Systemic Risk, Systemically Important Financial Institutions and Minimising Global Economic Crisis - Literature review Example

How Identification of ‘Systemic Risk’ And ‘Systemically Important Financial s’ helps To Minimise Global Economic Crisis ? Introduction If we analyse the past banking history, there were many bank failures and bank runs in many countries in the past. For example, Bank of England in 1946 was established immediately after many bank failures in UK. Between 1930s and 1940s, there were more than 100 bank failures in U.S.A’s financial and banking sector. However, between 1940s and 1980s, there were less bank runs in USA, mainly due to tight legal framework and due to the transformed atmosphere. However, the banking tighter regulation in U.S.A not proved to be satisfactory as more than 250 banks filed insolvency petitions between 1980s and 1990s. In 1990s, Asian countries witnessed an economic turmoil as a result many banks in those regions failed. The issue started with individual bank and slowly enveloped into the whole banking system of a nation and finally impacted the creditworthiness of such nation itself. Likewise, the subprime mortgage crisis occurred in the 2007 -2008 started with U.S financial institutions and U.S banks and finally impacted many financial institutions around the world. However, bank failures or bank runs are not occurring in all the nations. For instance, there is no bank failure at all in Ireland and in Switzerland. Rochet (2008) is of the view that interferences by politicians can play a significant role in bank runs. (Neave 2009: Chp 20). Many frequent bank failures and bank runs urged the need to recognise and deter financial agonies in the future well before they commence. Hence, there is a necessity to establish a well-structured supervision system in the financial sector, and it should be given authority to identify “systemic risks.” Bini Smaghi (2009) is the first to emphasise the theoretical issues of systemic risk, and the agency established for the same is to be well versed in detection of risks, evaluation of risk, and finally giving warnings about risks. (Eijffinger 2009:44). This research will make an earnest effort to elucidate w what is meant by ‘systemic risk’ and discuss the relevance of ‘systemically important financial institutions’ for policymakers and the ways and means to avoid future bank and financial institution failures. “What is Systemic Risk?” Systemic risk is a peril that is widespread in a nation or the economy as a whole and cannot be avoided by coalescing the assets in well-diversified and large portfolios, and it is also called as non-diversifiable risk. Systemic risk starts off in various sizes, shapes and magnitude. In some countries, systemic risk has occurred due to foreign exchange risks and economic shocks and in some other nations, it has occurred due to internal or external war or due to political instability. In between 1992 to 2002, there were about eight regional / global economic crisis happened in Europe, Asia and U.S.A. In case of banks, the systemic risk area includes forex risk and interest rate risks. The low-quality credit assets will first collapse when the systemic risks deteriorate. A portfolio approach is the need of the hour to recognise such unique and susceptible sectors and credit asset allocations, which may witness a negative effect in various economic conditions. Hence, it is essential to structure the portfolio to be fine-tuned methodologically so that the rigorousness of varying macro-economic crisis is minimised. It is to be noted that systemic risk differs from industry to industry. (Joseph 2007:242). As per G10, a systemic risk is one where an incident will activate a deprivation of confidence or diminution of economic value and may result in vagueness that would compel the major segment of the financial system to destabilize due to negative impact on the real economy. Thus, a systemic risk will have four significant ingredients namely erosion of faith, a sudden spurt of vagueness, major segment of the financial system that might be impacted and poignant negative impact on the real economy.”(Eijffinger 2010 :44).” Systemic risk can also be defined as that economic turbulence that creates harm to a nation’s economy through impacting the capability of the financial system to distribute funds. Adrian and Brunnermeier (2009) define it as peril that financial institution’s misery engulfs broadly and disturbs the availability of capital and credit to a nation’s economy. “Acharya et al. (2009)” defines it as the peril of large scale malfunctions of financial institutions or complete collapse of capital markets, which could considerably minimise the availability of such transitional capital to the a nation’s economy. (Eijffinger 2010:45). From the above discussion, we can understand that systemic risk impacts the entire financial system of a nation instead of individual financial institution of such nation and due to this, there is likely an overflow of risk to the real economy of a nation from the financial sector and would likely impact the welfare that is linked with these overflows. Alessi and Detken (2009) found that systemic risk can be early warned by indicators like property prices, equity prices and credit variable about the asset price disparity that present in a financial system which has restricted the capability to endure the imminent reversal in asset price (bust). The above authors were of the opinion that the 82% of financial meltdown can be correctly predicted by the global private credit gap. They were of the opinion that international financials variables is acting as the best indicator in forecasting costly booms where global credit surpasses global money. They also cautioned that indicators should be understood methodologically and should not be employed as the sole input to the information data of policy makers. (Eijffinger 2010:45). “Acharya et al. (2009)” employed a method to identify risks within a bank that is likely to spread over the countrywide financial system as a whole. They employed systemic expected shortfall (SES) to evaluate the externalities from the banking sector to the real economy, and this externalities occurs when the total of the banking capital slips well below a certain yardstick. One of the main disadvantages of SES is that it is really an arduous task to evaluate when the “systemically important financial institutions “are probable to fail and to create overflows to the real economy of a nation. (Eijffinger 2010:46). Hart & Zingales (2009) employed the prices of credit default swaps (CDS) as a pointer of failure of systemic institutions and as an activator for regulatory intervention. The main advantage of this technique is to evaluate the systemic risk by employing the data of individual institutions and exponent it for future predictions. (Eijffinger 2010:46). We can employ the techniques suggested by the above learned authors in a harmonising way. Thus , the findings of Adrian and Brunnermeier and Acharya et al. can be employed to find out which financial institution is probably at peril to systemic solidity while the finding of Hart and Zingales can be used to evaluate when this peril may occur so that watchdog can introduce preventive measures. “Systemically important financial institutions” Subprime mortgage crisis that occurred in 2007 stressed the drawbacks of the management and prevention of failure of large financial institutions around the world. “Systemically important financial institutions” (SIFI) are those whose failure and bankruptcy would impact the whole financial system of a nation. They are classified as SIFI since they are having complex and leveraged, with multirole and diffused financial operations with large scale off-balance sheet transactions and obscure financial statements. In US, the Dodd-Frank Act offers the FDIC with vast authority to resolve issues of SIFI by creating the orderly liquidation authority (OLA). In UK, the Bank of England is toothed with adequate authority by the Banking Act to address, rescue and to prevent the failure of deposit-taking building societies and banks. However, the Banking Act does not offer a completely efficient solution to the collapse of giant, intricate and international financial institutions. (Bank of England 2012: iii). IMF in its global financial stability report (GFSR) (2011) stressed to introduce a slant to recognise globally systemically important banks or institutions and also the features of extra loss taking capital needs to be catered with common equity : 1% to 2.5% of risk-bearing assets , with probable additional capital transformation of 3.5% to dishearten any spurt in systemic significance. Initially, 29 SIB (Systemically important banks) has been identified on the global level. (IMF 2012:61). For instance, with an excess of $6.3 trillion in assets, Citigroup, JP Morgan & Chase Co and Bank of America have been designated as SIFI. This denotes if any breakdown by any one of the above institutions would have a systemic outcome. If one takes into account of their collective assets value, which is equivalent to about fifty percent of the aggregate of US commercial banking assets, which appears to be realistic. The advantage of being SIFI is that it would be under an apparent safety net which the government is trying to withdraw, and the disadvantage is that it is being asked to bring in additional capital to meet any future systemic risk.(Kriz 2012:80). The main aim to identify the SIFI is to pump in additional capital and to make it as “too big to fail” thereby offering more funding vantages. Further, due to their giant size, rating agencies may exhibit more admiration to these institutions. (Jacobsson 2012). It is alleged that SIFI with cross-border transactions’ witness all the issues linked with local financial institutions together with enhanced issues like absence of any global system for finding solutions to globally active institutions. Hupkes (2004) explained many grave issues associated to wind up or streamlining SIFIs functioning around the national borders. One of these issues is that improper arrangement of fiscal incentives, which prohibit global resolutions. As per Hupkes (2004), country-level regulators will give more significance to their local creditors and their national markets in precedence over the global players in their market. As per Rosengren (2009), the local government supervisory institution may try to woe the parent operation in abroad into a receivership and will endeavour to consider the group as a bridge financial institution and in such cases, such bridge financial institution could not prolong its daily operations as host-country watchdogs would likely to introduce checks and balances on the mobilisation of resources out of their country, mainly to safeguard the interest of their creditors. Meyers (2006)cited the requirement of government of New Zealand that foreign financial institutions should function in New Zealand through their subsidiary and if the parent company cannot provide service , then , this subsidiary company should come forward to provide service on the value day itself which contrasts with financial institutions functioning in European Union where there is a system of single passport for financial institutions functioning in EU, which prohibits a New Zealand type structure in European Union. (Kawai & Mayes 2012:60). Conclusion Forewarnings for a systemic debacle can be predicted by employing earlier mentioned techniques of systemic risk. Systemic risk includes systemic risk pertaining to the whole fiscal system which can be triggered by asset booms while any risk sustained by an individual financial system may impact the whole financial system of a nation or across the world. A Systemic Regulatory Board which is to be established should take into account all systemic risk mechanisms and should appraise their outcome over time. As per Eijffinger and Mujagic (2009), systemic risk board should not employ the interbank money markets’ interest rates for financial and price stability as financial stability might need a lower interest rate, whereas price stability may need higher interest rates. However, to explore a novel mechanism that is easy to employ, efficient and not dependent on the interest-rate instruments appears to be an unfeasible task. (Eijffinger 2010:48). The sudden spurt of exotic derivatives, the decline of the risk premium on financial markets, misuse of derivatives was the main reason of the recent global financial crisis, and systemic important financial institutions should pay special attention to these kinds of instruments in the future and by setting framework for the recognition of systemic risk, the future global financial debacle can be averted. List of References Kawai, M & Mayes, D G. (2012). Implications of the Global Financial Crisis. New York: Edward Elgar Publishing. Jacobsson, P. (2012). Per Jacobsson Lecture: What Financial System for the Twenty-First Century? New York: International Monetary Fund. International Monetary Fund. (20120. Global Financial Stability Report, April 2012. New York: IMF Publications. Joseph, C. (2007). Credit Risk Analysis: A Trust with Strategic Prudence. New Delhi: Tata McGraw Hill Education. Neave, E H. (2009). Bank Runs and Systemic Risk. John Wiley and Sons Kriz, J. (2012). (2012). Fisher Investments on Financials. John Wiley & Sons Bank of England. (2012). Resolving Globally Active, Systemically Important, Financial Institutions [online] available from http://www.bankofengland.co.uk/publications/Documents/news/2012/nr156.pdf > [accessed 16 March 2013] Eijffinger, SCW. (2009). Defining and Measuring Systemic Risk [online] available from < http://www.mendeley.com/catalog/defing-measuring-systemic-risk-4/#page-1> [accessed 16 March 2013] Read More