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RISk DEvELOPMENT AND ASSESSMENT OF THE FINANCIAL STABILITY IN 2013 IN STABILITY FINANCIAL THE OF ASSESSMENT AND DEvELOPMENT RISk 2013 REPORT SYSTEMS PAYMENT AND STABILITY FINANCIAL involving selected countries with a higher relative degree of degree involving selected countries with a higher relative 2 Data for the network analysis is derived from the for International Statistics, with conservativeData for the network analysis is derived from Settlements (BIS) Locational country the cross for selected countries. Alternatively, and funding exposures interpolation and estimation of bilateral credit risk basis). basis or ultimate analysis can be undertaken using the BIS Consolidated Statistics (immediate borrower connectivity with the Malaysian banking system, either due to (i) high direct external claims and connectivity with the Malaysian banking system, either due to (i) high direct 2 placements and borrowings (Chart 1). The counterparty risks associated with these transactions are are these transactions risks associated with The counterparty (Chart 1). and borrowings placements also which of the counterparties, default probability based on the low to be manageable assessed peak of the GFC. shocks during the or funding credit avoided destabilising exposures in cross-border the increase and borrowings, interbank placements Apart from was securities (CAGR of 29% and higher holdings and issuances of debt also contributed by the 17% respectively). These external accounted for 16% and 5% of claims and liabilities exposures papers debt securities were of the ’ holdings of non-resident 40% than More respectively. non-bank private and by financial institutions, sovereigns standing issued of good credit securities debt total of 83% approximately On the liability side, and Singapore. entities in the uS and denominated in uS dollar banks in the internationalissued by domestic markets were capital in part driven by the securities were and issuances of these debt The higher holdings Singapore dollar. and funding liquidity portfolios, and to better meet growing cation of trading and investment diversifi for the locally-incorporated for overseas operations. As particularly, cant currencies, needs in signifi during this period had also of the Malaysian operations expansion steady the banks, foreign at a CAGR of 9%, constituting earnings to grow in the paid-up capital and retained resulted 13% of total external of Malaysian banks. liabilities by on-balance sheet transactions was dominated exposures The country composition of cross-border Malaysian banks have overseas operations; and (ii) countries where nancial centres; fi with (i) regional (iii) countries with internationally active banks, particularly those with locally-incorporated subsidiaries to, Asian countries accounted for 62.8% of Malaysian banks’ in . Claims on, and liabilities at a CAGR of 8% over the steadily grew claims on ASEAN total external Cross-border exposures. expansion by several ve years in tandem with new business acquisitions and the organic past fi Vietnam, , , Laos and Cambodia. Within in Singapore, domestic banking groups by 15%, driven by higher placement countries also increased the same period, claims on East Asian and PR liates in SAR and affi the parent balances with of interbank deposits and nostro fth of the cross-border About a fi settlements. trade and currency regional China to facilitate growing and interbank of uS Treasuries holdings arising from to the uS and uK, predominantly claims were banks in Malaysia and the parent or locally-incorporated foreign transactions between domestic banks banks exposures, in cross-border result of the growth york. As a liates in London and New and affi exchange markets and yield in the foreign exposed to adverse developments more in Malaysia were domestic market felt in the were economies. Moderate spillover effects different movements across spreads the increased conditions in 2008, as evident from during periods of tightened uS dollar of short-term uS dollar liquidity swap rates and the widening uSD/RM cross-currency of onshore is mitigated largely by the low reliance mismatch positions of banks in Malaysia. This risk however, wholesale funding markets, limits on funding and offshore of banks in Malaysia on cross-currency within active centralised liquidity management of uS dollar funds and more counterparty exposures below. This is supported by the network analysis presented the banking groups. contagion and Network Externalities to Assess cross-border A Network Approach and of credit The network simulation analysis is used to (i) quantify and trace the propagation banking systems induced by a hypothetical default event in funding shocks (contagion paths) across between domino effects a particular country; (ii) identify potential systemic linkages and cross-border a banking system’s internationally active banks and the Malaysian banking system; and (iii) measure the contagion. For susceptibility to external to amplify cross-border spillovers and its propensity system a matrix of inter-banking the network analysis is constructed from purpose of this study, claims and liabilities cross-border

, to establish if and to

Assets 1 Liabilities 2013 US dollar dollar Singapore Malaysian ringgit Australian dollar Currency 2009 2013 Instrument 2009 Deposits Debt securities Equity and retained earnings Financial derivatives 2013 Location 2009 US EU-3 Others ASEAN Other Asia Chart 1 0 % 20 40 60 80 80 60 40 20 100 100 Source: Bank Negara Malaysia Bank Source: Banking System: External Assets and Liabilities by Banking System: External Assets and Location, Instrument and Currency External System Malaysian Banking contagion to the and Risk of connectivity There are 12 global systemically important banks (G-SIBs) operating in Malaysia through locally-incorporated subsidiaries, locally-incorporated subsidiaries, 12 global systemically important banks (G-SIBs) operating in Malaysia through are There some of which have extensive branch networks operating in the major cities. 1 what extent external linkages have resulted in heightened contagion risks to Malaysian banks. what extent external have resulted linkages of Malaysian Banks Interconnectedness cross-border system have evolved and nancial linkages of the Malaysian banking and extent of externalThe nature fi counterparties liability obligations to, non-resident steadily since the GFC. Claims on, and increased over the past 13% and 12% respectively rate (CAGR) of at a compounded annual growth grew low at less than 10% and 15% of the total remained external however, Total exposures ve years. fi as at end-2013. The bulk of the external system respectively assets and total funding of the banking between banking institutions transactions to intra-group of the banking system relates exposures of interbank liates, mostly in the form and affi subsidiaries in Malaysia and their overseas parents, The increasing complexity and globalisation of fi nancial services has reinforced the interlinkages the interlinkages reinforced has nancial services of fi and globalisation complexity The increasing of interconnectedness This higher level markets and countries. institutions, nancial fi between of redistribution cation and diversifi allows for greater and competition, innovation, growth promotes interlinkages extensive However, allocation. ciency of liquidity and credit the effi risks, and enhances the through borders markets and contagion risk across can also increase nancial system of the fi links between banks reputational nancial obligations and sheet fi off-balance network of on- and have further networks of financial obligations complex their counterparties. Increasingly and internationally an active financial for idiosyncratic shocks affecting heightened the potential institution nancial (or to other fi system) to cause wider spillovers banking a highly interconnected (GFC). The magnitude of such contagion during the Global systems as experienced ed. to be amplifi shocks is also likely of Malaysian banks, and the potential risks claims and liabilities This article evaluates the cross-border a network analysis perspective. The network nancial integration from fi associated with increased the Malaysian banking system and banking systems in analysis is used to examine linkages between headquarter internationallyother countries, including those that active banks

RRISkisk DDEvELOPMENTevelopments AND and ASSESSMENT Assessment OF of THE Financial FINANCIAL Stability STABILITY in 2013 IN 2013 FINANCIAL STABILITY AND PAYMENT SYSTEMS REPORT 2013 462

2 RISk DEvELOPMENT AND ASSESSMENT OF THE FINANCIAL STABILITY IN 2013 IN STABILITY FINANCIAL THE OF ASSESSMENT AND DEvELOPMENT RISk FINANCIAL STABILITY AND PAYMENT SYSTEMS REPORT 2013 REPORT SYSTEMS PAYMENT AND STABILITY FINANCIAL other countries, including those that headquarter internationally activebanks other countries,includingthosethatheadquarterinternationally analysis isusedtoexaminelinkagesbetweentheMalaysianbankingsystemandsystemsin associated withincreased fi nancialintegrationfrom anetworkanalysisperspective.The This articleevaluatesthecross-border claimsandliabilitiesofMalaysianbanks,thepotentialrisks shocks isalsolikelytobeamplifi ed. systems asexperiencedduringtheGlobalFinancialCrisis(GFC).Themagnitudeofsuchcontagion a highlyinterconnected bankingsystem)tocausewiderspilloversotherfi (or nancial institution heightened thepotentialforidiosyncraticshocksaffectingactivefinancial aninternationally and their counterparties.Increasingly complexnetworksoffinancialobligationshavefurther network ofon-andoff-balance sheetfi nancialobligationsand reputational linksbetweenbanks of thefi nancialsystemcanalsoincrease contagionriskacross marketsandborders through the risks, andenhancestheeffi ciencyofliquidityandcredit allocation.However, extensiveinterlinkages promotes innovation,growth andcompetition,allowsforgreater diversifi cationand redistribution of between fi nancialinstitutions,marketsandcountries.Thishigherlevelofinterconnectedness The increasing complexity and globalisationoffi nancialserviceshas reinforced theinterlinkages in Malaysiaandtheiroverseasparents, subsidiariesandaffi liates,mostlyintheformofinterbank exposures ofthebankingsystemrelates tointra-group transactionsbetweenbankinginstitutions assets andtotalfundingofthebankingsystemrespectively asatend-2013.Thebulkoftheexternal fi ve years. exposuresTotal external however, remained lowatlessthan10%and15%ofthetotal grew atacompoundedannualgrowth rate(CAGR)of13%and12%respectively overthepast increased steadilysincetheGFC.Claimson,andliabilityobligationsto,non-resident counterparties The naturefi andextentofexternal nanciallinkagesoftheMalaysianbankingsystemhaveevolvedand cross-border Interconnectedness ofMalaysianBanks linkageshaveresultedwhat extentexternal inheightenedcontagionriskstoMalaysianbanks. 1 some ofwhichhaveextensivebranch networksoperatinginthemajorcities. There are 12global systemicallyimportantbanks(G-SIBs)operatinginMalaysiathrough locally-incorporatedsubsidiaries, External connectivityandRiskofcontagiontotheMalaysianBankingSystem External Location, InstrumentandCurrency Banking System:ExternalAssetsandLiabilitiesby Source: BankNegaraMalaysia 100 100 80 60 40 20 20 40 60 80 % 0 Chart 1 Others EU-3 US Other Asia ASEAN 2009 Location 2013 Financial derivatives earnings Equity andretained Debt securities Deposits 2009 Instrument 2013 2009 Currency Australian dollar Malaysian ringgit Singapore dollar US dollar 2013

Liabilities Assets 1 , toestablishifand 2 cross-border claimsandliabilities purpose ofthisstudy, thenetworkanalysisisconstructedfrom amatrixofinter-banking system spillovers anditspropensitysusceptibility toexternal amplifycross-border contagion.Forthe activebanksand theMalaysianbankingsystem;and(iii)measureinternationally abankingsystem’s a particularcountry;(ii)identifypotentialsystemiclinkages andcross-border dominoeffects between funding shocks(contagionpaths)across bankingsystemsinducedbyahypothetical defaulteventin The networksimulationanalysisisusedto(i)quantifyand tracethepropagation of credit and A NetworkApproach toAssesscross-border contagionandNetworkExternalities the bankinggroups. Thisissupportedbythenetworkanalysispresented below. counterparty exposures andmore activecentralisedliquiditymanagementofuSdollarfundswithin of banksinMalaysiaoncross-currency fundingandoffshore wholesalefundingmarkets,limitson mismatch positionsofbanksinMalaysia.Thisriskhowever, ismitigatedlargelybythelowreliance of onshore uSD/RMcross-currency swapratesandthewideningofshort-termuSdollarliquidity during periodsoftighteneduSdollarconditionsin2008,asevidentfrom theincreased spreads movements across different economies.Moderatespillovereffects were feltinthedomesticmarket in Malaysiawere more exposedtoadversedevelopmentsintheforeign exchangemarketsandyield and affi liatesinLondonandNew york. Asa result ofthegrowth incross-border exposures, banks transactions betweendomesticbanksorlocally-incorporatedforeign banksinMalaysiaandtheparent claims were totheuSanduK,predominantly arisingfrom holdingsofuSTreasuries andinterbank China tofacilitategrowing regional tradeandcurrency settlements.Aboutafi fth ofthecross-border of interbankdepositsandnostro balanceswiththeparent andaffi liatesinHongKongSARandPR the sameperiod,claimsonEastAsiancountriesalsoincreased by15%,drivenhigherplacement domestic bankinggroups inSingapore, LaosandCambodia.Within Indonesia,Thailand,Vietnam, past fi veyearsintandemwithnewbusinessacquisitionsandtheorganicexpansionbyseveral exposures.total external Cross-border claimsonASEANgrew steadilyataCAGRof8%overthe in Malaysia.Claimson,andliabilitiesto,Asiancountriesaccountedfor62.8%ofMalaysianbanks’ activebanks,particularlythosewithlocally-incorporated subsidiaries (iii) countrieswithinternationally with (i)regional fi nancialcentres; (ii)countrieswhere Malaysianbankshaveoverseas operations;and The countrycompositionofcross-border exposures wasdominatedbyon-balance sheettransactions liabilitiesofMalaysianbanks. 13% oftotalexternal resulted inthepaid-upcapital andretainedtogrow earnings ataCAGRof9%,constituting foreign banks, the steady expansion oftheMalaysianoperationsduringthisperiodhadalso needs insignifi cantcurrencies, particularly, foroverseasoperations.Asthelocally-incorporated diversifi cationoftradingandinvestmentportfolios,tobettermeetgrowing liquidityandfunding dollar.Singapore The higherholdingsandissuancesofthesedebtsecuritieswere inpartdrivenbythe capitalmarketswereissued bydomesticbanksintheinternational denominateduSdollarand entities intheuSandSingapore. Ontheliabilityside, approximately 83% of total debt securities of goodcredit standing issued byfinancialinstitutions,sovereigns andnon-bankprivate respectively. More than 40% of thebanks’holdingsnon-resident debtsecuritieswere papers exposuresclaimsandliabilities accountedfor16%and5%ofexternal These respectively). 17% also contributedbythehigherholdingsandissuancesofdebtsecurities(CAGR29% was Apart from interbankplacements andborrowings, theincrease incross-border exposures avoided destabilisingcredit orfundingshocksduringthepeakofGFC. assessed tobemanageablebasedonthelowdefaultprobability ofthecounterparties,whichalso placements andborrowings (Chart1).Thecounterpartyrisksassociatedwiththesetransactionsare connectivity withtheMalaysianbankingsystem,either dueto(i)highdirectclaimsand external analysis canbeundertakenusingthe BISConsolidatedStatistics(immediateborrower basisorultimateriskbasis). interpolation andestimationofbilateral credit andfundingexposures forselectedcountries. Alternatively, thecross country Data forthenetworkanalysisisderived fromSettlements(BIS)LocationalStatistics, withconservative theBankforInternational 2 involvingselectedcountrieswithahigherrelative degree of

473 FINANCIAL STABILITY AND PAYMENT SYSTEMS REPORT 2013 RISkR isDEvELOPMENTk Developments AND and ASSESSMENT Assessment OF THE of FINANCIALFinancial STABILITYStability INin 2013

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RISk DEvELOPMENT AND ASSESSMENT OF THE FINANCIAL STABILITY IN 2013 IN STABILITY FINANCIAL THE OF ASSESSMENT AND DEvELOPMENT RISk 2013 REPORT SYSTEMS PAYMENT AND STABILITY FINANCIAL hypothetical defaults, six trigger countries were found to have no contagion impact on the domestic impact on the to have no contagion found countries were defaults, six trigger hypothetical is only spillovers cross-border banks to adverse of Malaysian The susceptibility banking system. contagion in subsequent countries to two or more spreads system distress when a banking heightened the Malaysian banking the capitalisation of simulations, single trigger country In all of the rounds. from the contagion loop round of contagion (where nal the fi in affected system was only severely nancial fi extreme have also suffered after other banking systems in the sample a simulation ends), Asia, the total capital ratio the trigger country is outside where For example, in simulations distress. major has affected system-wide distress system only fell below 8% after of the Malaysian banking internationally This indicates that economies within the sample. active banks in at least seven advanced ed by network externalities. amplifi losses only felt through spillovers are indirect when the pronounced system was more impact on the domestic banking As expected, the contagion with sheet links on- and off-balance with a stronger trigger countries originates from nancial distress fi accounted banks on Singapore claims by Malaysian example, the total cross-border Malaysian banks. For for 23% of total external of the domestic banking system as at end-2013, assets while external 46% of total external liabilities represented counterparties liabilities of Malaysian banks to Singaporean of Malaysian banks presence is attributed primarily to the strong of the domestic banking system. This alone accounted of Malaysian banks in Singapore and vice versa. The branch operations in Singapore contributing between operations in Singapore ts from assets, with profi for at least 4% of the group banks operating in Malaysia accounted for 8.4% of total ts. Singaporean profi 4% and 25% to group these linkages, the simulated contagion impact on the Malaysian banking system assets. Despite scenario originating banking system distress a hypothetical Malaysian banking system arising from such as the uS and uK which For countries contagion round. was only felt in the third Singapore from on the Malaysian contagion effects headquarters to internationally banks, the indirect are active banking systems in the sample have experienced acute banking system only occur after all major susceptibility of the Malaysian banking system to the fi nding supports the limited This nancial distress. fi in subsidiaries of six G-SIBs headquartered the Malaysian spillovers originating from potential indirect ndings were occurring in these countries. Similar fi distress the uS and uK in the event of system-wide in Malaysia. G-SIBs operating observed for the two European trigger countries Two a simultaneous banking banking system from contagion impact to the Malaysian The potential direct defaults to be contained. The simulated pair-wise in two countries was also found system distress of contagion, after all other banking systems in rounds domestic banks in the second to fourth affect The extent and speed of contagion paths were nancial distress. fi extreme the sample have suffered both advanced and major banking systems in crisis affects cantly augmented when a cross-border signifi found to emerge for countries which New contagion paths were emerging economies simultaneously. in other banking systems under the single trigger country simulations. nancial distress did not induce fi of two banking systems permutations of simulated joint distress the different Conclusion derived from of a contagion impact to the Malaysian banking system was found to be showed that the probability This is explained partly by to simulations involving a single trigger country. twice as high compared spillovers on a in countries without cross-border distress the new contagion paths caused by extreme ed by connections between a potential losses could be further amplifi standalone basis. In other words, pair of banking systems that together can cause wider spillovers than individually. Contagion by Malaysian banks system on contagion posed by the Malaysian banking and indirect The extent of potential direct and advanced economies was also found to be limited. banks in the regional cross-border system-wide in the Malaysian banking system alone does not threaten nancial stress The simulated fi in the Malaysian banking system solvency in other countries. In addition, simulations of joint distress region that headquarters internationally c active together with a banking system outside the Asia Pacifi in other countries in the sample. This implies that banks did not induce add through a fi re sale of fi a through 6 which is then fully absorbed using system-wide which is then fully 4 . While the likelihood of such extreme events occurring in a events . While the likelihood of such extreme 8 are applied in the model to capture the amplifi cation of that can the amplifi applied in the model to capture are 7 without taking into account any policy response by the authorities such as by the authorities account any policy response without taking into 3 , contributing to liquidity strains in other counterparty banking systems. The affected counterparty banking systems. The affected , contributing to liquidity strains in other 5 unanticipated decline in interbank funding depends on the liquidity conditions in the global or domestic money markets. As unanticipated decline in interbank funding depends on the liquidity conditions in the global banking led to a system-wide liquidity squeeze GFC, the complexity and opacity in cross-border demonstrated in the recent solvency concernsdue to perceived and heightened counterparty risk aversion. periods. abundant, instantaneous liquidity in the money and capital markets diminishes during stressed and liabilities. time for distress-debt rates in the short run, particularly when it takes considerable face substantial uncertainty over recovery defaulted instruments. markets to price in recently The simulations arbitrarily assume only a fraction (75%) of the banking system defaults. The simulations arbitrarily assume only a fraction (75%) of the banking system Assume no rollover of outstanding external funding irrespective of maturity and funding sources. of outstanding external of maturity and funding Assume no rollover funding irrespective replace an nanced in the simulations. The extent to which a bank is able to assumed not to be refi 50% of funding needs are value) when the availability of traded at a discount (market value is less than book The model assumes that assets are Cross-border exposures include (i) loans and deposits; (ii) holdings or own issues of debt securities; and (iii) other claims include (i) loans and deposits; (ii) holdings or own issues of debt securities; and (iii) other claims exposures Cross-border recover any of the loans as banks typically banking system to ects the inability of a creditor Loss given default of 100% refl arise from exposures to common asset classes, in turn reinforcing a downward spiral in asset values a downward to common asset classes, in turn reinforcing exposures arise from value of the portfolios of other banks. The combined and triggering steep declines in the market an iterative manner until no additional simulated in and funding contagion shocks are of credit effects in capitalisation below 8%. banking system experiences a decline of a particular banking the likelihood of distress to predict This analytical framework is not intended cross-border indirect and direct useful insights on the potential it seeks to provide system. Rather, and the ability of the system to absorb losses under spillovers to the Malaysian banking system, each banking system as data treat using aggregated tail-risk events. The hypothetical simulations by all individual banks default assume a widespread counterparty and therefore, a single foreign exposures within a country on its foreign contemporaneous and homogenous manner is low, the stringent assumption was used to estimate manner is low, contemporaneous and homogenous defaults and funding shocks multiple credit arising from the maximum potential contagion impact risk transfers, loss mitigation response of credit the effects disregarding materialising simultaneously, The static modelling of institutional behaviour at the by banks or policy intervention by authorities. external (direct impact of distress rst order both the fi level also allows an assessment of aggregated spillovers due to result of indirect banking systems as a across ed effects contagion) and its amplifi may not necessarily lead to system-wide effects domino network externalities.self-reinforcing Such banking system may be weakened by the to which a particular but can indicate the degree failures, nancial distress. fi transmission of cross-border Simulation Results Single trigger country country of the banking system in one trigger that the simulated distress The network analysis revealed contagion impact on the Malaysian banking system. Out of the 11 individual has limited direct counterparty banking systems are assumed to replace a fraction of the lost funding a replace assumed to counterparty banking systems are liquidity assistance or capital support. To simulate a credit shock, the banking system in the trigger shock, the banking system simulate a credit or capital support. To liquidity assistance causing other borrowings, interbank to default on the outstanding cross-border country is assumed systems to incur a 100% loss counterparty banking 8 5 6 7 3 4 funding obligations with Malaysian banks; (ii) the presence of signifi cant regional operations of regional cant of signifi the presence banks; (ii) with Malaysian funding obligations or with parent banks foreign linkages of locally-incorporated intra-group banks; or (iii) high Malaysian 80% of than more represented of these 11 countries The banking systems abroad. institutions related total externalexternal on, and of total claims banks. to, all Malaysian liabilities the impact on the capitalisation of the model is applied by generating The network simulation default by the banking system of (i) a hypothetical the sample population from: banking systems in simultaneous default by two banking (the `trigger country´); or (ii) hypothetical a particular country funding shocks on the cross-border and credit simulates the combined impact of systems. The model interbank obligations capital. For funding shocks, the banking system in the trigger country ceases to provide cross-border cross-border trigger country ceases to provide shocks, the banking system in the capital. For funding interbank funding assets. Severe haircuts assets. Severe

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4 RISk DEvELOPMENT AND ASSESSMENT OF THE FINANCIAL STABILITY IN 2013 IN STABILITY FINANCIAL THE OF ASSESSMENT AND DEvELOPMENT RISk FINANCIAL STABILITY AND PAYMENT SYSTEMS REPORT 2013 REPORT SYSTEMS PAYMENT AND STABILITY FINANCIAL assets. Severe haircuts interbank funding capital. Forfundingshocks,thebankingsystemintriggercountryceasestoprovide cross-border 8 7 6 5 4 3 interbank obligations systems. Themodelsimulatesthecombinedimpactofcredit andfundingshocksonthecross-border a particularcountry(the`triggercountry´);or(ii)hypotheticalsimultaneousdefaultbytwobanking banking systemsinthesamplepopulationfrom: (i)ahypotheticaldefaultbythebankingsystemof The networksimulationmodelisappliedbygeneratingtheimpactoncapitalisationof liabilitiesto,allMalaysianbanks. claimson,andoftotalexternal total external related institutionsabroad. Thebankingsystemsofthese11countriesrepresented more than80%of Malaysian banks;or(iii)highintra-group linkagesoflocally-incorporatedforeign bankswithparent or funding obligationswithMalaysianbanks;(ii)thepresence ofsignifi cant regional operationsof counterparty bankingsystemstoincura100%loss country isassumedtodefaultontheoutstandingcross-border interbankborrowings, causingother liquidity assistanceorcapitalsupport.To simulateacredit shock,thebankingsystem inthetrigger counterparty bankingsystemsare assumedtoreplace afractionofthelostfunding has limiteddirect contagionimpactontheMalaysianbankingsystem.Outof 11individual The networkanalysisrevealed thatthesimulateddistress ofthebankingsysteminonetriggercountry Single triggercountry Simulation Results transmission ofcross-border fi nancialdistress. failures, butcanindicatethedegree towhichaparticularbankingsystemmaybeweakenedbythe Suchself-reinforcingnetwork externalities. dominoeffects maynotnecessarilyleadtosystem-wide contagion) anditsamplifi edeffects across bankingsystems asa result ofindirect spilloversdueto aggregated levelalsoallowsanassessmentofboththefi rstorder impactofdistress (direct external by banksorpolicyinterventionauthorities.Thestaticmodellingofinstitutionalbehaviouratthe materialising simultaneously, disregarding theeffects ofcredit risktransfers,lossmitigationresponse the maximumpotentialcontagionimpactarisingfrom multiplecredit defaultsandfundingshocks contemporaneous andhomogenousmannerislow, thestringentassumptionwasusedtoestimate within acountryonitsforeign exposures a singleforeign counterpartyandtherefore, assumeawidespread defaultbyallindividualbanks tail-risk events.Thehypotheticalsimulationsusingaggregated datatreat eachbankingsystemas spillovers totheMalaysianbankingsystem,andabilityofsystemabsorblossesunder system. Rather, itseekstoprovide usefulinsightsonthepotentialdirect andindirect cross-border This analyticalframeworkisnotintendedtopredict thelikelihoodofdistress ofaparticularbanking banking systemexperiencesadeclineincapitalisationbelow8%. effects ofcredit andfundingcontagionshocksare simulatedinaniterativemanneruntilnoadditional and triggeringsteepdeclinesinthemarketvalueofportfoliosotherbanks.Thecombined arise from exposures reinforcing tocommonassetclasses,inturn adownward spiralinassetvalues The simulationsarbitrarilyassumeonlyafraction(75%)of thebankingsystemdefaults. The modelassumesthatassetsare tradedatadiscount(marketvalueislessthanbook value)whentheavailabilityof 50% offundingneeds are assumednottoberefi nancedinthesimulations.Theextenttowhichabankisable replace an Assume norollover fundingirrespective ofoutstandingexternal ofmaturityandfundingsources. Loss givendefaultof100% refl ectstheinabilityofacreditor bankingsystemto recover anyoftheloansasbankstypically Cross-border exposures include(i)loansanddeposits;(ii)holdingsorownissuesofdebtsecurities;(iii)otherclaims abundant, instantaneousliquidityin themoneyandcapitalmarketsdiminishesduringstressed periods. due toperceived andheightenedcounterpartyriskaversion. solvencyconcerns demonstrated intherecent GFC,thecomplexityandopacityincross-border bankingledtoasystem-wideliquiditysqueeze unanticipated declineininterbankfundingdependsontheliquidityconditions intheglobalordomesticmoneymarkets.As markets topriceinrecently defaultedinstruments. face substantialuncertaintyoverrecovery ratesintheshortrun,particularlywhenittakesconsiderable timefordistress-debt and liabilities. 5 , contributingtoliquiditystrainsinothercounterpartybankingsystems.Theaffected 3 withouttakingintoaccountanypolicyresponse bytheauthoritiessuchas 7 are appliedinthemodelto capture theamplifi cationofsystemicriskthatcan 8 . Whilethelikelihoodofsuchextreme eventsoccurringina 4 whichisthenfullyabsorbedusingsystem-wide 6 through a fi of sale re potential lossesfrom awidespread distress among banks headquartered inadvanced economies banks didnotinduceadditional system-widedistress in othercountriesinthesample.Thisimpliesthat together withabankingsystemoutsidetheAsiaPacifi c active region thatheadquarters internationally solvency inothercountries.Inaddition,simulationsof joint distress intheMalaysian bankingsystem simulated fi The nancialstress intheMalaysianbankingsystemalonedoesnotthreaten system-wide cross-border banksintheregional andadvancedeconomieswasalsofoundtobelimited. The extentofpotentialdirect andindirect contagionposedbytheMalaysianbankingsystemon Contagion byMalaysianbanks pair ofbankingsystemsthattogethercancausewider spillovers thanindividually. standalone basis.Inotherwords, potentiallossescouldbefurtheramplifi edbyconnections betweena the newcontagionpathscausedbyextreme distress incountrieswithoutcross-border spilloversona twice ashighcompared tosimulationsinvolvingasingletriggercountry. Thisisexplainedpartlyby showed thattheprobability ofacontagionimpacttotheMalaysianbankingsystemwasfoundbe Conclusion derivedfrom thedifferent permutationsofsimulatedjointdistress oftwobankingsystems did notinducefi nancialdistress inotherbankingsystemsunderthesingletriggercountrysimulations. emerging economiessimultaneously. Newcontagionpathswere foundtoemergeforcountrieswhich signifi cantlyaugmentedwhenacross-border crisisaffects majorbankingsystemsinbothadvancedand the samplehavesuffered extreme fi nancialdistress. Theextentandspeedofcontagionpathswere affect domesticbanksinthesecondtofourthrounds ofcontagion,afterallotherbankingsystemsin system distress intwocountrieswasalsofoundtobecontained.Thesimulatedpair-wise defaults The potentialdirect contagionimpacttotheMalaysianbankingsystemfrom asimultaneousbanking Two triggercountries observed forthetwoEuropean G-SIBsoperatinginMalaysia. the uSanduKineventofsystem-widedistress occurringinthesecountries.Similarfi ndingswere potential indirect spilloversoriginatingfrom theMalaysiansubsidiariesofsixG-SIBsheadquartered in fi nancial distress. This fi ndingsupportsthelimitedsusceptibilityofMalaysianbankingsystemto banking systemonlyoccurafterallmajorsystemsinthesamplehaveexperiencedacute are activebanks,theindirect headquarterstointernationally contagioneffects ontheMalaysian from Singapore wasonlyfeltinthethird contagionround. ForcountriessuchastheuSanduKwhich Malaysian bankingsystemarisingfrom ahypotheticalbankingsystemdistress scenariooriginating Malaysian bankingsystemassets.Despitetheselinkages,thesimulatedcontagionimpacton 4% and25%togroup profi ts.Singaporean banksoperatinginMalaysiaaccounted for8.4%oftotal for atleast4%ofthegroup assets,withprofi tsfrom operationsinSingapore contributingbetween in Singapore andviceversa. ThebranchoperationsofMalaysianbanksinSingapore aloneaccounted of thedomesticbankingsystem.Thisisattributedprimarilytostrong presence ofMalaysianbanks liabilities ofMalaysianbankstoSingaporean counterpartiesrepresented liabilities 46%of totalexternal external while assetsofthedomesticbankingsystemasatend-2013, for 23%oftotalexternal Malaysian banks.Forexample,thetotalcross-border claimsbyMalaysianbanksonSingapore accounted fi nancialdistress originatesfrom triggercountrieswithastronger on-andoff-balance sheetlinkswith As expected,thecontagionimpactondomesticbankingsystemwasmore pronounced whenthe indirect spilloversare onlyfeltthrough lossesamplifi edbynetworkexternalities. activebanksinatleastsevenadvancedeconomieswithinthesample.Thisindicatesthat internationally of theMalaysianbankingsystemonlyfellbelow8%aftersystem-widedistress hasaffected major distress. Forexample,insimulations where thetriggercountryisoutsideAsia,totalcapitalratio a simulationends),afterotherbankingsystemsinthesamplehavealsosuffered extreme fi nancial system wasonlyseverely affected inthefi nal round ofcontagion(where thecontagionloopfrom rounds. Inallofthesingle trigger countrysimulations,thecapitalisationofMalaysianbanking heightened whenabankingsystemdistress spreads totwoormore countriesin subsequentcontagion banking system.ThesusceptibilityofMalaysianbankstoadversecross-border spilloversisonly hypothetical defaults,sixtriggercountrieswere foundtohavenocontagionimpactonthedomestic

495 FINANCIAL STABILITY AND PAYMENT SYSTEMS REPORT 2013 RISkR isDEvELOPMENTk Developments AND and ASSESSMENT Assessment OF THE of FINANCIALFinancial STABILITYStability INin 2013

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RISk DEvELOPMENT AND ASSESSMENT OF THE FINANCIAL STABILITY IN 2013 IN STABILITY FINANCIAL THE OF ASSESSMENT AND DEvELOPMENT RISk 2013 REPORT SYSTEMS PAYMENT AND STABILITY FINANCIAL Given the potential for externalGiven the and exacerbate domestic vulnerabilities shocks to expose contagion priority on places a high system, the Bank nancial the domestic fi instability within the risk of effective and and comprehensive prudently managed, that are institutions domestic strong ensuring by the critically supported This is and resolution. management for crisis containment, arrangements of put in place under the Central Bank stability arrangements that have been nancial enhanced fi 2013 the Islamic Financial Services Act (CBA), the Financial Services Act 2013, Malaysia Act 2009 to They include the ability of the Bank Insurance Corporation Act 2011. and the Malaysia Deposit and activities the exposures stability arising from nancial risks to fi to address measures take broad governance to oversee and coordinate strengthened arrangements institutions; of non-regulated is established under the Stability Executive Committee which the Financial through such measures fi nancial and non-bank nancial institutions of fi to undertake resolutions powers CBA; comprehensive strong that provides deposit insurance system and comprehensive effective institutions; and an framework and enhanced prudential risk management. The strengthened incentives for sound nancial of fi being implemented for the oversight that are cooperation arrangements cross-border nancial of the domestic fi resilience the reinforce (elaborated further in Chapter 3) will further groups system against external contagion. References No.1, pp1-33. 108, Vol. and D. Gale, (2000), `Financial Contagion´, Journal of Political Economy, Allen, F. and J. Solé (2009), `Assessing the Systemic Implications of Chan-Lau, J., M. Espinosa, K. Giesecke Stability Report, 2. Financial Linkages´, IMF Global Financial the Danger of Contagion in C. (2007), `using Counterfactual Simulations to Assess upper, 234. Paper No. Interbank Markets´, BIS Working 3rd contagion round 3rd 2nd contagion round domino effects and network losses domino effects and network Simulated joint distress may amplify potential Simulated joint distress 1st contagion round No system-wide distress and no contagion effects on a standalone basis and no contagion effects Limited concentration of cross-border exposures Limited concentration of Trigger country Trigger Each node represents the banking system of a country from the sample population (12 in total, including Malaysia). The width of the lines denotes the relative the sample population (12 the banking system of a country from Each node represents Diagram 1 Interconnectedness of Malaysian Banking System and Effects of Network Externalities on Contagion of Malaysian Banking System and Effects Interconnectedness Source: Bank for International and internalSource: Settlements, Bank Negara Malaysia estimation Note: degree of interconnectedness between two banking systems, as measured on a net cross-border exposures basis. The size of the node in the right diagram represents basis. exposures on a net cross-border between two banking systems, as measured of interconnectedness degree in all contagion rounds. and funding shocks simulated credit of cumulative capital losses arising from measure the relative Policy Priorities regionally active nancial linkages among internationally or nancial and non-fi level of fi The increasing of systemic as a potential source the importance of monitoring interconnectedness banks underscores fl ux and therefore, complex, constantly in are nancial network structures fi However, vulnerability. enhance the use of often challenging to ascertain. While the Bank will continue to develop and nancial linkages within and outside of the surveillance tools to monitor systemic fi macroprudential role for is a fi nancial network analysis, there application of nancial system, including the practical fi systemic linkages. the monitoring of global and regional by policymakers to improve collective efforts arrangements for multilateral information sharing and surveillance, This should include effective the regional front, nancial obligations. At the fi on cross-border and wider coverage of reporting c Central Banks (EMEAP) serves as an important platform in Executives’ Meeting of the East Asia Pacifi multilateral This monitoring interconnectivity. global and regional potential risks associated with greater relating in areas within the region coordination cross-border framework has forged strong cooperation resolution. Going forward, management and crisis prevention, nancial safety nets and to surveillance, fi nancial fi arrangements as in bolstering such regional EMEAP will continue to play an important role deepens. integration within Asia and between Asian and other regions are not signifi cantly amplifi ed as a result of connections with the banking system in Malaysia. banking system connections with the result of ed as a amplifi cantly not signifi are region c the Asia Pacifi banking system in involves another distress the system-wide when However, with increases, within the sample on other jurisdictions impact the potential contagion simultaneously, pronounced with the more 1). This is consistent observed (Diagram contagion paths two additional and trade the expansion of intra-regional following within the region, interconnectedness cross-border the Malaysian banks. activities of regionalisation

RRISkisk DDEvELOPMENTevelopments AND and ASSESSMENT Assessment OF of THE Financial FINANCIAL Stability STABILITY in 2013 IN 2013 FINANCIAL STABILITY AND PAYMENT SYSTEMS REPORT 2013 506

6 RISk DEvELOPMENT AND ASSESSMENT OF THE FINANCIAL STABILITY IN 2013 IN STABILITY FINANCIAL THE OF ASSESSMENT AND DEvELOPMENT RISk FINANCIAL STABILITY AND PAYMENT SYSTEMS REPORT 2013 REPORT SYSTEMS PAYMENT AND STABILITY FINANCIAL regionalisation activitiesof theMalaysianbanks. cross-border interconnectedness withintheregion, followingtheexpansionofintra-regional tradeand two additionalcontagionpathsobserved(Diagram1).Thisisconsistentwiththemore pronounced simultaneously, thepotentialcontagionimpactonotherjurisdictions withinthesampleincreases, with However, whenthesystem-widedistress involvesanotherbankingsystemintheAsiaPacifi c region are notsignifi cantlyamplifi edasa resultofconnections with thebankingsysteminMalaysia. integration withinAsiaand between Asianandotherregions deepens. EMEAP willcontinuetoplay animportantrole inbolstering suchregional arrangements asfi nancial to surveillance,fi nancialsafetynetsandcrisisprevention, managementand resolution. Goingforward, cooperation framework hasforgedstrong cross-border coordination withintheregion inareas relating potential risksassociatedwithgreater globalandregional interconnectivity.monitoring Thismultilateral Executives’ MeetingoftheEastAsiaPacifi cCentralBanks (EMEAP)servesasanimportantplatformin and widercoverageofreporting oncross-border fi nancialobligations.Atthe regional front, the This shouldincludeeffective arrangementsformultilateralinformationsharingand surveillance, collective efforts bypolicymakerstoimprove themonitoringofglobalandregional systemiclinkages. fi nancialsystem,includingthepracticalapplicationof fi nancial networkanalysis,there is a rolefor macroprudential surveillancetoolstomonitorsystemicfi nanciallinkageswithinand outsideofthe often challengingtoascertain.WhiletheBankwillcontinue todevelopandenhancetheuseof vulnerability. However, fi nancialnetworkstructures are complex,constantlyin fl uxandtherefore, banks underscores theimportanceofmonitoringinterconnectedness asapotentialsource ofsystemic The increasing leveloffi nancial andnon-fi or nanciallinkagesamonginternationally regionallyactive Policy Priorities the relative measure ofcumulativecapitallossesarisingfrom simulatedcredit andfundingshocksinallcontagionrounds. degree ofinterconnectedness betweentwobankingsystems,asmeasured onanetcross-border exposures basis.Thesizeofthenodeinrightdiagramrepresents Bank for International Settlements, Bank Negara Malaysia and internal estimation Source: Settlements,BankNegaraMalaysiaandinternal BankforInternational Note: Interconnectedness ofMalaysianBankingSystemandEffectsNetworkExternalitiesonContagion Diagram 1 Each noderepresents thebankingsystemofacountryfrom thesamplepopulation(12intotal,includingMalaysia).Thewidthoflinesdenotesrelative Trigger country Limited concentrationofcross-borderexposures and nocontagioneffectsonastandalonebasis No system-widedistress 1st contagionround Simulated jointdistressmayamplifypotential domino effectsandnetworklosses 2nd contagionround 3rd contagionround Interbank Markets´,BISWorking PaperNo.234. upper, C.(2007),`usingCounterfactualSimulationstoAssesstheDangerofContagionin Financial Linkages´,IMFGlobalStabilityReport,2. Chan-Lau, J.,M.Espinosa,K.GieseckeandJ.Solé(2009),`AssessingtheSystemicImplicationsof Allen, F. ofPoliticalEconomy, andD.Gale,(2000),`FinancialContagion´,Journal Vol. 108,No.1,pp1-33. References contagion. system againstexternal groups (elaboratedfurther inChapter3)willfurtherreinforce theresilience ofthedomesticfi nancial cross-border cooperationarrangementsthatare beingimplementedfortheoversight offi nancial incentives forsoundriskmanagement.Thestrengthened prudentialframeworkandenhanced institutions; andaneffective andcomprehensive depositinsurancesystemthatprovides strong CBA; comprehensive powers toundertakeresolutions offi nancialinstitutionsandnon-bank fi nancial such measures through theFinancialStabilityExecutiveCommitteewhichisestablishedunder of non-regulated institutions; strengthenedarrangementstooverseeandcoordinate governance take broad measures toaddress riskstofi nancialstabilityarisingfrom theexposures andactivities and theMalaysiaDepositInsuranceCorporationAct2011.TheyincludeabilityofBankto Malaysia Act2009(CBA),theFinancialServices2013,Islamic2013 enhanced fi nancialstabilityarrangementsthathavebeenputinplaceundertheCentralBankof arrangements forcrisiscontainment,managementandresolution. Thisiscriticallysupportedbythe ensuring strong domesticinstitutions thatare prudentlymanaged,andcomprehensive andeffective the riskofinstabilitywithindomesticfi nancialsystem,theBankplacesahighpriorityon contagionshockstoexposedomesticvulnerabilitiesandexacerbate Given thepotentialforexternal

517 FINANCIAL STABILITY AND PAYMENT SYSTEMS REPORT 2013 RISkR isDEvELOPMENTk Developments AND and ASSESSMENT Assessment OF THE of FINANCIALFinancial STABILITYStability INin 2013