On a New Approach for Analyzing and Managing Macrofinancial Risks (corrected)

At the fifth annual CFA Institute European Investment Conference on 19 October 2012 in Prague, Robert C. Merton gave a presentation on analyzing and managing macrofinancial risk. This article is based on his talk and on research he carried out with his coauthors. A framework for measuring and analyzing macrofinancial risk, particularly financial system credit risk and sovereign credit risk, is described, along with how one might go about monitoring the connections. The data suggest that the degree of connectedness across different types of financial institutions and sovereigns changes considerably over time.Current financial system models used by economists and central banks to assess and manage economies are generally not capable of accurately analyzing and managing the macrofinancial risks because they do not incorporate the fundamental nonlinear structures of credit risks. As a result, they cannot measure the changing degree of connectedness among financial institutions and sovereigns. A new approach for analyzing and managing macrofinancial risks is needed, particularly one that integrates monetary, fiscal, and financial stability policies and accounts for interconnectedness and risk transmission. At the fifth annual CFA Institute European Investment Conference on 19 October 2012 in Prague, Robert C. Merton gave a presentation on analyzing and managing macrofinancial risk. This article is based on his talk and on research he carried out with his coauthors. Editor’s Note: Much of the research discussed herein is from the paper “Sovereign, Bank, and Insurance Credit Spreads: Connectedness and System Networks,” by M. Billio, M. Getmansky, D. Gray, A. Lo, R.C. Merton, and L. Pelizzon, MIT working paper (forthcoming 2013). Authors’ Note: This article was accepted before 3 February 2013.