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Russia’s invasion of Ukraine and the sanctions applied to it by the Western world sharply raises systemic financial risk, and we have to look back to the build-up to WWI to find a precedent.
Systemic risk does not capture the most likely, or even the plausible. Instead, a systemic crisis is an unlikely and highly destructive event where the forces of instability come together to create a major financial crisis – one whose cost is a meaningful fraction of GDP.
The 1914 systemic crisis was triggered by the assassination of Archduke Franz Ferdinand of Austria on 28 June 1914, amid raised expectations of an impending war. This anticipation created worries that financial institutions would have trouble getting cross-border loans repaid — after all, if two countries are at war, enforcing contracts across borders is difficult.
The specific crisis trigger was that major trading nations Austria, Germany (Hungerland et al. 2021), and France, intent on protecting their own financial markets, prohibited payments to foreign names. The cessation of cross-border loan payments and clearing created immense difficulties for banks with clients in those countries, rapidly spreading to all banks. As a result, a typical systemic risk feedback loop emerged, with everybody hoarding liquidity and not providing credit, while financial institutions and real economy firms faced the threat of bankruptcies. Moreover, further sanctions exacerbated the crisis once the war started, with the central powers particularly suffering from blockades (Brunnermeier et al. 2018, Roberts 2013).
The policy remedy was familiar: massive creation of liquidity (Bagehot 1876). Germany was prepared, having large stocks of high-quality paper and ink ready for printing money. Britain did not, and the newly printed pounds were printed with low-quality ink on cheap paper, causing widespread derision. The resulting quantitative easing was immense and succeeded in containing the liquidity crisis. However, that wasn’t sufficient, and many governments suspended requirements for making most private loan payments. In addition, the governments of Britain and the US closed the stock exchanges for half a year, as they were then the primary trading venue for bonds. A further important lesson is that while the Bank of England was the putative entity fighting a crisis, the severity was such that the Treasury took the lead and made all the crucial decisions and printed all the pound notes.
1914 was the last global systemic crisis triggered by economic sanctions and war. Then, as now, the financial system was globally integrated, so the resulting crisis has much to teach today’s policymakers.
There are significant differences between 1914 and 2022. Unlike in 1914, today's financial system is flush with liquidity due to the governments' response to Covid, and the belligerents today account for a smaller fraction of global trade, although Western European countries are more dependent on that trade than they were in 1914.
Even after WWI started, remittance between the Central Powers and the Allies continued via neutral countries – notably, Switzerland. Today, there are already signs that sanctions will assist the rise of new intermediaries, China, and cryptocurrency exchanges. In doing so, not only will they erode the power of the West over the global financial architecture, but they will also increase the system's diversity, which would reduce global systemic risk in the long term.
Systemic crises involve the worst possible outcomes, not the likely ones. At the heart of scenarios under which one could develop, the worst is a consequence of the dreaded government-bank doom loop.
As in 1914, the most apparent financial risks are to the European banks directly exposed to belligerent creditors. Fortunately, these do not appear to pose an immediate systemic concern. Capital cushions appear ample. Instead, we surmise that the initial systemic risk will emerge elsewhere. The most immediate threat is that Russia may retaliate by cutting off gas exports to Europe, which would trigger an immediate economic crisis in energy-dependent economies, particularly Germany.
Even if that does not come to pass, higher commodity prices and losses faced by those exposed to Russia create significant problems for financial and non-financial firms, and contribute to the considerable political instability.
The initial impact will be strongest felt by Germany and those countries with the strongest energy dependence on Russia, but every European country will be affected.
We expect calls for the ECB to help European countries to overcome the crisis. However, that won't be easy. Sharply rising commodity prices and limited supply immediately curtail economic activity. If the ECB attempts to monetise the shortfall in an environment of a contracting economy, the consequence is likely sharply increased inflation far beyond the current 7%.
Interest rates across the maturity structure will then sharply rise, causing problems for those most indebted European states with the shortest maturities, and hence the heaviest refinancing need. Moreover, as European banks hold a relatively large portion of sovereign debt, their balance sheets will consequently come under increasing strain, curtailing lending and setting the bank-government doom loop in motion.
One way to see how financial markets perceive the severity of the current situation is by looking at how they price insurance (options) against significant long-term losses on the market value of firms. We use data from such long-term and deep ‘out of the money’ options to construct what we term ‘market fear’. Technically, the quantiles associated with the 10% risk-neutral probabilities were obtained from one and ten-year options, using data obtained from IHS Markit (Bevilacqua et al. 2021)
Figure 1 shows market fear for the Standard & Poor'sP500, DAX index, and Deutsche Bank on the worst day of the Covid crisis on March 2020, 1 January 2022, and 8 March 2022.
At the one-year horizon, fear in S&P 500 is similar to the DAX index. For all three assets, the one-year fear was much higher in March 2020 than it is now. However, the picture is different at the one-decade horizon. The S&P 500 long-term fear appears unaffected by the war, while fears have significantly increased in both DAX and Deutsche Bank.
The charts indicate that the financial market expects German financial institutions and its broader economy to significantly suffer over the coming decade.
Figure 1 One-year and one-decade market fear
Such a complex crisis scenario in a general environment of high and rising inflation is particularly challenging for the central banks as stewards of both the currency and macroprudential policy. The macroprudential policy response calls for vast injections of liquidity. However, central banks, with their eye on inflation approaching 10%, will be reticent to create more liquidity via blunt tools such as QE and low interest rates. They could, of course, provide instead large-scale collateralised lending, which in turn raises concerns about the role of private sector lending institutions.
Central banks have had the benefit of macroprudential policy and monetary policy pulling in the same direction over the past decade and half, but no more. Monetary policy today calls for less liquidity and will oppose any emerging macro requirement for more liquidity. Market participants know this, so a relatively minor disruption to liquidity could lead to a self-fulfilling prophecy. Having done whatever it took over the past decade and a half, central banks have left themselves little ammunition to fight the consequences of the Ukraine war and sanctions.
If the crisis worsens, governments will be called on to support those entities suffering most from the war and the sanctions. They are in a poor position to do so, with sovereign debt at record peacetime levels, revenues likely to fall, and inflation high and rising. If the crisis turns especially severe, governments will have no choice but to monetise the interventions, further fuelling inflation.
The consequence could be increasing European fragmentation, as some states have strong economies and a good fiscal position and hence find it much easier to weather the crisis, while the most indebted European economies face more serious challenges.
The severe systemic crisis in 1914 provides a cautionary lesson for policymakers reacting to Russia’s invasion of Ukraine today. In 1914, countries intent on protecting their own financial systems and punishing their enemies closed off most cross-border provision of financial services, with the immediate consequence of a systemic crisis.
The consequences of Western sanctions against Russia are not of the same magnitude, and a systemic crisis remains unlikely. That changes if Russia opts to retaliate by cutting off gas supplies to Europe, and even if it does not, the longer the war lasts and the more biting the sanctions become, the worse the financial system and the real economy will be affected.
Regulators have 150 years of experience in dealing with financial crises, but their preferred tool – liquidity – is difficult to wield due to inflation and weak fiscal positions. We are now living with the consequences of central banks’ enthusiasm for liquidity creation in the years after 2008, especially 2020. This has served well but now leaves us in a poor place for responding the current crisis, particularly given its focus in the real rather than financial economy.
Jon Danielsson, Charles Goodhart, Robert Macrae