Systemic risk has been defined many ways, in most cases explained in ways that best align with the interest of specific constituents ranging from bankers, economists, regulators and politicians. Regardless of the agenda, systemic risk is probably best summarized as that of an economic shock or event triggering market dislocation, illiquidity and the potential for failure of a group of institutions that jeopardizes the integrity of the local or global financial system.
Assessing systemic risk (especially in the “So What” rather than the What” sense) can be challenging or virtually impossible. Consider the following examples where, without sufficient warning (at least of the even-I-understand-that variety), market events triggered the failure of these entities and immediately threatened the financial system.
- LTCM, a hedge fund run by “the best of the best” saw its fortunes turn when an unexpected failure on Russian debt triggered a global flight to quality causing LTCM bets to go awry while creating disproportionately large margin calls due to excess leverage.
- Fannie Mae and Freddie Mac, two GSEs thought to be “default-proof” but whose use of excessive leverage and a hedge fund like operating strategy brought each firm to the brink of collapse costing taxpayers hundreds of billions in bailout funding.
- Bear Stearns and Lehman Brothers, a pair of iconic financial institutions whose lack of proper risk management and investment in an undiversified, illiquid, highly leveraged portfolio of mortgage backed securities led to the demise of each.
Assuming systemic risk can be measured in some meaningful way, what are the options for mitigation that would help with the So-What ??
- Creation of a systemic risk regulator is being discussed and on the surface sounds like a nifty idea. The problem is nobody really understands what any ex-ante actions can be taken or catalyzed by such an entity. The other problem is that it reeks strongly of a “lender of last resort” which brings us back to a moral hazard problem.
- Implementation of higher bank capital thresholds would provide a larger margin for error in the event a “systemic financial shock” permeates markets and causes an extensive drawdown in system-wide capital. But “higher” than what, and how high is enough?
- Regulation of leverage has in many cases been self imposed by financial institutions since the financial crisis (the question is does all this last beyond the immediate memory of the 2007-2009 brouhaha). Creating formal regulatory requirements around maximum leverage ratios for regulated financial institutions could go a long way toward mitigating systemic risk, ensuring we do not see a repeat of the crisis.
- Development of a market based systemic risk index used to account for and value a number of independent variables that, when combined, may signal a build-up in system wide risk. This I think is something definitely worth pursuing in the world of risk.
- Adoption of 21st century Glass-Stegal Act as been discussed in Washington recently and may be gaining support among legislators. The original Glass-Stegal Act was created during the Great Depression era to address many of the same questions and concerns we face today. While the complete separation of commercial banking and investment banking activities would certainly help alleviate systemic risk, it is unclear how this might be practically accomplished in today’s highly integrated financial system. More to come on this…..
My armchair view meanwhile is a convenient one now that I am not in a commercial enterprise: simply eliminate leverage altogether. There goes your systemic risk too !!
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Create a systemic risk regulator is not a good idea. The main countries regulators weren't able to manage credit risk problems in the origination of subprime credits. I think countercyclical capital buffers and better stress tests would help.
Well. Aggressive positioning, ability to raise huge capital, leveraging on such capital, ability to create ‘structured’ products with such features to seduce the market were some features wrongly assumed by the organizations listed out in the post to make them big and feared for. As long as they could call the shots, they made merrily more money and nothing could stop them. They believed in their self proclaimed philosophy that money makes money and they put all their money (their own and borrowed) in the markets as if there was no tomorrow. They did not exercise any restraint even when the markets cautioned them at periodic intervals. They did not pursue prudent practices. Such greediness, failure to learn lessons, failure to live up to the role of a trustee, sheer arrogance and lack of humility brought them ignominy.
In addition to the call for more external regulations and regulatory authorities, I would strongly advocate for more self regulation. Knowing one’s limitations, recognizing nature’s intelligence, providing for superiority of the market place will definitely go a long way in realizing assured growth and avoiding failure shocks. After all, it is a ‘zero sum’ game ultimately.
Thanks for the opportunity to interact! Raghavan Guruswami, Hyderabad, India
The global forum for financial stability can do a good job to ensure that such systemic risk does not impact the fianancial institutions in future. What you have cited as the example of victims of systemic risk ; I fear are the example of reasons behind the financial risks suffered by other fianancial institutions. These FIs have suffered because of their major holding in the market which became illiquid in short time because of the basic flows and also heavy concentration of the instruments with these FIs. The fall / near fall of these FIs triggered systematic risk through panic, rush to short the instrument and lastly lack of intra institutional confidence.
The fight with these malign forces is on with Central banks pouring more and more liquidity to increase confidence between the financial institutions.
The best strategy to safeguard against systemic risk at institutional level would be to control the urge of monopolising any market irrespective of the attractiveness :resisting the greed to gain the most from arbitrage.
From a regulatory viewpoint there are two key issues : deposit and infrastructure protection on the one hand and avoidance of system shockwaves.
As to former, reinstating some sort of segregation between the highly regulated utility function of banks (i.e. deposit taking, handling payments and making mortgage or corporate loans), and their capmarkets and proprietary risk taking, makes sense. Call it Glas Steagal II.
As to the latter, a leverage cap (defined as real equity to total assets)and a stressed minimum liquidity ratio (calculated to include off-balance sheet risks) would avoid that banks become too bloated whilst being able to meet their liability maturities.
None of this would have been possible without the explosion securitization practice (which transformed static/untradable instruments into dynamic/tradable counterparts with under-priced risk), without the full backing of the Fed and U.S Treasury, without the repeal of Glass-Steagall, without Monoline insurance, without the collusion of the major rating agencies, and the selling on of that risk by the mortgage-originating banks to underwriters who bundled them, rated and insured them as all AAA. It is worth mentioning that Money Trust still heavily lobbies against re-regulation of the financial system (OTC market regulation, symmetrical remuneration schemes, homogenous regulation of all the whole financial sector including commercial banks, investment banks, hedge funds and insurances, etc.)
People most responsible for start, growth and spread of U.S. financial crisis (all of them “Friedmanites” by belief) now blame “the extraordinary combination of circumstances” for the global financial crisis, most of them denounced the importance of the roles they played and key mistakes they made and now they’ve given authority to lead the rescue – Question: Was it just an ad hoc unpredictable thing or deliberate and planed agenda?
True winners of all this is by all means Wall Street Money Trust bankers, i.e. those related to organizations like from Goldman Sachs, JP Morgan and CitiBank, while the losers are, if we confine our selves only to U.S.; working blue collar and middle income Americans, but afterwards, the whole World (which now pays for the global damage caused by this mess in the Wall Street).
Unanswered yet is whether Fed sponsored deregulation and financial securitization agenda was a “bridge too far,” which may lead to the end of the U.S. dollar (and of Wall Street Money Trust) global dominance, i.e. has shortsightedness, as a peculiar affliction of western elites and power circles, made the irreversible damage to the interests of Money Trust from Wall Street?
Question: Can we say in the end that facts from the ground support the hypothesis that subprime crisis and related housing bubble in the U.S. leading to the global crisis was not an accident (or ad hoc in any way) but desperate and deliberate attempt of the Wall Street Money Trust to preserve its world dominance. If the answer is yes the question whose responsibility was is: compliance (meaning of regulatory/supervisory agencies and of risk controlling departments within banks) or business (meaning risk taking units within the banks and financial industry) is IRRELEVANT.
TWO MAJOR QUESTIONS TO BE SOLVED IN THE FUTURE
1. Who is behind the paychecks of key politicians, key media people and top officials working in supervisory and regulatory agencies in major financial markets, i.e. how to detect possible conflict of interest of these people, and generally, how to solve the problem of system risk caused by teaming up of powerful people from “the industry” with those from regulatory and supervisory bodies?
2. How to solve problem (practically) of institution and systemic level risk caused different time horizons of targets set by individuals and those set by organizations, i.e. how to deal with potential moral hazard or fraudulent behavior of senior managers in financial institutions, especially those labeled TBTF which are heavily burdened by corporate politics and networks of hidden interests of top players?
Stjepan Anic
Human nature being what it is, it is impossible to design any system or write any act that will completely exclude collusion. Having said that we can do a few things to greatly reduce the frequency and the impact of events triggering systemic risk:
1)Leverage of FIs of all hues should be brought under regulatory purview.
2)Leverage standards should be prescribed for every kind of FI.
3)The Compensation of Top Management should be linked to the Core Capital plus Reserves in as much as the compensations should rise and fall with the capital.
4)Disclosure norms should be further strenghthened to force FIs to make more information public.For instance, all the meetings,whether official or prsonal, of the the Top Management should become a part of the disclosed infrmation.
I would think an independent council might be established like a COSO, although that is flawed as well. But risk associations should be represented as well as academia, government, financial institutions etc. This is to prevent it from becoming an enforcment institution (legal, SEC) or a banking institution (FED, FDIC)...
Just remembered: Robert Jarrow at the Feb/09 convention had an economic method to define a bubble economy that could be used as just one tool...
My suggestion for this is to put teeth into Economic Capital. All financial institutions already calculate an EC number, and many are required to reserve against it. I suggest passing a Sarbanes-Oxley kind of law that, if a bank loses more than it's EC, then:
1) The firm loses its corporate charter and is immediately liquidated
2) The CEO goes to jail as a felon
The above would make them take risk much more seriously,
While return of Glass Steagal Act through new rules may help emitting signals, the financial system more globalised and much more integrated between all segments of the financial services with risks constantly building up into a high potent systemic risk. I think the inter regulatory collaboration post crisis should now be institutionalised in a constant shared goal context with new Systemic Regulatory Body and its regional institutions assuming independence, diligence and empowerment overriding national interests. The warnings that emanate from this body should be adhered to by regulators representing concentration of capital, investment and trade flows. The risks are pandemic and beyond a handful of nations and regulators to handle. And every reactive response can cascade the problem faster than the original trigger. Secondly, there should be stiff requirements for countercyclical reserves and restrictions on the pay and perks which can potentially erode into the sustainability of the entities in the financial services sector. The accounting requirements and disclosure requirements should be enhanced in due regard to the change in the composition of stakeholders.
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