Systemic Risk in Financial Services

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Systemic Risk in Financial Services 1 SYSTEMIC RISK IN FINANCIAL SERVICES BY D. BESAR, P. BOOTH, K. K. CHAN, A.K.L. MILNE AND J. PICKLES [Presented to the Institute of Actuaries, 7 December 2009 and to the Faculty of Actuaries, 15 February 2010] ABSTRACT The current banking crisis has reminded us of how risks materialising in one part of the financial system can have a widespread impact, affecting other financial markets and institutions and the broader economy. This paper, prepared on behalf of the Actuarial Profession, examines how such events have an impact on the entire financial system and explores whether such disturbances may arise within the insurance and pensions sectors as well as within banking. The paper seeks to provide an overview of a number of banking and other financial crises which have occurred in the past, illustrated by four cases studies. It discusses what constitutes a systemic event and what distinguishes it from a large aggregate system wide shock. Finally, it discusses how policy makers can respond to the risk of such systemic financial failures. KEYWORDS Banking Crisis; Financial Crisis; Global Financial Crisis; Financial Deregulation; Credit Cycle; Governance; Control Mechanisms; Systemic Risk; Financial Infrastructure; Payment Systems; Short Term Funding Markets; Collateral Exposure; Securities; Derivatives; Counterparty Risk; Recession; Pension System CONTACT ADDRESS Alistair Milne, Faculty of Finance, Cass Business School, City University of London, 106 Bunhill Row, London EC1Y 8TZ, U.K. Tel:+44(0)20 7040 8738; E-mail: [email protected] © Institute of Actuaries and Faculty of Actuaries 2 1. EXECUTIVE SUMMARY 1.1 We provide an overview of previous banking and financial crises, drawing on a number of historical comparative studies. Banking and financial crises have occurred on many occasions in many countries, since the early 1970s (Table 1). There were also many earlier banking and financial crises before the Second World War (Appendix A). The current global crisis is unusual mainly because of the number of financial institutions and countries involved. 1.2 Financial deregulation has played a facilitating role in these crises. Without deregulated financial markets, there are no financial crises. But this does not mean that financial deregulation is a cause of crises; rather, financial deregulation exposes weaknesses of governance and control or inappropriate government intervention that then undermine the disciplines on individual financial institutions. Problems are especially likely to arise immediately after deregulation, when institutions have not yet learned to understand properly the new environment. Financial innovation can have a similar impact, because institutions do not always understand novel financial instruments as well as they should. 1.3 Many financial crises have been associated with misguided attempts to maintain unsustainable fixed exchange rates. It is relatively easy, in a country committed to fixed exchange rates and deregulated capital markets, for banks to attract short term foreign deposits to finance domestic lending. Overseas investors are often attracted by relatively high domestic rates of interest used to defend the exchange rate peg. As long as the confidence in the peg is maintained then there can be rapid expansion of domestic demand. But if confidence is then lost the result is a painful combination of banking losses and a sharp rise of domestic interest rates, to counteract rapidly depreciating exchange rates. The policy challenge is especially difficult for small countries. Larger countries, whose currencies are well established for trading in foreign exchange markets, find it relatively easier to negotiate the fall out of such ‘twin’ crises. 1.4 A common factor found in almost all banking and financial crises has been a pronounced credit cycle, with banks employing increased leverage and maturity mismatch to finance a lending boom, accompanied by unsustainable increases in the pricing of housing and other real estate. The sources of these credit booms are much debated. One school of thought, associated with the US economist, the late Hyman Minsky, argues that freely operating banking and credit markets are inherently unstable, and that stability can only be restored by using regulation to limit the extent of credit growth and prevent large scale credit expansions. An opposing view is that these unsustainable credit expansions are a consequence of weaknesses of governance and control, and also of inappropriate government and regulatory intervention that protects bank lenders when there are substantial losses, so that by addressing these problems it is possible to have the advantages of freely operating capital markets without necessarily enduring financial crises. © Institute of Actuaries and Faculty of Actuaries 3 1.5 Weaknesses of governance and control have certainly played a major role in these previous crises. A large share of losses is often incurred by a relatively small number of institutions. 100% deposit insurance can further weaken the discipline on failing firms, allowing them to continue to attract the funding that allows them to stay in business and thus allows their losses to mount. Accounting rules and risk-management systems also play a central role in the control of exposures. But these can create damaging ‘feedback loops’ that undermine rather than protect bank stability. 1.6 It is notable and rather surprising that there are no widely used definitions of systemic risk. Many commentators assume, without further thought, that a systemic risk means any disturbance which threatens the insolvency of a large number of banks or other financial institutions. But this is too crude an approach. Equating ‘systemic’ with ‘very large’ makes it difficult to distinguish systemic risks from other risks and to analyse the policy responses that can help mitigate systemic risk. 1.7 We therefore put forward the following definition: A systemic risk materialises when an initial disturbance is transmitted through the networks of interconnections that link firms, households and financial institutions with each other; leading, as a result, to either the breakdown or degradation of these networks. For brevity we do not include government bodies in this definition, although they could be added. An implication of this definition is that an event can be systemic without affecting every network, for example the recent credit crisis affected credit availability and money markets, but did not lead to the breakdown of payment and settlement systems. 1.8 By ‘networks’ of interconnections we mean the markets and other institutional arrangements that firms, households and financial institutions use for conducting economic transactions with each other. The simplest economic transactions, for example a small farmer or artisan bartering his or her wares directly to households, do not require such networks. But all more sophisticated economic activity, including financial and monetary transactions, rely on such networks. In our analysis, systemic risk arises when these networks no longer operate or become much more difficult to use. 1.9 Any aggregate shock – if sufficiently large – will be systemic under this definition. Were there to be a sufficiently large enough common shock – for example one arising from a global environmental or epidemiological catastrophe – then the consequence would be widespread insolvency and a breakdown of markets and other institutional arrangements that support economic activity. But our definition is more helpful than simply equating ‘systemic crisis’ with large scale insolvency. By distinguishing the different risks that can trigger the breakdown of the various networks in banking and financial services, we can then identify specific actions that can be taken to mitigate particular risks. This is more helpful than a ‘one size fits all’ approach to analysing and responding to potential systemic risk. © Institute of Actuaries and Faculty of Actuaries 4 1.10 We identify four groups of networks of interconnections in banking that can be subject to such systemic risk. These are: (1) payments systems and other financial infrastructure such as systems of clearing and settlement; (2) short term funding markets; (3) common exposures in collateral, securities and derivatives markets; and (4) counterparty exposure to other financial market participants, especially in over- the counter markets. 1.11 Two of these networks of interconnections, namely (2) and (3), have played a major role in most of the banking and financial crises listed in Table 1. These are the use of short term funding and common exposure to real estate collateral; easy access to short term funding and rising real estate prices have both encouraged unsustainable credit expansion and then, when the booms have ended, these mechanisms have gone into reverse creating severe liquidity and solvency problems for many banks. 1.12 Similar interactions, between the availability of external funding and the value of investments undermining net worth could affect other investment vehicles relying on short term funding, not just banks. We think of the impact of the financial crisis, and in particular of the losses of the Madoff investment fraud, on hedge funds. A loss of confidence could trigger large scale redemptions and this might turn into a systemic risk, with withdrawal of funds triggering declines in asset values and further withdrawals. In practice, such erosions of confidence in hedge funds seem to have occurred in the
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