Systemic risk management in banking during the financial crisis

¶ … systemic risk management in the banking industry, in the context of the global financial meltdown. Systemic risk has increased, owing to a high degree of economic interdependency and due to a lack of orientation towards systemic risk. While interdependency has not increased, it is at a high level. Modernizing the measures of systemic risk to reflect today's financial institutions is a necessary step to understanding the nature of, and therefore dealing with, systemic risk.

The recent financial crisis took many economic and financial observers by surprise. Regulators such as Sheila Bair at the FDIC were aware that risk levels were too high at financial institutions. Even those aware that problems existed, however, were unaware of the scope of the damage that would eventually result from these high risk levels. Not only were firms heavily engaged in the subprime mortgage industry suffering, but so too were financial institutions across the U.S. And around the world. The FDIC has been forced to liquidate over 100 banks and hundreds of billions of dollars of government intervention has been required to stabilize the banking industry.

There are two main reasons why the risk levels of the subprime crisis were unexpected. The first is that the increased linkages between markets have led to a higher degree of interdependency between markets. When the housing bubble burst, it took the subprime market with it. The impacts, however, spread quickly throughout the economy as a result of linkages that perhaps had not been clearly identified by those in government and the private sector who were involved in risk management for the banking industry. Indeed, these linkages had been identified by the Federal Reserve Bank of New York in 2006 (Hendricks, Kambhu & Mosser, 2006), but went for the most part unheeded. If the extent of the spread had been known, perhaps steps would have been taken proactively to prevent such a crisis from materializing in the first place. It is believed that global markets and sectors within those markets have become increasingly correlated over time, culminating in today's high level of interdependency.

The second reason why the crisis was so unexpected is because the very nature of risk management is oriented towards firm-specific risk. Beyond firm-specific risk, it is assumed that systemic risk cannot be addressed. Certainly, it cannot be addressed through diversification, the main means by which firm-specific risk is addressed. Systemic risk needs to be addressed in other ways. Understanding how those ways might work is critical, specifically because the high level of interdependency increases the volatility of the economic system as a whole. Frameworks such as the one proposed by Huang, Zhou and Zhu (2009) to explore the systemic risk in the financial system will be examined in order to develop theories as to how systemic risk in the financial system can be better managed, and by who.

Interdependency

On the surface, it is easy to see how the banking system has a high degree of interdependency with the economy as a whole. Banks, after all, are major providers of capital for industry. Without industry in which to invest, banks would be left with only the mortgage market. Without financing from banks, industry would only be left with the stock market. The banks' role as the facilitator of borrowing and lending inherently gives the banking industry a high degree of interdependency with the state of the economy.

The intuitive interdependency of financial systems does not, however, bear itself out in numerical analysis. Correlations between the returns on the world's major stock exchanges have not evidenced a clear trend to market interdependency. Major markets are highly correlated, but the degree of correlation has not demonstrably improved in recent years.

At one point, the banking industry was strictly a local or regional affair. With limited geography, a banking crisis in one town may have impacts on the next town over, but will be unfelt the next country over. The economic geography of banking, however, has shifted significantly in recent decades. The United States -- in particular the large banking institutions colloquially referred to as "Wall Street" -- has become the geographic center of the global banking industry. Banking is relatively unique among global industries in that restrictions on the transborder flow of its main product, capital, are much lower than they are for the physical goods produced in other global industries. American banks invest around the world; foreign banks invest in America. It is ironic that this occurs in the name of diversification. By seeking to remove firm-specific risk, linkages are built between the economies of the world through their banking systems. This dramatically increases the systemic risk in the banking system.

Conclusions

The evidence did not support the hypothesis that markets are becoming increasingly interdependent. The evidence did show, however, that interdependency is already high. Regulators and those in the financial industry did understand the threat posed by systemic risk in the banking industry. Systems for measuring systemic risk do need to be improved -- they must be given more temporal primacy and they must be more comprehensive to reflect the increasingly complex nature of the banking industry. Real time information needs to be synthesized with traditional balance sheet approaches in order that regulators and industry leaders have a better sense of the systemic risk in the system. Measuring risk is the first step. Beyond that, risk management systems must be implemented. These have not changed much lately -- they still focus on liquidity and portfolio diversification. Derivative instruments in particular run the risk of distorting the finances of banks because of their leverage. On the systemic level, then, finding ways to curtail the enthusiasm for these instruments is the best course of action. Whether this means an increase in direct agency intervention or whether it means a reversal of the too big too fail policy that encourages risk-taking behavior is subject for further study and consideration.

Works Cited:

Huang, X; Zhou, H. & Zhu, H. (2009). A framework for assessing the systemic risk of major financial institutions. Journal of Banking and Finance. Vol. 33, 11, 2036-2049.

Kaufman, G. (1996). Bank failures, systemic risk and bank regulation. Cato Journal. Vol. 16, 1. Retrieved December 4, 2009 from http://www.cato.org/pubs/journal/cj16n1-2.html

Hendricks, D., Kambhu, J. & Mosser, P. (2006). Systemic Risk and the Financial System. Federal Reserve Bank of New York. Retrieved December 4, 2009 from https://www.newyorkfed.org/registration/research/risk/background.pdf