Five categories help estimate market risk

The Federal Reserve evaluates systemic risk using five criteria: size, interconnectedness, complexity, substitutability, and cross-jurisdictional activity. Substitutability addresses the degree of difficulty of replacing the firm in the banking system. Cross-jurisdictional activity focuses on foreign assets and liabilities.

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The Fed released data to help evaluate systemic risk on June 26 for year-end 2013. Central bankers will update the data annually. In terms of size, JPMorgan Chase & Co. (NYSE:JPM) presents the largest systemic risk among the five top banks by assets. It has about $2.69 trillion in notional credit derivatives, the highest number among its peers.

Interconnectedness can be double edged sword

Janet Yellen described interconnectedness as “vital to the functioning of our financial system” in her 2013 American Economic Association/American Finance Association Joint Luncheon remarks. Particularly, she discussed the need for financial institutions to work with one another to channel capital to productive uses. For example, banks use savers’ deposits to fund loans for businesses. Other financial institutions may have capital needs but cannot finance them; hence they turn to their peers for help. Interconnectedness helps institutions share risks as well.

The recent financial crisis, however, highlighted that interconnectedness can magnify liquidity shortages and market inefficiencies. When financial institutions saw economic contraction in 2007-2008, they got hit by both depositors withdrawing their funds and peers limiting or eliminating credit. Central banks, market participants and regulators need to work together to keep the benefits of interconnectedness and minimize its harmful side effects.

The year end 2013 data suggests JPMorgan Chase & Co. (NYSE:JPM) is more exposed to interconnectedness risks based on assets and liabilities. Its total intra-financial system assets, which include funds lent to other financial institutions and undrawn credit lines, were $435.7 billion. Its intra-financial system liabilities were $544 billion, second to Citigroup Inc (NYSE:C)’s $512 billion.

JPMorgan Chase ahead in substitutability and complexity

JPMorgan Chase (NYSE:JPM) processes the largest payment amount and holds $21.3 trillion in custody on behalf of clients. It also underwrites $507 billion, the highest amount in debt and equity transactions. Bank of America follows in underwriting amount with $390 billion.

Complexity indicators include notional amount of over the counter (OTC) derivatives and trading securities. A bank that holds large notional amounts of OTC derivatives and trading securities may pose a higher systemic risk relative to other firms. JPMorgan Chase & Co. (NYSE:JPM) is ahead of all other top banks with $68 trillion with Citigroup Inc (NYSE:C) following at $59 trillion.

Cross-jurisdictional risk highest for Citigroup

Citigroup Inc (NYSE:C) operates in 100 jurisdictions, the most for a U.S. top bank. While having operations in different jurisdictions diversifies revenues, the bank is more exposed to changing regulations and fluctuations in revenue. The firm posted $40.4 billion in foreign net revenue for 2013. JPMorgan Chase & Co. (NYSE:JPM) follows with $24.4 billion in foreign net revenue and operations in 60 jurisdictions. Cross-jurisdictional liabilities for Citigroup stand at $742 billion followed by JP Morgan Chase at $673 billion.