CHAPTER 16
Conclusion: Looking Ahead

In this book, we have presented a detailed history of some of the numerous financial crises that have occurred over many centuries. For example, we discussed one of the first well-documented events from the early 1600s, referred to as the Dutch Tulip Crisis, as well as the South Street Sea Bubble, which gripped Europe in the 1700s. These events were only precursors to the Great Depression in the late 1920s and 1930s and the Credit Crisis of 2007–2009, arguably the two worst global financial crises ever. In Chapters 1 and 2 we discussed in detail some of the key drivers that fueled the Credit Crisis, as well as many of the crises in modern history. For example, while bank failures have occurred for centuries, the volume of bank failures during the past 40 years or so has been considerably higher than in previous decades. Between 1970 and 2011 there were 147 episodes of banking crises around the globe, and the costs to society have been substantial. In addition to banking-related crises, we highlighted some of the other common drivers of systemic events throughout history:

  • Bursting of asset bubbles
  • Speculative manias
  • Sovereign defaults
  • International contagion

To better understand and hopefully avoid or minimize the impact of future crises, in Chapter 4 we discussed several longstanding economic and behavior theories. Regarding the former, there are many theories that point to a so-called “easy credit” environment that often persists in the years leading up to financial crisis. The basic premise is that loose monetary conditions lead consumers and businesses to overleverage, and take excessive business risks, which in turn leads to unsustainable asset bubbles that eventually burst. Furthermore, there are many theories that relate to human behavior, including groupthink, excessive optimism, and the role of fear and greed in contributing to prior crises.

We also learned through the Credit Crisis that future risk analysis and monitoring by financial market participants and supervisors needs to go well beyond assessing the impact of a firm on a stand-alone basis. Analysis and monitoring must become more sophisticated and consider the interconnections that firms have around the globe. When a large, highly interconnected firm such as Lehman Brothers fails, that could lead to a significant risk of global contagion by spreading losses to hundreds, if not thousands of counterparties.

Because of the catastrophic impact of the Credit Crisis on the global financial sector, as well as the economies of the United States and Europe, the response by financial regulators has been dramatic. As outlined in Chapters 7 and 8, in 2010 the United States enacted the Dodd-Frank Act, the most sweeping set of enhanced regulations the financial services sector has experienced since the Great Depression. Meanwhile, internationally the response was also significant. The Financial Stability Board was formed by the G20 following the Credit Crisis to promote international financial stability. In addition, the European Systemic Risk Board was created in 2010 to provide macroprudential oversight of the EU's financial system and work to mitigate systemic risk. The creation of the ESRB was driven by the 2009 de Larosière report, which is a report by a group formed by the EU that was chaired by Jacques de Larosière. The de Larosière report argued that the financial crisis was driven by several failures, including a lack of adequate macroprudential supervision; ineffective early warning mechanisms; failures to challenge supervisory practices on a cross-border basis; and no means for supervisors to take common decisions, among others. To address these failures, the de Larosière report recommended the creation of a new entity at the EU level. The ESRB plays a role in the EU like the role of the Financial Stability Oversight Council (FSOC) in the United States, and both were established in response to the Credit Crisis.

As discussed in Chapter 9, the FSOC implemented two new categories of entities that will be deemed systemically important:

  1. Systemically Important Financial Institutions (SIFIs), which include both systemically important banks and systemically important nonbank financial companies.
  2. Systemically Important Financial Market Utilities (SIFMUs). Financial market utilities are systemically important multilateral systems that comprise the infrastructure of financial markets.

Furthermore, the Financial Stability Board in conjunction with Basel developed an indicator-based measurement approach through which to identify Globally Systemically Important Banks (G-SIBs) based on the following five equally weighted measures: (i) cross-jurisdictional activity, (ii) size, (iii) interconnectedness, (iv) substitutability/financial institution infrastructure, and (v) complexity. The list of G-SIBs is updated each year by the FSB and the complete list is covered in Chapter 9.

IT'S NOT A QUESTION OF IF, BUT WHEN, WHERE, AND HOW

If history has taught us anything, it's that financial crises are sure to occur again, and likely soon. As mentioned previously, the frequency of financial crises has increased dramatically over the past few decades. At least some of these events may be attributed to common themes that have emerged through several centuries, such as reckless speculation by investors, loose monetary policies of certain central banks, and excessive leverage, to name just a few. However, financial markets have become potentially more susceptible to new crises for several reasons. First, as discussed in Chapter 15, financial markets and financial institutions have become more interconnected than ever before. This increases the likelihood that should a single, systemically important institution fail, risk can spread throughout global markets, impacting multiple institutions and/or economies. Second, new and more challenging risks have emerged in recent years with more frequency and impact, such as cybersecurity attacks and geopolitical events. Both risks are extremely difficult to anticipate and defend against for different reasons and have the potential to cause massive financial losses or operational failures. Furthermore, market structure and regulatory changes have led to heightened risks associated with market liquidity and shadow banking activities.

It is an understatement to say that it is a challenge to predict from where and when the next systemic event might emerge. That said, perhaps because of lessons learned from the Credit Crisis, there are several organizations that monitor the landscape of potential systemic threats to the global financial system that are widely disseminated publicly. A few examples include annual systemic risk surveys conducted by ISOCO, the Bank of England, and the Depository Trust & Clearing Corporation.

A SUMMARY OF GLOBAL SURVEYS

As part of the heightened focus in recent years on the early identification of emerging systemic threats, several organizations have launched periodic surveys of financial industry participants. While these surveys all differ to varying degrees in terms of their respective scope and intended use of the data, most share the common goal of gauging the overall climate of systemic risk facing the global financial services industry and identifying those risks that are deemed most likely to occur and to have a systemic impact on the markets or a region. Following are some of the key findings from a select group of surveys conducted in 2016:

Overall Outlook for Potential Systemic Events:

  • A Bank of England survey1 finds the perceived probability of a high-impact event in the U.K. financial system over the short term has fallen, but the perceived probability of such an event in the medium term (1–3 years) has increased significantly (+26%) to 63%. The report shows that medium-term risks are building, driven by continued slowdown in global growth, low inflation expectations, low interest rates, and an uncertain political climate in many countries.
  • The OFR's 2016 Financial Stability Report represents its annual assessment of potential threats to U.S. financial stability, weighed against an evaluation of financial system resilience. The report finds that financial stability risk remains in a medium range overall.
  • The results of the 3Q 2016 Systemic Risk Barometer Survey conducted by the Depository Trust & Clearing Corporation revealed that respondents felt the probability of a systemic event occurring in the next 12 months increased 42% over the past six months.

Sources of Systemic Risk

Listed here are the top risks cited in several surveys conducted by financial regulators and other institutions involved in the monitoring of global financial stability in the financial markets:

  • Respondents to the 2016 H2 Bank of England Survey cited the following top five risks:
    1. U.K. political risk (86% of respondents)
    2. Risks surrounding the low-interest-rate environment (47%)
    3. Risks of a global/overseas economic downturn (37%)
    4. Geopolitical risks (36%)
    5. Cyberattack (34%)
  • Respondents to the 2016 EY/IIF Bank Risk Management Survey2 revealed the following as the top-five risks requiring most attention by chief risk officers in the next 12 months:
    1. New regulatory rules and expectations (68%)
    2. Cybersecurity (51%)
    3. Credit risk (44%)
    4. Risk appetite (37%)
    5. Operational risk (37%)
  • Among respondents to the Oct. 2016 IMF report, the top risks cited were:
    1. Emerging markets risks
    2. Credit risks
    3. Market and liquidity risks
    4. Macroeconomic risks
    5. Monetary policy
  • The top risks cited by the IOSCO Securities Markets Risk Outlook 2016 include:
    1. Corporate bond market liquidity
    2. The use of collateral in financial transactions
    3. Harmful conduct in relation to retail financial products and services
    4. Cyber-threats
    5. Risks associated with asset management activity
  • Per the Two Sigma Street View 2016 survey,3 the top-five macro risks cited by its respondents include:
    1. Loss of central bank credibility or ability to influence economic growth and market prices (65%)
    2. Risk of a market liquidity event (49%)
    3. The bursting of an asset bubble (46%)
    4. China hard landing (27%)
    5. Breakup of the European Union (25%)
  • The OFR's 2016 Financial Stability Report finds the following themes to represent the greatest threats to financial stability in the United States:
    1. Disruptions in the global economy, such as the uncertainties related to the U.K.'s exit from the European Union
    2. Risks facing U.S. financial institutions, such as cyber-risk and weakness in the banks' resolution plans
    3. Challenges to improving data
    4. Central counterparties (CCPs) as contagion channels
  • The DTCC Systemic Risk Barometer Survey 3Q 2016 revealed the following risks selected as their top-five concerns:
    1. Cyber-risk (56%)
    2. U.S. presidential election (50%)
    3. Geopolitical risk (38%)
    4. Impact of new regulations (35%)
    5. Britain's exit from EU (33%)

PREPARING FOR THE NEXT CRISIS

Trying to accurately predict the source and timing of a financial crisis is a daunting if not impossible task. As history has shown, time and time again crises continue to emerge despite the existence of numerous financial regulatory bodies across the world and despite the ever-increasing sophistication of risk management departments of financial institutions and the tools they employ to manage risk.

Nonetheless, since the Credit Crisis of 2007–2009 there has indeed been a paradigm shift in terms of the degree to which both financial regulators and firms operating in the financial services industry attempt to monitor and mitigate emerging systemic threats. This is exemplified in part by the numerous systemic risk surveys now being conducted across the globe by a wide range of institutions and regulators. It is also evidenced by the significantly enhanced rigor of internal stress testing programs employed by financial institutions. Such programs are utilized to estimate the potential losses their firm might suffer should any of a wide range of historical or hypothetical events occur.

In Chapters 7 and 8 we discuss the new regulatory bodies and key new regulatory requirements designed to mitigate systemic risk. In the United States, the enacting of the Dodd-Frank Act, which includes, among other requirements, designations of Systemically Important Financial Institutions and Systemically Important Financial Market Utilities, was the most significant regulatory development to affect the financial services sector since the Great Depression. The primary purpose of the Dodd-Frank Act is to reduce the exposure of both the U.S. financial system and the U.S. government to systemic risk. Internationally, enhanced capital and liquidity standards under the Basel Accords, as well as enhanced Principles for Financial Market Infrastructures, have also contributed to a heightened focus on financial stability versus the pre–Credit Crisis environment.

It should be evident from this book that the topic and scope of systemic risk is extremely broad and complex. We explained how even though financial crises have been occurring for hundreds of years, we continue to witness events that have similar characteristics to those that have taken place many times before. In addition to providing a chronological history of key systemic events dating back to the 1300s in Chapter 2, we group many of these events into key themes or drivers, such as dislocations in global banking sectors, easy monetary conditions that fueled speculative manias and the bursting of asset price bubbles, and sovereign debt crisis, to name a few.

Any broad analysis of systemic risk must also consider the role that human behavior has played throughout history in either fueling or contributing to systemic events. As described in detail in Chapter 3, an entire body of research exists on behavioral finance that includes longstanding theories such as Rational Expectations Theory, Homogeneous Expectations versus Heterogeneity, Risk Aversion Bias, and many others that help to explain investors' behaviors under a variety of circumstances, particularly during periods of market stress.

Another key message from this and other studies of systemic risk should be the tremendous costs that systemic events can have for the financial markets, institutions, and society as a whole. We explain in Chapter 3 the massive number of bailouts provided by the U.S. government following the Credit Crisis of 2007–2009, which exceeded $600 billion, and the failure of more than 300 financial institutions in the United States. The latter included the bankruptcy of Lehman Brothers Holdings Inc., which not only served as a tipping point for the Credit Crisis, but represented the largest bankruptcy in U.S. history. Concerning the Credit Crisis, the recession in the United States officially began in December 2007 and the fallout on the U.S economy was dramatic. In 2008, the United States lost 3.8 million jobs, the greatest annual decline since records were first kept in 1940. With respect to the impact on economic growth, the average downturn in GDP following severe financial crises is 4.8 years. Regarding the Credit Crisis, GDP fell at an annual rate of 4% in the third quarter of 2008 and 6.8% in the fourth quarter, representing the largest decline since 1946. One model used by Fed staff4 estimates that cumulative loss in output relative to potential over the period was on the order of one quarter of a year's worth of economic output. Overall, in advanced economies, the median cumulative loss in output relative to its pre-Crisis trend has been 33% of GDP. In the European Union, through 2013, GDP remained below pre-Crisis level and is about 13% below its pre-Crisis trend.

What should be very evident from this book is that following the catastrophic impact of the Credit Crisis, systemic risk for the first time is now becoming engrained in the risk management cultures of financial market participants and is clearly the most important focus of global financial regulators. As described earlier this chapter and elsewhere in the book, stakeholders in the financial sector continue to develop new and enhanced tools designed to monitor the buildup of risks in key areas and to attempt to quantify potential risk exposures via stress testing analyses, more sophisticated collateral models, and so forth.

Despite these very encouraging developments concerning the industry's enhanced appreciation for and understanding of systemic risk, the financial industry and global economies may be just as susceptible to future risk events as they were pre–Credit Crisis. A few reasons for this include the fact that the largest banks in the world, despite the improved risk profiles of their individual balance sheets, remain as large, interconnected, and systemically important as ever before. In addition, market structure changes, together with the unintended impact of certain regulations, may lead to reduced market liquidity, a key factor in prior financial crises. Finally, new risks have begun to emerge in recent years, such as cyber-risk, against which the financial industry is struggling to defend itself.

Given the ever-changing landscape and complexity of systemic threats, it is imperative that stakeholders in the financial industry remain vigilant, do not fall prey to complacency, and collaborate very closely going forward. These behaviors are unlikely to prevent all future crises, as history has proven, but these efforts may allow for better preparation for systemic events and hopefully reduce the impact that such events will have on society.

NOTES

..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.
Reset