Understanding Systemic Risk in Global Financial Markets

Aron Gottesman, Michael Leibrock

• Publisher: Wiley
• Year: 2017
• ISBN:
  9781119348467
• Edition: 1
• Topic: Commerce
• Subtopic: Gestion des risques financiers

An accessible and detailed overview of the risks posed by financial institutions

Understanding Systemic Risk in Global Financial Markets offers an accessible yet detailed overview of the risks to financial stability posed by financial institutions designated as systemically important. The types of firms covered are primarily systemically important banks, non-banks, and financial market utilities such as central counterparties. Written by Aron Gottesman and Michael Leibrock, experts on the topic of systemic risk, this vital resource puts the spotlight on coherency, practitioner relevance, conceptual explanations, and practical exposition.

Step by step, the authors explore the specific regulations enacted before and after the credit crisis of 2007-2009 to promote financial stability. The text also examines the criteria used by financial regulators to designate firms as systemically important. The quantitative and qualitative methods to measure the ongoing risks posed by systemically important financial institutions are surveyed.

• A review of the regulations that identify systemically important financial institutions
• The tools to use to detect early warning indications of default
• A review of historical systemic events their common causes
• Techniques to measure interconnectedness
• Approaches for ranking the order the institutions which pose the greatest degree of default risk to the industry

Understanding Systemic Risk in Global Financial Markets offers a must-have guide to the fundamentals of systemic risk and the key critical policies that work to reduce systemic risk and promoting financial stability.

CHAPTER 1
Introduction to Systemic Risk

The topic of systemic risk should be of critical importance to the numerous actors and stakeholders that make up the global financial ecosystem. This includes, among others, financial institutions such as banks, investment banks, and asset managers, financial regulators, policymakers, and central banks, as well as individual investors. It is also important to the general consumer, given that systemic events have the potential of spilling over from the financial system and impacting the real economy. Many historical systemic events have led to national or even global recessions, significant loss of employment, and a spike in both corporate and personal bankruptcies and taxpayer losses. Clearly, the most widely known and recent example of a systemic event was the Credit Crisis of 2007–2009, which involved, among other events, the collapse of the U.S. residential real estate and asset-backed securities markets, as well as the bankruptcy or bailout of many globally recognizable financial institutions, including Lehman Brothers, Bear Stearns, and American International Group (AIG), among others.

Given the high-profile failure or effective failure of these long-established financial firms, combined with the fact that financial crises have occurred with far greater frequency over the last several decades, some people may assume that systemic risk is only a recent phenomenon. However, it is important to understand that systemic events have been occurring for many centuries. Some well-known and relatively recent examples of such events include the U.S. savings & loan crisis, the bursting of Japan's real estate bubble, the Latin American debt crisis, the collapse of the U.S. junk bond market, the failure of hedge fund Long-Term Capital Management, and the bursting of the dot-com bubble.

Before the Credit Crisis the topic of systemic risk was rarely discussed within the financial services industry. Furthermore, organized research on the topic was limited and occurred only within academia and the research divisions of certain financial regulators or central banks. However, given the devastating impact of this event globally and the massive response by global financial regulators, the focus on systemic risk has skyrocketed over the past five years and is now the subject of regular discussion, analysis, and monitoring by all stakeholders across the globe.

This chapter introduces the topic of systemic risk, explores the many definitions that have been published or discussed in recent years, summarizes the key drivers of historical systemic events, and explains why it is critical that this topic be further analyzed and understood.

After you read this chapter you will be able to:

• Describe the common definitions of systemic risk.
• Understand the key drivers of prior systemic events.
• Explain the different impacts a systemic event can have on the financial industry and real economy.

WHAT IS SYSTEMIC RISK?

The area of systemic risk analysis is still in its very nascent stages and there currently is no single, universally accepted definition employed by those involved in analyzing and monitoring systemic risk. Moreover, as research on this topic evolves over time, it is likely that existing definitions will morph or that new definitions will be put forth by the various constituents who have an interest in this topic. Furthermore, it is important to note that having a single definition of systemic risk is not a prerequisite for studying and enhancing one's knowledge of this topic or benefiting from some of the existing approaches to measuring and monitoring systemic risks covered in this book. To provide some context and a foundation for the remainder of this book, listed here are examples of some definitions publicly communicated in recent years by well-known regulators and academics:

• “Systemic risks are developments that threaten the stability of the financial system as a whole and consequently the broader economy, not just that of one or two institutions.”¹
• “In the context of our economic environment, systemic risk is the threat that developments in the financial system can cause a seizing up or breakdown of this system and trigger massive damages to the real economy. Such developments can stem from the failure of large and interconnected institutions, from endogenous imbalances that add up over time, or from a sizable unexpected event.”²
• “Systemic Risk is the risk of a disruption in the market's ability to facilitate the flows of capital that results in the reduction in the growth of GDP globally.”³
• “One or more global financial centers are mired in a severe crisis that spans two or more distinct regions, with at least three countries impacted in each region. There must also be a corresponding and significant impact on a composite GDP index.”⁴
• “A risk of disruption to financial services that (i) is caused by an impairment of all or parts of the financial system and (ii) has the potential to have serious negative consequences for the real economy. Fundamental to the definition is the notion of negative externalities from a disruption or failure in a financial institution, market or instrument.”⁵
• “Systemic risk emerges when the financial sector as a whole has too little capital to cover its liabilities. This leads to widespread failure of financial institutions and/or the freezing of capital markets, which greatly impairs financial intermediation, both in terms of the payment systems and in terms of lending to corporates and households.”⁶
• “Credit risk, liquidity risk, market risk and operational risk are often difficult to quantify, and more so when the interaction of different types of risk leads to systemic risks. Systemic risks affect a financial system's stability when idiosyncratic shock to an individual financial institution generates contagious effects on others in the system.”⁷

One common aspect of these definitions is that to be characterized as a systemic threat, the underlying risk(s) should have the potential to severely impact the financial system and real economy. In contrast to the characteristics of a systemic event, an event that might not rise to the level of a systemic risk is one that may have a significant impact on an industry sector or geographic region, but does not spill over into the broad economy. For purposes of this book we will treat the terms systemic event and financial crisis as synonymous.

SYSTEMIC RISK DRIVERS

Under the broad topic of systemic risk, there have been a wide range of causes for past events. While these events will be discussed in more detail in Chapters 2 and 3, we introduce this topic by providing some of the more common themes behind the many crises that have impacted countless countries and economies across the world.

One of the earliest recorded crises occurred in the middle of the 1200s and was referred to as a currency debasement,⁸ which can be thought of as the predecessor to today's foreign exchange crisis or devaluation. Occurring during the Middle Ages, when metallic coins represented the primary medium of exchange, currency debasements involved the intentional significant reductions in the silver content of coins. This action helped provide a critical source of war financing for governments.

Currency crashes have been a significant source of past crises, which we will define as an annual depreciation versus the U.S. dollar or the relevant anchor currency for that time (most frequently the U.K. pound, French franc, or German deutsche mark) of 15% or more. While there are many currency crashes throughout history that exceeded this threshold, the largest single crash was experienced by Greece in 1944.

Another frequent driver of systemic events throughout history is the bursting of asset bubbles. A commonly employed definition of a bubble is a non-sustainable pattern of price changes or cash flows. Historically, many asset bubbles have been observed in the real estate sector, particularly over the past 30 years. Major real estate bubbles have burst in Japan, non-Japan Asia, and most recently in the United States, in connection with the Credit Crisis. The bursting of Japan's real estate bubble in the early 1990s led to the widespread failure of banks and a prolonged period of sluggish growth, which came to be known as the “lost decade.”

It is noteworthy that bubbles in real estate and stock markets are often closely linked.⁹ Three prominent examples of such linkages include (i) the fact that stock markets of many emerging market countries are heavily weighted toward real estate and construction companies, reflecting the growth stage of such nations, (ii) the fact that the wealth obtained by successful real estate investors is often invested into the stock market, and (iii) that the same high-net-worth individuals referenced in the second example deploy profits made from stock market increases into additional real estate holdings.

There are longstanding economic theories that posit asset bubbles are fueled by significant increases in the pro-cyclical supply of credit during economic booms. This “easy money” climate facilitated by central banks has contributed to a spike in investor spe...