Systemic risk and firm size: is notional amount a good metric?

Abstract

Purpose Many recently enacted financial regulations exempt smaller entities. While the literature on systemic risk provides efficiency justifications for certain exemptions, the efficiency rationale depends on measuring size appropriately. This paper aims to argue that notional amount, the metric used in derivatives regulations, is a flawed measure of an entity’s contribution to systemic risk. This study discusses an alternative size measure – entity-netted notionals or ENNs – which better reflects risk exposure as discussed in that literature and provides empirical evidence on these two metrics. Design/methodology/approach This study first discusses the relationship between the systemic risk literature and size-based exemptions. This study then describes the current metric and our risk-based alternative. Finally, this paper presents regulatory data on US interest rate swaps (IRS) and uses this to characterize some features of risk exposure. Findings The unique data set provides empirical insight into how well the size metric used in current regulations corresponds to a more theoretically oriented measure. This study finds the relationship between the metrics is fairly weak for entities for whom the size-based exemption will soon be ending, and provide an empirical basis for understanding why they differ. This study also provides evidence on the correlation of risk within this group of entities. Practical implications The paper has important implications for regulation of derivatives and financial markets more generally. To the extent exemptions for small entities make good policy, having the appropriate metric is critical. As such, the metric could be a valuable tool for regulators. Originality/value This paper examines the likely objectives of size-based exemptions from financial regulations and relates them to the systemic risk literature. It provides a unique empirical description of IRS positions, which allows us to examine the relationship between the metric used by regulators and our alternative.