Toward Determining Systemic Importance

We introduce a methodology for measuring systemic importance. Investors care about systemicimportance because this knowledge may enable them to assess their portfolio’s vulnerability toparticular events and, if warranted, to pursue defensive strategies. Policymakers also need thisinformation to ensure that policies and regulations target the appropriate entities and to engage inpreventive or corrective measures more effectively when circumstances warrant intervention.We derive our measure of systemic importance from the absorption ratio, which equals thefraction of a market’s total variance explained by a subset of important factors. A high valueindicates that a market is compact and therefore fragile, whereas a low value indicates that risk isbroadly distributed, thus rendering a market more resilient to shocks.We extend this methodology to determine an entity’s centrality. This measure captures anentity’s vulnerability to failure, its connectivity to other entities, and the risk of the entities towhich it is connected. We convert this measure of centrality into a measure of systemicimportance by conditioning it on periods of high systemic risk.