Measuring the interconnectedness of financial institutions

This paper uses sophisticated empirical methodology to measure the interconnectedness of financial institutions in five developed economies - France, Germany, Japan, UK and USA - for the period January 2000 to November 2009. The study goes beyond the conventional use of first and second moments of returns and uses the timevarying equity price of risk methodology to measure the level of convergence of the financial sectors in the countries of interest. More specifically, Kalman filter convergence tests are applied to the weekly equity price of risk data to measure the interconnectedness between these countries' and the US finance sectors. Results indicate the presence of short-term timevarying interconnectedness of the finance sectors of France, Germany and the UK with that of the US and steady-state longer term interconnectedness only between Germany and the US. Short-term and long-term steady-state interconnectedness between Japan and the US is not evident. We conclude that going forward in an environment of increased interconnectedness of international financial markets, a coordinated global financial regulatory policy with discretionary allocation of resources and execution strategy at a national level is the preferred regulatory structure to ensure sound operations of international financial systems.

► The recent financial crisis prompted investigations how does such a crisis spread to another geographically different market. ► The methodology is not dependent on stationarity property of the time series to measure the interconnectedness of financial institutions. ► The estimation tactic is a variation of the state space approach based on Kalman filter convergence tests. ► It does not rely on the moments of returns but uses the time varying equity price of risk to measure convergence of the financial sectors. ► Short term and long term steady state interconnectedness between markets is also revealed. ► In an environment of increased interconnectedness of financial markets, a coordinated global financial regulatory policy is needed.