24 November 2009

Containing systemic risk: ECON report by Karl Whelan from University College Dublin for dialogue with ECB in December

The report presents initiatives that can be taken to reduce the problem of systemic risk. It shows that a way to increase liquidity ratios would be via the Turner recommendation of a minimum required ratio of “core funding” to total liabilities.

In the context of the ECON committee dialogue with the ECB taking place on 7 December 2009, some experts have provided the Committee with a series of papers analysing the systemic risk issue.

At present, the data available to central banks and financial regulators are not at all adequate for the task of assessing systemic risk and the new European Systemic Risk Board needs to address this issue.

There is a lot of exciting ongoing research devoted to measuring systemic risk and providing signals to regulators as to when and where they should intervene.

 

However, the tools being developed are still limited in their usefulness. Perhaps more pressing than the development of these tools is the implementation of policy measures to make the financial system more robust. These measures should include higher capital ratios, limits on non-core funding and redesigning financial systems to be less complex.

Whelan’s report tackles the issue of how to control systemic risk and presents the following initiatives:

 

1. Higher Capital Ratios: The G20 has agreed that capital ratios must be increased. That’s the easy part. The hard part will be deciding over the next year or so what these higher required ratios should be and at what point the costs associated with higher capital ratios (due to more expensive capital and less efficient financial intermediation) start to prevail.

 

2. Core Liquidity Ratios: The report shows how reliance by financial institutions on short-term sources of funding, such as the repo market, contributed to systemic risk. The G20’s Pittsburgh communiqué called for strengthened liquidity requirements. A strict way to enforce this would be via Lord Turner’s recommendation of a minimum required ratio of “core funding” (defined as deposits plus certain types of longer funding) to total liabilities.

 

3. New Infrastructure: Much of the systemic risk problem stems from the complex nature of interactions between financial institutions. Andrew Haldane of the Bank of England has argued that governments should work to simplify the structure of the global financial network. For example, governments could set up a central counterparty for interbank lending, which would simplify the system to a basic hub-and-spoke structure and reduce the potential for spillovers from the failure of an individual institution. Requiring private centralised counterparties could also help to simplify and stabilise complex markets such as those for Credit Default Swaps.

 

4. Addressing Too Big to Fail: Large financial institutions—those most likely to trigger a systemic financial crisis—should be required to hold higher capital levels.

 

5. Resolution Framework: The ESRB should take the lead in establishing an agreed EU-wide resolution framework for dealing with troubled banks. This framework needs to ensure financial stability but should also provide a credible commitment that providers of risk capital to failed banks should lose their money. Such a framework should come with sanctions for countries failing to comply.

 

Ultimately, it should be accepted that all financial systems are subject to periods of financial instability. However, the recent crisis has taught us many lessons about the features of the current global financial system that have made it so vulnerable to a system-wide failure. The development of new data sources and tools to monitor systemic risk will play an important role in the future. But redesigning the system to be more stable will be more important.

 

 

Full report

 

© Karl Whelan