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The Actuary The magazine of the Institute & Faculty of Actuaries
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Systemic risk: A measured response

The Global Financial Crisis Group was set up by the Profession at the end of 2008 in response to the worldwide situation within the financial sector. A key piece of research was commissioned from Cass Business School, City University of London and an interim report was presented on 9 June 2009 at Staple Inn to an audience of major figures in the financial world. Their feedback helped shape the final paper, which was presented at a sessional meeting in Staple Inn on 7 December 2009 and will also be presented in Edinburgh on 15 February (further details available on the Actuarial Profession website). The report is available at: www.actuaries.org.uk.

The purpose of our research was to analyse the factors that create systemic risk in financial services of the kind that emerged on such a large scale in the recent global financial crisis, to consider whether systemic risk can emerge in insurance and pension funds as well as in banking and make some policy recommendations. Over the centuries there have been many financial crises and substantial amounts of research literature (reviewed in an appendix to the main report). Drawing on these sources, we present tabulations of large-scale financial crises over the past two centuries, including more than 30 that have occurred since 1973.

Perhaps surprisingly, there is no generally accepted definition of systemic risk. The phrase is often employed to mean any large-scale disruption of the economic and financial system but this is not especially helpful for policy analysis. Reducing such disruption requires that we distinguish an overwhelming external shock, for example, an epidemiological or environmental catastrophe, from weaknesses found within the economic and financial system. Identifying such weaknesses allows us to address them before they are able to trigger large-scale problems.

With this in mind, we propose the following definition of systemic risk: ‘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.’ We might have used a slightly different definition but we believe ours is more useful for investigating the causes of systemic risk in financial services.

With the help of this definition we identify four different networks of interconnections in banking that can degrade or breakdown in a financial crisis:

1. Payments networks.
The best-known example of a systemic disturbance materialising in payment systems is the near failure of the New York CHIPS interbank payment system, following the failure of the relatively small Hamburg foreign exchange bank Herstatt with large gross liabilities to New York institutions.

2. Short-term funding markets.
All banks engage in maturity transformation, using short-term funding to finance long-term illiquid investments. This practice of relying on short-term funding has been responsible for many systemic banking crises, since at least the late 18th century, with a vicious circle of declining confidence and withdrawal of funds.

3. Common exposures.
These arise most often in mortgage or other lending where banks rely on property as collateral for lending. A decline of property prices can lead to banks reducing the availability of loans, so reinforcing the initial price decline. In many financial crises this has had a cumulative effect, reducing the value of bank collateral, triggering loan default and undermining bank net worth.

4. Counterparty risk.
Banks often transfer risk to insurers or to government. If many banks lay off risks to the same counterparty, this can lead to a false sense of security. Banks do not always sufficiently recognise the possibility that, following a large and widespread shock, counterparties will default and losses return to bank balance sheets.

The 1997 Asian crisis, one of the four case studies examined in our report, illustrates the impact of both excessive short-term funding and of common exposure to real estate collateral. The systemic impact was exacerbated by fixed exchange rate arrangements, with domestic banks turning to relatively cheap foreign currency funding and assuming that their central banks would maintain a permanent fixed exchange rate peg.

They were, in effect, obtaining insurance against foreign currency outflows from their central banks and did not recognise the constraints on the central bank balance sheet and the consequent substantial counterparty risk to which this exposed them. With few exceptions, systemic risk does not arise within pension and insurance networks. The major shocks to pension fund net worth in 2000-02, another of our case studies, did not lead to a breakdown or degradation of the networks which link firms (plan sponsors), financial institutions (pension funds) and households (pension beneficiaries) and was therefore not systemic.

Another take-home point from our report is that incentives matter. It is useful to contrast two prototype views of financial crises. One, associated in particular with the economist Hyman Minsky, is that the pursuit of profits from financial intermediation is inherently unstable and results in repeated episodes of unsustainable expansion, ending in a financial crisis. The economic impact of a crisis can be reduced, for example, by reducing interest rates or bailing out failing banks, but these policy responses only sow the seed for the next unsustainable boom. Our work suggests a different conclusion; that a free market for financial services can function without suffering repeated crises, but that this requires appropriate incentives for both management and employees of financial firms.

Policy responses have a major impact on incentives. Government and central banks have a responsibility to protect critical networks from shocks and so limit the resulting economic disturbance. However, the expectation that governments will provide protection of this kind creates ‘moral hazard’. If bank employees, management and shareholders expect government support, they have relatively little incentive to control their exposures to credit losses or other risks and this increases the risk of systemic breakdown.

Capital reserves
Our view, which is one shared by many other commentators, is that policy-makers need to ensure that banks and other financial institutions hold substantial reserves of capital — reserves that can be run down and, if necessary, replenished whenever there is a major disturbance. This appears to be the only way to make banking and other financial networks more resilient without encouraging moral hazard.

Similar policy dilemmas arise in fiscal and monetary policy. Expansionary policy is needed to counteract aggregate shocks and reduce system-wide problems. However, the expectation of such a response creates yet more moral hazard, guiding savings towards relatively high risk investments and so encouraging the Minskian credit cycle. Worse still, fiscal stimulus may eventually end in loss of fiscal credibility and magnify the systemic crisis.

Our remaining case studies illustrate these difficult policy questions. In the 1930s, policy-makers did not do enough to protect the system. Most countries had returned to the gold standard by the late 1920s but, in contrast to the 19th century, there was no political commitment to ‘reflation’ by surplus countries, in order to help deficit countries. This created a substantial deflationary bias. The bias to deflation was even more marked in the US, which continued to pursue a contractionary monetary policy even when domestic bank failures were undermining confidence in bank deposits and leading to a major contraction of bank lending. These policies were the major cause of the extended worldwide slump in economic activity.

The danger of an excessively deflationary policy has been avoided in the current crisis but we now face the possibility that current efforts to maintain aggregate expenditure in developed countries will lead to eventual loss of fiscal credibility. The challenge of managing this difficult situation goes beyond the scope of our research report.

Here are some personal views. It is over-optimistic to assume that, after the bail-out of the financial system, there will be an automatic return to strong economic growth generating the tax revenues to close yawning fiscal deficits. What can pension and insurance trustees do? It is their responsibility to ensure that savings are allocated effectively to productive investment opportunities and so help maintain national and global economic growth. Incentives matter — this requires major changes in the governance and control of banking and asset management and an energetic pursuit of alternative investment vehicles, such as venture capital and small business finance mutual funds, in order to finance investment opportunities that are inadequately served by existing financial intermediaries.

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Alistair Milne is a lecturer for the Faculty of Finance at Cass Business School