Abstract

We introduce a methodology for measuring systemic importance. Investors care about systemic importance because this knowledge may enable them to assess their portfolio’s vulnerability to particular events and, if warranted, to pursue defensive strategies. Policymakers also need this information to ensure that policies and regulations target the appropriate entities and to engage in preventive or corrective measures more effectively when circumstances warrant intervention.

We derive our measure of systemic importance from the absorption ratio, which equals the fraction of a market’s total variance explained by a subset of important factors. A high value indicates that a market is compact and therefore fragile, whereas a low value indicates that risk is broadly distributed, thus rendering a market more resilient to shocks.

We extend this methodology to determine an entity’s centrality. This measure captures an entity’s vulnerability to failure, its connectivity to other entities, and the risk of the entities to which it is connected. We convert this measure of centrality into a measure of systemic importance by conditioning it on periods of high systemic risk.