File Name: global financial systems stability and risk .zip
Back to Key Terms Explained. There are numerous definitions of financial stability. Most of them have in common that financial stability is about the absence of system-wide episodes in which the financial system fails to function crises.
We show that banks are now part of the solution, rather than part of the problem, thanks to regulatory and institutional reforms over the past decade.
Heeding the lessons from the Global Financial Crisis has paid dividends. COVID has caused a global collapse in activity and loss of jobs that is probably unprecedented in its scale and speed. Small and large businesses across every country in the world have had to close their doors to customers and employees.
It will also present the global financial system with its largest stress event since at least the global financial crisis. All crises are different. A decade ago, the financial system, and in particular banks, were the epi-centre of the global financial crisis, both its key cause and its key catalyst.
This time a pandemic is at the epi-centre of the crisis and the banking sector is now seen as part of the solution rather than the problem. This is evident from the large and rapid flow of new loans to businesses and households during the current crisis, often backed by state guarantees, to support them in the face of cash-flow shortfalls. This paper compares and contrasts these two crises from a financial stability perspective. It begins by reprising some of the events, the lessons and the policy responses during and following the global financial crisis, with a focus on the banking system.
It explains how responses to the global financial crisis left the financial system much better-equipped to cope with the COVID crisis while offering support to the wider economy. It concludes by drawing out some financial stability lessons from recent events, including future areas of research and reform. At the dawn of the global financial crisis, the balance sheets of the major global banks looked very different than today.
So too, not coincidentally, did the set of prudential regulatory standards they were required to meet. This combination led to the emergence of excessively low levels of capital and liquidity, and excessively high levels of leverage, in the global banking system.
As in crises past, these fault-lines sowed the seeds of the largest financial earthquake since the Great Depression. Figure 1 shows the evolution of the simple leverage ratio, defined as equity over assets, of UK and US banks over the past years. This fell by a factor of between 3 and 5 during the course of the twentieth century. At the time the crisis broke, many banks had leveraged their common equity capital in excess of 30 times, meaning that even a 2—3 per cent loss in asset values was enough to render them insolvent.
Before the crisis, no internationally agreed standards for minimum levels of the leverage ratio had been set. US and UK leverage ratio Notes : a US data show equity as a percentage of assets ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets.
SNL data from on, based on accounting definition of equity. Historical data refer to commercial banks. The solid line adjusts for this. Data from onwards is based on the simple leverage ratio published by the FPC as of September as one of its core indicators for the countercyclical capital buffer. The end accounts were also restated on an IFRS basis.
Sources : Aikman et al. USA: Berger et al. These fell secularly and significantly in the half-century prior to the global financial crisis, by a factor of between 3 and 5. Tellingly, no internationally agreed standards for minimum levels of liquidity had been put in place pre-crisis either, which could have arrested this secular drain of liquidity from the global banking system. As well as being low, this requirement was a hard floor. The absence of meaningful capital buffers meant there was very limited capacity for banks to run down their capital to cushion losses in the event of stress to protect their capacity to lend to the wider economy.
They then flattened these same capital ratios during the downswing, as risk weights were revised up at just the point banks were suffering losses. Data are not available for the remaining G-SIBs. Sources : Haldane based on The Banker and Bank calculations.
Low levels of equity capital in the banking system are, in principle, less of a problem if other forms of capital can be converted into equity in situations of stress. These were not the only fault-lines in the pre-crisis banking and regulatory systems.
This meant, pre-crisis, the largest and most systemically-important banks typically ran with smaller capital buffers than the small banks. This had two negative side-effects for financial stability. This state support arose because of an understandable fearfulness among the authorities about the systemic costs of allowing a big bank to fail.
These myriad fault-lines in the global banking and regulatory systems could, in principle, have been identified and remediated—for example, had regulatory authorities undertaken comprehensive stress-testing not just of individual institutions but the banking system as a whole.
While some stress-testing was carried out pre-crisis, this was done neither comprehensively nor systematically. This meant, when it came, both banks and the regulatory authorities flunked the stress test.
The combination of leveraged and illiquid bank balance sheets on the one hand, and a flawed and poorly-calibrated regulatory regime on the other, were a perfect storm. When it broke, it risked sweeping away the global banking system. It would probably have done so were it not for unprecedented levels of support from governments and central banks around the world, in the form of equity injections, asset purchases, guarantee extensions and liquidity provision.
Even with that support, the costs of the global financial crisis for the global economy were as large and lasting as any since the Great Depression. The financial sector was both a key cause and a key catalyst. Those banks with the lowest levels of capital and liquidity reigned in lending most sharply, imposing the largest costs on the economy Figure 3. This was an aggregate demand externality.
But the collective consequence of these individual lending decisions constricted aggregate credit, imposing an externality on aggregate demand that was both large and long-lived and fed back to raise losses for the banking system in a vicious cycle. The global financial crisis, and the regulatory fault-lines it exposed, also swept away the pre-crisis system of global regulatory rules.
The Basel III rebuild has been multi-faceted, reflecting the multi-faceted nature of problems exposed by the crisis. Liquidity and leverage were at the heart of the global financial crisis. For the first time, international regulatory minima have now been put in place covering both.
The quality as well as the quantity of capital have also been improved, with much tighter eligibility criteria for loss-absorbing capital. The collective consequence of these changes is that the minimum level of loss-absorbing capital for global banks has been raised by a factor of around four since the crisis.
These micro -prudential requirements capture only one element of the new capital regime. Basel III reforms have given this regime, for the first time, an explicitly macro -prudential overlay. New requirements have been set that focus on risks across the financial system in addition to idiosyncratic risks and on enabling banks to maintain lending in periods of stress to limit aggregate demand externalities. In that sense, the key lessons of the financial crisis have been acted on.
Under Basel III, banks are now required to hold buffers of capital over and above their minimum requirements through: a capital conservation buffer ; a countercyclical capital buffer CCyB that can be raised by the authorities to build resilience during the upswing of a financial cycle and released during stress; and a systemic risk buffer , for banks which are designated by the FSB as systemically-important, based on a set of objective criteria such as size and connectivity.
As importantly, macro-prudential buffers, in particular the releasable CCyB, mean this stack is much more flexible than in the past, with half available to support the wider needs of the financial system and economy in averting a credit crunch during a stress event. The new capital regime provides both the global financial system with greater insurance against extreme events and global regulators with extra degrees of policy freedom when dealing with such stress events.
Stylized illustration of capital stack after post-crisis reforms Source : Bank of England. Augmenting and complementing all of these international regulatory actions, the authorities in a number of countries, including the UK, have begun conducting regular, comprehensive stress-tests of their banking systems.
These regulatory reforms have largely been implemented across major economies. Their effect is clear. Average Tier 1 capital ratios across economies with large financial systems are more than basis points higher than at the end of In many countries, the regime for resolving banks facing acute stress has also been transformed. Pre-crisis, many countries did not have a special resolution regime in place for banks that recognized the different risks they posed and the different tools needed to resolve them safely.
Those special bank resolution regimes are now in place in many more countries, including in the UK. For example, the Bank of England redesigned its existing long-term repo operations in order to increase the availability and flexibility of liquidity insurance provision, against a wider range of collateral. In summary, the entire system of financial regulation, in particular around banks, has been reformed over the past decade.
The open question, until recently, is how the reformed financial system would fare under stress. The economic shock induced by COVID is the largest stress-test to have faced the financial system since the global financial crisis. This is also the set of circumstances in which the financial reforms put in place over the past decade would be expected to yield a dividend in improved financial sector resilience and, relative to a counterfactual, a lower cost and greater availability of credit to businesses and households.
Although the crisis is still in its early stages, there is already evidence of these dividends paying out. While these spreads have risen in response to the COVID crisis, they remain at far lower levels than at the time of the global financial crisis. This suggests a much greater degree of banking resilience in the eyes of investors in banks. The same is true, by and large, of perceptions of other global banks. Rapid injection of liquidity by central banks will also have played a role in limiting increases in CDS spreads, although this was in response to signs of more general market dysfunction and not directed at stabilizing banks.
Series starts in Sources : Bank of England Financial Policy Committee counter-cyclical capital buffer core indicators, based on Markit Group Limited, published accounts and Bank calculations. Improved resilience and a lower cost of capital can be seen in measures of the cost and availability of credit by banks.
The COVID-crisis has squeezed the cash-flows of many businesses and households, increasing their demand for credit. Supported by government schemes, global banks have been able to supply that credit to millions of companies so far during the COVID crisis. Absent regulatory reforms, a shock of this scale would have resulted in an illiquid and prospectively insolvent banking system.
Since the crisis, a number of countries have cut their CCyB requirements, providing banks with the capital space to support lending. Regulatory authorities have also taken actions to encourage banks to make use of other capital buffers, as well as asking banks to refrain from distributing dividends.
Moreover, the FPC stated it was in the best interests of the banks themselves to extend such lending to support the economy and avoid credit losses. This is an example of a positive aggregate demand externality at work—the reverse of the situation during the financial crisis.
Financial regulators heeded the lessons of the last war, the global financial crisis. The result has been a financial system, in particular on the banking side, much better equipped to fight this one. At the same time, all crises contain lessons for the future.
Looking ahead, this calls for both further research to better understand these fault-lines, and potentially further regulatory reform to repair them. We conclude by discussing a number of these fault-lines. One area of the financial system needing further consideration is non-bank, market-based finance , including asset managers, hedge, investment and money market funds.
This is an all-hands-on-deck moment. It is incumbent on policymakers across the issue spectrum—from energy and tax policy to infrastructure and financial services—to mitigate the impacts of climate change and facilitate a timely transition to the U. In particular, the Federal Reserve Board and the Financial Stability Oversight Council FSOC have the statutory mandates and tools necessary to coordinate the integration of climate-related risks into the financial supervisory and regulatory frameworks. This brief outlines why climate change poses a threat to financial stability in the United States and details steps that regulators should take to integrate climate risk into their regulatory and supervisory frameworks. Climate change is a systemic risk to the financial sector that warrants the heightened scrutiny and enhanced mitigation efforts of regulators. In the financial system, systemic risks are risks that have the potential to destabilize the normal functioning of the system and lead to serious negative consequences for the real economy.
Global Financial Systems: Stability and Risk On–line chapters Version , November, Jon Danielsson Systemic Risk Centre London School of Economics.
We show that banks are now part of the solution, rather than part of the problem, thanks to regulatory and institutional reforms over the past decade. Heeding the lessons from the Global Financial Crisis has paid dividends. COVID has caused a global collapse in activity and loss of jobs that is probably unprecedented in its scale and speed.
President and Chief Executive Officer. Loretta J. Mester participates in the formulation of U. She assumed her role as president and CEO in June
In finance , systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to the risk associated with any one individual entity, group or component of a system, that can be contained therein without harming the entire system. Systemic risk has been associated with a bank run which has a cascading effect on other banks which are owed money by the first bank in trouble, causing a cascading failure. As depositors sense the ripple effects of default, and liquidity concerns cascade through money markets, a panic can spread through a market, with a sudden flight to quality , creating many sellers but few buyers for illiquid assets. These interlinkages and the potential "clustering" of bank runs are the issues which policy makers consider when addressing the issue of protecting a system against systemic risk. Securities and Exchange Commission SEC , and central banks often try to put policies and rules in place with the justification of safeguarding the interests of the market as a whole, claiming that the trading participants in financial markets are entangled in a web of dependencies arising from their interlinkage. In simple English, this means that some companies are viewed as too big and too interconnected to fail. Policy makers frequently claim that they are concerned about protecting the resiliency of the system, rather than any one individual in that system.
View larger. Request a copy. Buy this product. Alternative formats. Danielsson draws on economic theory, finance, mathematical modelling, risk theory, and policy to posit a coherent and current analysis of the global financial system. Pearson offers special pricing when you package your text with other student resources.
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