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A Systemic Approach to Systemic Risk

As India officials look at the international debate on "too-bigto- fail" issues they should reflect on the more general problem that while there is now universal familiarity with the words systemic risks, systemic resilience and macro-prudential action, there is precious little agreement on their meaning. To make the financial system safe we need to shift the focus away from an obsession with the component parts, and focus more on the system as a whole and how we can make it work as a system that transfers risk from places with limited capacity for those risks to other places with greater capacity.

HT PAREKH FINANCE COLUMN

A Systemic Approach to Systemic Risk

Avinash Persaud

political pressures led the risk-weights for lending to housing and all Eurozone government bonds to be fixed at artificially low levels. The RBI has long been attentive to these flaws in international banking regulation but previously had no voice in their development.

As India officials look at the international debate on “too-bigto-fail” issues they should reflect on the more general problem that while there is now universal familiarity with the words systemic risks, systemic resilience and macro-prudential action, there is precious little agreement on their meaning. To make the financial system safe we need to shift the focus away from an obsession with the component parts, and focus more on the system as a whole and how we can make it work as a system that transfers risk from places with limited capacity for those risks to other places with greater capacity.

This article is based on joint research with Charles Goodhart of the London School of Economics.

Avinash Persaud (apersaud@me.com) is chairman of the financial firm, Intelligence Capital and senior fellow, London Business School.

A
t the Financial Stability Board, where India’s finance minister, governor of the Reserve Bank of India (RBI), and chairman of the Securities and Exchange Commission, sit alongside their counterparts in the world’s 20-odd largest economies, it has become fashionable to see the villain of the financial peace as financial institutions that had grown too big to fail, and when governments tried to save them, proved so large as to bankrupt the national coffers. Ironically, this is a narrative that applies most to Ireland, Spain and Portugal – who are not members of G-20 – and within G-20 only to the United Kingdom and the United States. However, such is the centre of gravity of intellectual discourse, efforts at the Financial Stability Board and elsewhere have focused on minimising taxpayers’ exposure by ring-fencing retail banking from wholesale, bailing in creditors and making financial institutions more exposed to competition in an attempt to downsize their systemic risks.

How should India’s international representatives engage in a debate that is so offbeat from the domestic one. The problem with these three proposals is that they are not born from an analytical framework of financial stability or what makes institutions systemically important, but rather flow from the politically seductive notion that bigness, especially big investment banking, is the root of all badness. They will make the financial system and taxpayers no safer, and perhaps less.

At the centre of the financial crisis in the US and the UK which spread to continental Europe and elsewhere was a nexus of excessive leverage and an unsustainable expansion in domestic housing and property markets, accelerated by the fundamentally flawed use of risk-weighted assets as the basis of capital, liquidity and accounting ratios. To make matters worse,

may 21, 2011

Weak Points

Contrary to popular fashion, the financial crisis had little to do with the structure of banking. As Charles Goodhart of the London School of Economics argues, where unsustainable housing and property finance was provided by pure retail banks like Northern Rock and the Irish banks, they were the weak points; when provided by investment banks like Lehman Brothers and Bear Stearns, or by universal banks like UBS and Royal Bank of Scotland, or even quasi-government agencies like America’s “Fannie” and “Freddie”, they too were the weak points.

Moreover, the notion that we can limit the exposure of taxpayers to the finan- cial system by saving the retail part of the banks and letting the wholesale part go to the wolves seems, stunningly, to ignore the example of the failure of Lehman, a modestly-sized wholesale bank, whose failure seized up the whole banking s ystem. In the credit economy, confidence is everything and is not easily divisible. Water-proofing individual compartments did not save the Titanic from a systemic crash either. However inconvenient the truth, saving Lehman would have been much the cheaper route for taxpayers.

Creditor bail-ins and “co-co” bonds where debt is converted into equity in a period of banking distress are clever instruments that make their protagonists seem cleverer still, but they will lead to an even quicker and more complete shutdown of the credit markets were we once more to be in the breach of systemic failure, where asset prices have dropped out of the sky, and as a result, every bank is about to bail in their creditors. On the day after the night before of the Lehman default, almost every British financial institution was technically insolvent based on the sharp rise in the cost of capital and

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all of their creditors would have been bailed in. The panic would have momentarily shifted from banks to markets and back to banks again. These instruments are better suited to the failure of a single bank where one set of careless creditors are to be bailed in, not all. But we are already reasonably good at managing single-bank failures as evidenced by the contained failures of BCCI and Barings in the UK.

Tension between Competition and Stability

More competitive and more humble banks would be a good thing, but it is important to remember that it was precisely banks like Northern Rock, HBOS and Anglo Irish which were trying to challenge cosy oligopolies that introduced “dodgy products” and took most risks to build market share. Recall Northern Rock’s “Together” 1.25% loan-tovalue mortgages. The Icelandic banks were archetypical challengers; “Icesave” offered better returns to depositors. Their success leads normally more prudent, incumbent banks to emulate them. There is a long-standing tension between competition and stability. The US Glass-Steagall Act of 1933 deliberately opted for more stability and less competition.

It is seductively easy to think that the solution to protecting taxpayers lies in saving boring domestic retail banking from “Gordon Gekko” style international investment banking. But systemic risks are caused by a previous, collective, underestimation of risk by most lenders and borrowers that promotes excessive lending and leverage. It follows from this that the way to make the financial system safe is to make it less vulnerable to the mispricing of risk and pro-cyclical valuation.

There are two ways to do this, first, by limiting leverage in ways that are divorced from perceptions of risk. A simple leverage ratio (assets to equity) and counter-cyclical loan-to-value ratios for housing should be key components. Second, we need to increase the capacity of the financial system to absorb risks for a given amount of leverage. This requires common capital adequacy requirements across the financial system that incentivise transfers of credit and liquidity risks so that when risks do blow up, credit risks in the system as a whole are diversified and maturity mismatches (liquidity risk) are minimised.

As India officials look on to the international debate on “too-big-to-fail” they should reflect on the more general problem that while there is now universal familiarity with the words systemic risks, systemic resilience and macro-prudential action, there is precious little agreement on their meaning. This is because officials do not generally have a framework of thinking on the nature of systemic risk and how to do systemic risk management.

I have long argued that a key source of systemic instability has been the growing homogeneity of financial sector behaviour so that almost everyone is buying or selling at the same time. Systemic liquidity requires diversity. This homogeneity relates to many things including the otherwise positive collapse of information costs. Everyone now knows everything at the same time. Another force for homogeneity that has grown rapidly over the past two decades has been the imposition of common

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regulatory, risk management and accounting rules that appear sensible from the perspective of one firm, but are systemically dangerous if all firms follow them at the same time: finance is full of fallacies of composition.

A critical source of offsetting heterogeneity in the financial system is the legitimately different objectives of long-term savers and investors and short-term, precautionary holders of cash. The key task of making a financial system resilient therefore must be about how we tap into this natural heterogeneity and diversity. Ring fencing sectors and putting their regulation in individual silos is counterproductiv e to doing so and incentivising stability-supporting transfers of risk within the financial system, such as between short-term and long-term savers. To make the financial system safe we need to shift the focus away from an obsession with the component parts, and focus more on the system as a whole and how we can make it work as a system that transfers risk from places with limited capacity for those risks, to other places with greater capacity.

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