as hedge funds and private equity
funds, is less fully explored[8]. Although it is acknowledged that linkages may comprise
different channels[9], particularly interbank linkages with interbank exposures
(solvency) and interbank credit lines (liquidity), information linkages, and connectivity
through asset sales, earlier research mostly focused on lending relationships among
banks. Within a given pattern of linkages among financial institutions, different types of
spillovers may occur. Stern and Feldman (2009, p. 14) refer to contagion effects from
direct losses, run-like behavior, back-office management, fire sales, and spillovers to the
real economy.
Rochet and Tirole (1996) provide a first framework for analyzing interbank lending
for systemic risk and for central banks’ effects on the stability and efficiency of
interbank markets. They specifically investigate how benefits derived from
decentralized interbank transactions and banks’ monitoring ability can be matched
Derivatives: top 5 US NA′s in % of total US NA′s

100
95
%
90
Credit derivatives
85
All derivatives
Figure 5.
80 Concentration of total
Jun-99
Jun-00
Jun-01
Jun-02
Jun-03
Jun-04
Jun-05
Jun-06
Jun-07
Jun-08
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
derivatives and credit

derivatives in the US
banking system 1998-2008
Source: Data from: OCC (2009)
JRF with central banks’ role in rescuing banks. They present conditions for enhancing
12,4 monitoring by banks. Allen and Gale (2000, 2007) investigate how contagion among
banks is influenced by the extent of lending relationships. They conclude that
“incomplete” lending structures, described by few and asymmetric relationships are
more exposed to contagion. This result is confirmed by Upper and Worms (2004) in a
survey on interbank exposures in the German market. They test the banking system’s
276 vulnerability by aggregating individual balance-sheet information to 25 matrices of
bilateral exposures and simulate the effects of different loss rates.

A similar result for the “completeness” of bank relationships is obtained by Müller
(2006) for the Swiss market. Referring to the network-modelling approach of Eisenberg
and Noe (2001), Müller simulates the consequences of banks’ distress for the solvency
and liquidity of connected banks. She finds that credit line (liquidity) effects are even
more important than solvency effects and that regulation should, therefore, limit the
extent of counterparty exposure. From a different perspective, Leitner (2005) concludes
similarly that concentration can lead to a network breakdown. He argues that a large
bank might not participate in a private bailout within a concentrated network if the
cost of its participation exceeds the amount it would lose by not participating.
However, networks that provide incentives for healthy banks to help troubled banks
can be effective in stopping contagion.
On the other hand, Furfine (2003) investigates federal funds transactions between
US banks[10]. He concludes that bilateral fund exposures are not important enough to
cause a great risk of contagion. Another result, which contradicts the “completeness”
hypothesis is found in Beck et al. (2005). They look at concentration measures in
banking systems and find that concentration – as opposed to symmetric and
equivalent bank relationships – does not increase fragility. In the light of current
crises, the IMF (2009, p. 73) assumes that more extensive financial linkages allow for
greater risk diversification but increase the potential for disruptions to spread quickly
across markets. This mechanism relates to the seemingly paradoxical finding by
Wagner (2008), who postulates that diversification increases portfolio benefits on a
micro level but simultaneously raises the risk of contagion on a macro level. This may
be interpreted to mean that while greater diversification reduces unsystematic risk,
it also facilitates the propagation – and so tends to increase the impact – of systematic
risk. Hence, the complex simultaneous effects and multiple characteristics of structural
fragility must be carefully identified and added together (Table I).
In addition to looking at the quantity of financial linkages (“connectivity”) and their
distribution (“concentration”), it is important to consider their effects. Thomson’s (2009)
“4 C’s” of financial systems structure adds “correlation” and “condition” as well.
Correlation refers to the degree of simultaneity with which connected firms react to
common factors; condition refers to the specific environment by which financial linkages
are determined and to the situation-specific operations of the financial supervision.
Connectivity and concentration may be regarded as institutional aspects of systemic
structure, whereas correlation and condition are linked to the intensity of actions within
this structure and refer more to its behavior. Another dynamic aspect of the recent crisis
is highlighted by Caballero and Simsek (2009). They distinguish several phases in
financial systems’ response to shocks. In contrast to the literature’s prevalent view that
contagion is a developed function of connectivity, they see contagion as an independent
cause of worsening opaqueness and increased confusion and, hence, as a starting point
Rochet Allen and Lagunoff van Allen and Caballero Aikman

and Tirole Gale and Schreft Leitner Müller Order Gale Thomson and Simsek et al. Krishnamurthy
(1996) (2000) (2001) (2005) (2006) (2006) (2007) (2009) (2009) (2009) (2010)
Connectivity/linkages x x x x x x x
Concentration/
diversification
(size of institutions) (x) x x
Correlation x
Conditions/context (x) x
Complexity/
opaqueness (x) (x) (x) x x
Dynamics/volatility x x x
Behavior/rationality x (x)
factors described
systems
in the literature
Structural fragility
Early warning
277
Table I.
JRF for additional distress and feedbacks. These ideas are related to views that attribute to
12,4 behavioral finance an additional role in explaining systemic risk.
Whereas previous models mainly address connectivity and concentration as the
basic patterns of system structure, more recent models also consider factors introduced
by new financial instruments and techniques, such as securitization, leveraging, and
credit-risk transfer. Effects from information asymmetries and new behavioral
278 patterns on financial markets receive increased attention as well. However, a consensus
on a comprehensive theoretical framework is still lacking (Lagunoff and Schreft, 2001,
p. 221)[11]. The question, therefore, is how the different structural fragility variables
can be classified and grouped within a general causal framework. The question of
formal assessment of structural variables provides the basis for more comprehensive
theoretical explanations of the system’s vulnerability. Furthermore, it can serve as a
critical component of an EWSs of systemic risk and as a basis for further empirical
testing. Consistent with signaling and regression approaches for EWSs, structural
factors may be monitored as an index and referenced to the level of systemic stress
(Oet et al., 2011)[12].
3. Modeling structural fragility in financial systems

3.1 Modeling framework
Requirements for modeling structural fragility include an adequate assessment of the
elements and interactions within a financial system. Borio (2007, p. 10) asserts that
approaches should take into account interactions between real and financial systems;
should consider the endogenous nature of risk processes; and must be conducted in a
dynamic, rather than static way. Similarly, the ECB (2009, p. 127) states that systemic
risk should be assessed from a “cross-sectional” (market infrastructure) and
“time-related” (evolution over time) perspective. Against this background, the
following elements that are desirable for modeling the fragility of financial systems are
defined and then examined from a more conceptual, more dynamic perspective[13]:
(1) Comprehensiveness. Major risk attributes to be included and assessed from
different perspectives are:
.
Risk causes as external and internal to the financial system, or as macro and
micro factors.
.
Risk players as banks, insurance companies, investment funds, etc.
.
Risk classes like loans, equity, real estate, etc.
.
Risk channels like solvency, liquidity, and information.
(2) Consistency. The modeled aspects should be arranged in a complementary way
within a causal framework. Specifically, the relations among internal factors
may be described in terms of:
.
Connectivity between risk players or between risk classes provides the
channels for risk transmission effects within the financial system.
.
Correlation and concentration affect the direction and intensity of risk
transmission through these channels. Correlation affects the parallel direction
of risk factor impacts on risk players that react with similar risk management
operations. Concentration of institutions or risk classes affects the degree of
risk mitigation within the system.
(3) Flexibility. The modeling framework should be adjustable to dynamic aspects. Early warning
Hence, it should be easy to modify and allow for simulations and scenario systems
analysis. It should integrate transformations in financial markets as well as the
dynamic behavior of market participants (behavioral finance).
(4) Forward looking. For an EWSs especially, the framework should focus on
elements that precede crises and allow for timely and sufficient reactions. If
upcoming stress is identified at an early stage, supervisors can act to prevent it.
279
The signaling function of structural variables can be tested by regressing

lagged values of structural variables (or a lagged index) with actual systemic
risk data.
(5) Based on a correspondence with empirical data. Once the model is run as a
mathematical tool, it has to be fitted against available data. Both the input
variables and the outcome should be judged in light of existing or available data
resources. This may restrict the model formulation on one hand and enhance its
applicability on the other.
(6) Suitability. Even in the context of complex, dynamic markets, the model should
be transparent and easy to handle. Simplicity and elegance may be achieved by
concentrating on major aspects and tailoring the model to the needs of model
users, that is, financial regulators.
Based on these considerations, a conceptual framework of systemic structure and

structural fragility is shown in Figure 6. Given the complexity of the situation,
a conceptual framework is useful as a first-step theoretical approximation and as a
basis for testing the relevance of structural factors further. This framework may be
assessed from different perspectives:
.
First, the financial system’s structure determines how risk incentives from
outside the system (external factors, macrofinancial drivers) are identified and
contribute to risk sources (internal factors, microfinancial drivers).
Feedback 3
Financial markets Supervision
Macro-financial drivers
Real markets Systemic risk Systemic risk
Macro- exposure management
economic
Profile
drivers
- Connectivity
Macro- - Concentration
financial Systemic risk
- Correlation
drivers Process
- Complexity Mitigation,
Figure 6.
- Behavior amplification Systemic risk Financial system
Feedback 1 - Dynamics (contagion) capital, systemic structure, risk
liquidity transmission, and
systemic risk
Feedback 2
JRF .
Second, the financial system’s structure is framed by its connectivity to the
12,4 macroeconomic environment on the one hand and to the relation between
systemic risk, capital, and liquidity on the other.
.
Third, the framework can be looked at from a dynamic (process) perspective.
The extent to which external and internal factors may affect financial stability depends
280 on – and, therefore, may be described in terms of – first, the structural pattern of
systemic risk transmission, that is, complete/incomplete, diversified/concentrated; and

second, the system’s capacity to mitigate risk: the system’s solvency and liquidity. From
the perspective of identifying financial stability conditions, contagion also describes a
relevant aspect of the dynamic process of risk transmission. The dynamics of contagion
result from underlying structural factors, which, in turn, serve as a starting point for
further risk transmission effects[14]. Financial supervision is also considered a part of
the dynamic risk transmission process: it defines and can redefine institutions’ risk
management policies, including solvency requirements, and can determine regulatory
reactions in times of distress. Given the complexity and dynamism of financial markets,
the conceptual model must be conceived flexibly, allowing non-linear interactions while
producing multiple feedbacks between the financial system and its environment
(feedback 1) as well as within the system itself (feedbacks 2 and 3).
At its center, the model addresses the structure of the financial system and its
capacity to mitigate risk on a systemwide level:
. Linkages between the macroeconomic environment and financial institutions
define the extent to which the financial system is sensitive to macroeconomic
shocks. Linkages among financial institutions themselves define the system’s
ability to offset or amplify risks. This basic infrastructure of financial markets
(profile) is mainly described as “connectivity” in the sense of risk linkages,
“concentration” as a proxy for the distribution of linkages, and “correlation” as
the extent to which these linkages are diversified or are parallel.
.
Although linkages among financial markets provide the infrastructure for risk
transmission and may, therefore, be regarded as a given, short-term, fixed
pattern, the speed and magnitude of risk flowing through these channels is
determined by further mechanisms (process, feedbacks). The magnification of
risk by behavioral aspects (“behavior”) is mainly linked to uncontrolled reactions
resulting from opaqueness and loss of confidence. Hence, the “complexity” of the
system might be considered as an additional variable. As has been shown,
modern financial markets are characterized by high-speed actions (“dynamics”),
which are mostly triggered by the use of derivatives and securitization as well as
by levering up the relation between debt and equity.
.
Finally, as a result of the system’s risk infrastructure and risk-processing factors
(“contagion”), a specific level of systemic risk evolves. A comparison with risk
capital and liquidity in the system can show the adequacy of system exposure on
a matched basis.
3.2 Dynamic aspects of structural fragility

The extreme and rapid changes in financial market conditions, particularly the high
volatility in credit spreads and lending conditions during the most recent crisis,
can be partly explained by technical market mechanisms. For example, a shock induced Early warning
by modified views of the risk associated with a given financial asset may drive up credit systems
spreads and correspondingly reduce the discounted value of asset cash flows.
In conjunction with falling prices, the liquidity reserves of affected institutions may
decrease; so may the revaluation component of institutional regulatory capital[15].
Fire sales of affected institutions’ assets drive their market prices down further, causing
a spiral effect in financial markets driven by market value, accounting, and regulatory 281
systems. After the initial shock, reactions come back as simultaneous, delayed
secondary effects (feedbacks), further increasing the negative dynamic effect on the
market (amplification).
The extent and speed of changes in financial markets can further be explained by
behavioral and emotional factors. Many actions at the core of the crisis-propagation
mechanism are driven, not by rational evaluations of complete information but by
confusion and herding behavior that arises partly from information opacity. In the
recent crisis, this behavior was shown mainly by professional members of the financial
community, while many private investors in the markets remained reasonably patient.
Thus, the recent crisis lacked the classic “mass-run” element[16]. The absence of this
element suggests that market dynamics originating in similar actions by the financial
institutions themselves – in the sense of shared strategies, operations, and
conventions – can be critically destabilizing.
As Figure 6 shows, the modeling framework contains three types of feedbacks:
.
Feedback 1 addresses financial markets’ response to real markets once a
macrofinancial risk factor has affected the financial system. As a consequence,
of macrofinancial risk, credit spreads are expected to increase and to constrain
both interbank and commercial/consumer credit, with an ensuing reduction in
investment and downward pressure on consumption. The shrinkage of interbank
credit activities may also depress other financial network functions, such as
hedging and clearing.
.
Feedback 2 within the financial system is mainly connected to spillover effects
from one troubled institution to others. As Stern and Feldman (2009) state, these
effects result from immediate linkages between banks (such as funding
restrictions) and indirect linkages, in which one bank’s troubles raise a general
concern about the system’s stability and may ultimately cause a bank run.
Spillover effects are mainly linked to interbank lending, with consequences for
liquidity and funding costs.
.
Feedback 3 comes from supervision and government responses to financial stress.
As discussed by Boyd et al. (2009), every action taken by public authorities
changes the course a crisis would otherwise have taken. Regulators may partly
reduce requirements for capital ratios and disclosure procedures. Similarly, public
bailouts may reduce market concerns. On the other hand, assistance from
supervision and government (or expectations of such assistance) may cause banks
to behave unsoundly ex ante and may raise concerns their stability (the moral
hazard problem).
Liquidity effects on financial markets are a particular focus in assessing dynamic

effects. Sarr and Lybek (2002) assess features of market behavior that are based on
various aspects of liquidity. They establish a market-efficient coefficient as an indicator
JRF of long- and short-term price volatility[17]. Kerry (2008) develops an indicator that
12,4 shows how market liquidity can fall rapidly in times of stress. Amplification
mechanisms during liquidity crises are modeled in Krishnamurthy (2010). About two
amplification channels are looked at, the first one generated by market shocks and the
subsequent need for liquidity. Since the sale of assets leads to declining prices and
reduced cash flow from sales, further disinvestment is needed and a balance-sheet
282 amplification mechanism is generated. The second mechanism is induced by the
dynamic effects of rising market uncertainty and demand for liquidity.
From the perspective of supervisors, these effects imply a strong need to incorporate
both infrastructural and dynamic aspects into the EWSs. In particular, the policy
implications require a lender of last resort to run robust resolution procedures and to
stabilize and reduce negative feedback mechanisms. In addition to its relevance for
single institutions, supervisory regulation must be critically assessed for its systemic
and worldwide consequences. The speed and amplitude of behavioral effects make them
difficult to manage once they have started. The above highlights the concurrent needs
for higher risk transparency within the system and for a more preventive ex ante policy.
3.3 Quantifying structural fragility

A mathematical model is necessary to assess systemic profile and processes. As this
paper argues, this model should be comprehensive and flexible at the same time. Yet,
although quantitative approaches provide more specific and formal results, they put
functional relations in a world that is not always subject to mathematical rationality.
Specifically, financial markets that are largely driven by participants’ expectations and
behavior need to balance models’ formalism with their flexibility. These modeling
requirements raise the question of whether existing models can adequately capture
complexity and dynamic change while staying significant and theoretically clear.
Quantitative approaches in particular should be assessed in terms of their empirical
relevance. While sufficient empirical data may contribute to the fit and verification of a
model’s specifications, modeling based on imperfect data may lead to misspecification.
In particular, to the extent that dynamic, changing elements such as behavioral factors
are significant, the absence of plausible market-response patterns may be equivalent to
measurement error and bad data regarding future response dynamics. Thus, modeling
based on past data may not adequately explain or forecast future dynamics.
The quantifying approaches suggested in the literature generally follow the
underlying framework for conceptualizing systemic fragility (Table II) [18], and can be
placed in two broad classes:
(1) Functional (causality) models mostly refer to network approaches and the
simulation of interbank connectivity with regard to risks and cash flows.
(2) Statistical models assess linkages and behavioral risk patterns (indirectly) on the
basis of common dependencies on underlying risk factors (mostly via regression).
For the modeling framework, functional approaches provide much flexibility and allow
for multiple specifications. In the case of structural fragility, the attributes of
connectivity, correlation, and concentration may be modeled explicitly in various forms.
On the other hand, too much freedom in modeling may lead to less consistent, more
complex approaches that are difficult to test empirically and hard to handle for users
who did not participate in developing the model. Network approaches, an increasingly
Early warning
Author(s) Modeling/quantifying Remarks
systems
Functional approaches/network models
Allen and Gale Connectivity of banks through cross- Effects derived from completeness of
(2000) holding of deposits. Liquidity shocks linkages
that are imperfectly correlated
Furfine (2003) Interbank exposure from credit risk in Failure of banks depends on size of 283
the federal funds market. Simulations loss and risk capital of creditor bank.
with failure of the largest borrower(s) Little impact from failures in the
federal funds market
BoE (2008), BoE RAMSI model. Causal model Effects of shocks on yields and
Aikman et al. (2009) approach, using transmission probability of default
and Nier et al. (2008) modeling
Caballero and Contagion as a starting point of Bank’s prudential actions (flight to
Simsek (2009) confusion and financial panic quality) increase complexity
endogenously
Statistical models
Lehar (2005) Systemic risk is measured as risk of Higher systemic risk (higher
regulators portfolio of banks (banks correlation) partly reduced by higher
asset volatility and asset correlation) capitalization
Acharya et al. (2009) Marginal expected shortfall is Quantifies on the basis of stock market
measured as the systemic risk returns. Threshold for identifying
contribution of an institution (cost of crisis to be defined. Predictive power is
the economy) assumed
Adrian and Quantile regression is used to model Regression data is taken from stock
Brunnermeier (2009) dependency of one bank on others in market prices
times of distress (CoVaR)
Segoviano and Common distress of banks is modelled Shows where spillover effects might
Goodhart (2009) using a copula function. Asset-value most easily develop. Market data for Table II.
movements are captured by the bank credit default swaps and options Quantitative approaches
system’s multivariate density are used to structural fragility
popular type of functional models, assess systemic structures based on the size and
direction of observed transactions between institutions (Aikman et al., 2009). The
linkages they consider mostly relate to the transfer of liquidity default risk among
institutions. Network approaches can be useful not only in identifying highly important
institutions, but also in enabling detection of these “systemic” institutions’ exposure
according to the size and direction of their network relationships.
The Bank of England (BoE) uses risk transmission maps and feedback techniques to
analyze financial crises (Alessandri et al., 2009, p. 53 and Bank of England, 2008, p. 51). In
its risk assessment model for systemic institutions (RAMSI), the transmission of shocks to
systemic crises is modeled in a bank solvency and liquidity framework[19]. RAMSI takes
balance-sheet data for top UK financial institutions individually and then constructs a
network model among these institutions on the basis of their interbank exposures. The
model sends simulated shocks through the network to study individual institutions’
feedback-induced collapse mechanisms and the resulting path of collapse through the
network. For RAMSI, the only source of shocks is a Bayesian vector autoregression
module that captures the evolution of macroeconomic and financial variables.
Therefore, in the context of structural fragility, a critical question is whether the model
can sufficiently allow for shocks originating within the financial system itself.
JRF Similarly, Elsinger et al. (2006) model domino effects between the large UK banks and
12,4 run simulations based on a network of linkages between them. A major advantage of
network techniques is their relatively direct, transparent approach. However, this
approach becomes increasingly complex as the number of institutions rises, due to the
dynamics of their market interactions. Accordingly, the use of network approaches for
near-real-time modeling may be seriously constrained by the data problems and
284 complexity of both potentially observable and unobservable transaction elements, as
well as additional measurement challenges peculiar to unobservable transaction data

such as risk and liquidity.
Statistical approaches to market structure use numeric algorithms and market data
to quantify systemic aspects of risk[20]. These approaches frequently involve
considering the tail distribution of market data, focusing particularly on the joint
movements of banks in distressed markets. Segoviano and Goodhart (2009) model
distress linkages in a regulator’s bank portfolio on the basis of non-linear, dynamic
dependencies. Using a specific type of copula function[21], they derive the common
distress of banks within a system, the risk between two specific banks, and the systemic
risk associated with a single bank.
While copulas provide functions through modelling connectivity, a more explicit
ratio for the dependency of financial firms can be obtained using regression analyses.
Specifically, quantile regression emphasizes the relatedness between institutions while
referring to particular segments of the (risky) distribution function for the income or
value of different banks. Adrian and Brunnermeier (2010) model conditional value at
risk (CoVaR)ijj as the effect for the VaR of an institution i conditional on the fact that
another institution j falls in distress. Specifically, the term DCoVaRijj represents the
difference between the ith institution’s VaR in unstressed times (unconditional VaR)
and the ith institution’s conditional VaR, and stands as a proxy for the magnitude of
risk spillovers. Although this approach is highly relevant for detecting connectivity in
distressed markets, as well as for reflecting the equity market’s correlation and
concentration aspects, it may reasonably be asked what variable can be used to assess
this measure empirically. The authors run calculations on the basis of market-valued
total financial assets, while considering time-varying CoVaR measures as well. Thus,
connectivity is described indirectly via equity prices (and their determinants) but not
directly from business links between institutions.
Alternatively, linkages and correlations may be derived from the co-movements of
banks’ credit spreads, with the theoretical view that credit spreads accurately reflect
the idiosyncratic drivers of risk. A critical argument in this case may be that these
observed spreads are historical data and may not fully capture future co-movements.
Similarly, the spreads in the interbank market and the market for credit default swaps
have been characterized by high volatility and some exaggeration during the recent
financial crisis. It may also be argued that the spread approach concentrates primarily
on spillovers of default risk, and only to a lesser extent on the liquidity risk with a
corresponding unobservable measurement error and inherent uncertainty.
To summarize, the conceptual framework of structural fragility may be described
via a number of different quantification approaches and data variables that might
lead to quite different results. It is, therefore, necessary that we be able to identify
and measure structural fragility on the basis of alternative empirical variables and
to test their suitability.
4. Implications Early warning
A financial system in transition points out the need for emphasizing systemic systems
structures as a driver of systemic risk. Particularly, structural fragility may be related
to the institutional (profile) and dynamic (process) aspects of the system. It is mainly
driven by institutions’ connectivity as well as the degree of concentration and
correlation in financial relationships. Markets’ heightened sensitivity to changing risk
factors and greater speed in reacting to these factors further increase systemic fragility. 285
This paper suggests a framework for identification and theoretical organization of

structural factors that may serve as a basis for further theoretical discussion and for
empirically testing the relevance of different indicators and models of structural
fragility.
As has become evident, different variables may be used for assessing structural
fragility and may be modeled in various ways. To this end, the elements must be tested
in isolation and in various combinations. This also applies to further development and
testing of various quantitative approaches for structural fragility, particularly the joint
use of selected functional and statistical models. As a part of an overall EWSs, a
sub-index of structural fragility as a set of weighted, single structural factors may be
developed. As financial markets move further away from relationship-based banking
systems toward transaction-based capital market systems, the influence of
psychological aspects on market prices and reactions to changing market indicators
are expected to grow[22]. These effects may also include elements of exaggeration and
irrationality. Hence, supervisory policy and EWSs must carefully consider the
increasing weight of behavioral factors.
Because indicators of structural fragility must be included into an EWSs for
systemic risk, a researcher must certainly not fail to include the elements that have
emerged in the advent of recent financial crises. To some extent, increasing parallelism
and leverage in financial markets may point to upcoming stress. The need to keep the
EWSs transparent for its users may necessitate a concentration on a few meaningful
elements, such as major financial institutions as key players in concentrated markets.
As a principal result of the analysis, the highly complex, dynamic structure of today’s
financial markets increases the need for preventive supervisory policy. The critical
importance of structural considerations for crisis management emphasizes the basic
need for EWSs. It also highlights the need for possible direct regulatory responses to
recognized structural weaknesses.
These responses may concentrate on the systemwide organization of financial
markets and may transcend the traditional supervisory challenges of regulating single
participating financial institutions. They aim to forestall and limit spillover effects
between institutions and to reduce the propagation of instability. Those responses
may include establishing structural “fire walls” to secure interbank trading; assessing
risk interconnections on a systemic level to reduce the risk that institutions might
become too interconnected to fail (IMF, 2009a, p. 74); limiting exposure to individual
lenders; and enabling a clearing house for over-the-counter derivatives[23]. Responses
intended to limit the impact of major institutions and their network must be considered
less with regard to asset size than with regard to risk volume and risk concentrations.
As has been shown, some structural factors, such as effects from accounting
or behavioral finance, may not be directly influenced by supervision and so may need a
different approach.
JRF Notes
12,4 1. An overview is given in Klomp (2010, p. 74). The BoE (2010, p. 215) and the ECB (2010,
pp. 138-9) recognize that existing macroeconomic models have deficiencies in capturing
systemic fragility and suggest directions for future research. An early warning system is a
data-driven approach for predicting systemic stress in financial markets.
2. Aikman et al. (2009, p. 7) see the dynamic of financial risk transmission as a function of the
286 financial system’s structural characteristics. Beck et al. (2009, p. 1) point out the risks created
by “an overleveraged and fragile financial system.” Borio (2007, p. 11) argues that a financial
system may also help to generate shocks, “not just passively absorb or amplify them.”
In a comprehensive overview of the early literature on real/ financial interaction, Gertler (1988,
p. 559) explains the abstraction from financial considerations with “the working hypothesis
that financial structure is irrelevant.”
3. Referring to market failures and regulatory policies, Allen and Carletti (2008, p. 2) comment
that financial markets and financial market regulation are “highly complex systems for
which there is no widely appreciated rationale based in economic theory.”
4. Similarly, the IMF (2009a) distinguishes between single elements and linkages in a banking
system.
5. Allen and Gale (2007, p. 126) use the term financial fragility “to describe situations in which
small shocks have a significant impact on the financial system.”
6. Gai et al. (2007, pp. 160-1) argue that financial crises should be less frequent but more severe
than before.
7. For an overview, see Simpson (2010, pp. 48-9).
8. Mostly, the relations between different types of banks are emphasized. For example, van
Order (2006) models the effects from collateralization of loans for the strategies of banks and
securities markets traders to explain the stability of the financial system.
9. See Müller (2006, p. 37) and Rochet and Tirole (1996, p. 733) for interbank claims as
composed of intraday debits, term lending, and contingent claims such as derivatives.
10. Includes transactions across 719 commercial banks in February-March 1998.
11. The ECB (2009, pp. 127-34) states that conceptions for a comprehensive systemic risk
management exist, but have not triggered concrete policy. The need for substantial “further
research efforts [. . .] to develop aggregate modeling frameworks” is acknowledged.
12. For an overview of EWSs models, see Gramlich et al. (2010, p. 201).
13. Similarly, Bårdsen et al. (2008, pp. 9-13), BoE (2010, pp. 215-17) and ECB (2010, pp. 143-5)
define desirable characteristics of macroeconomic models for financial stability analysis.
14. This means that contagion is considered not to be a risk cause on its own but to be driven by
the system’s characteristics. Similarly, Leitner (2005, p. 2925) remarks that “Linkages
present the threat of contagion.” Upper and Worms (2004, p. 427) argue that contagion
depends on the structure of interbank claims. Caballero and Simsek (2009) model further
amplification effects that follow from already existing contagion.
15. A more detailed view is presented in Blanchard (2009) and Brunnermeier (2009).
16. Blanchard (2009, p. 10) remarks that modern runs are characterized by financial institutions’
ability to continue financing themselves on wholesale funding markets.
17. Sarr and Lybek (2002) distinguish five characteristics of liquid markets, whose resilience
allows the quick flow of new orders to correct order imbalances that move prices away from
levels that are warranted by fundamentals.
18. An overview is given in IMF (2009a, p. 104). Early warning
19. Aikman et al. (2009). RAMSI stands for “risk assessment model for systemic institutions.” systems
20. For an overview, see IMF (2009a, p. 104).
21. Banks’ individual and joint asset-value movements are characterized by the banking
system’s multivariate density, which is based on an information-optimization technique and
can be applied using alternative estimates for an individual bank’s probability of distress
(for example, credit spreads and option prices).
287
22. Caballero and Simsek (2009) link irrational behavior to complexity and opacity of markets.
23. The BoE (2009, pp. 52-8) discusses possible restrictions on the scope of bank business as well
as more diversified funding sources for the real economy.
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About the authors

Dieter Gramlich studied Business Administration at the Universities of Mannheim
(Dipl.-Kfm.) and Paris Dauphine. He obtained a doctoral degree from University of
Mannheim (International Banking), and carried out post-doctoral research at
Martin-Luther-University, Halle-Wittenberg (habilitation degree, banks, and cross risks).
He is a Member of the Graduate School of Business at Cleveland State University and the
JRF Visiting Scholar at the Federal Reserve Bank of Cleveland. At Baden-Württemberg
Cooperative State University, he is the Head of the Banking Department. Dieter Gramlich is
12,4 the corresponding author and can be contacted at: gramlich@dhbw-heidenheim.de
Mikhail V. Oet holds an MBA in Finance from the New York University Stern School of
Business, a Master’s degree from Harvard University, and a BA from Yale University. As a
Quantitative Analyst in the Federal Reserve Bank of Cleveland, Mikhail reviews risk
quantification and internal capital adequacy processes of large and complex institutions.
290 He focuses on the development and implementation of principal dimensions of economic capital,
quantification for credit, market and interest rate models, and model validation. In the Federal
Reserve System, Mikhail is active in several supervisory and policy research working groups on
systemic risk, economic capital and Basel II quantification.
To purchase reprints of this article please e-mail: reprints@emeraldinsight.com

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1. Dalu Zhang, Meilan Yan, Andreas Tsopanakis. 2018. Financial stress relationships among Euro area
countries: an R-vine copula approach. The European Journal of Finance 24:17, 1587-1608. [Crossref]
2. Jean-Pierre Himpler. The World Financial Crisis: Impacts on GDP and International Trade in Taiwan .
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3. Dieter Gramlich, Mikhail V. Oet. 2018. Systemic Financial Feedbacks - Conceptual Framework and
Modelling Implications. Systems Research and Behavioral Science 35:1, 22-38. [Crossref]
4. Giannoula Karamichailidou, David G. Mayes, Hanno Stremmel. 2018. Achieving a balance between the
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1. Structural fragility as an element of systemic risk

Systemic risk exposure Systemic risk management

Systemic risk capital and liquidity

2.2 Transformation of financial markets

International debt and US GDP (trillions USD)

US banks (NA′s) total derivatives and assets

160 US NA′s total derivatives

2.3 Elements of structural fragility

Derivatives: top 5 US NA′s in % of total US NA′s

derivatives and credit

bilateral exposures and simulate the effects of different loss rates.

Rochet Allen and Lagunoff van Allen and Caballero Aikman

3. Modeling structural fragility in financial systems

The signaling function of structural variables can be tested by regressing

Based on these considerations, a conceptual framework of systemic structure and

systemic risk transmission, that is, complete/incomplete, diversified/concentrated; and

3.2 Dynamic aspects of structural fragility

Liquidity effects on financial markets are a particular focus in assessing dynamic

3.3 Quantifying structural fragility

well as additional measurement challenges peculiar to unobservable transaction data

This paper suggests a framework for identification and theoretical organization of

Finance, Vol. 29 No. 10, pp. 2577-603.

About the authors

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