Interconnectedness and systemic risk monitoring

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Defining desirable financial dynamics as well as when and how regulators should respond to systemic risks is as much an art as it is science. CreditUtility believes that the best financial market policy ideas emerge from broad (but organised and time limited) public discussion and debate, as well transparent information. We also believe that desirable market behaviour may be encouraged with a combination of control rules and incentives that support financing for the real economy.

 

To stimulate such discussion, the tabs on the right of this page link to materials elaborating on how credit risk transfer markets impact the economy and how banking’s growing interconnectedness contributes to financial system risk. Interconnectedness has increased substantially over the past several years in line with the rise in Shadow Banking. To some extent, this reflects banks' efforts to manage their own risk and revenue concentrations. However, it can also reflect less-desirable motivations. And when interconnectedness becomes hidden within complex corporate structures and Shadow Banking transactions, it increases the risk of contagion in times of stress.

 

Topics covered by the links to the right include securitisation market reform, systemic risk monitoring and shadow banking. Readers looking for a summary of CreditUtility's diagnosis of what has hobbled our economic system and how we might accelerate economic recovery are encouraged to read both the "Abbreviated Problem and Solution Statement" and the "Prudential Regulation and Capital Formation"[1] documents. Both are deliberately brief. Those interested in Shadow Banking as well as at least some of the more granular, technical issues may prefer to focus upon the "Comments on EC Green Paper on Shadow Banking" document as well as the “Banking and shadow banking’s role” discussion below. All these materials highlight opportunities to strengthen regulatory responses to future financial crises.

 

Throughout this website, CreditUtility’s objectives are to promote greater credit network:

-      liquidity and robustness

-      transparency

-      simplicity and standardisation

-      efficiency

while maintaining most existing competitive and due diligence disciplines.

 

Bank regulation and economic efficiency

 

Efforts to reform and stabilise volatile financial networks should first and foremost recognise what works and what network characteristics are desirable. In the case of the lending and credit risk transfer markets, past and prospective regulations impact both their systemic risks as well as their operating efficiency. That is, regulation impacts both short- and long-term profitability for market participants.

 

Much of today’s bank regulation debate revolves around commentators’ different time horizons for profit recognition[2]. A further consideration in the debate is that regulation also determines economic competitiveness and flexibility. And again, differing time horizons can influence perspectives here.

 

Whether the market’s economically desirable characteristics[3] have been fully understood and considered when drawing up the latest policy proposals is not clear as of November 2012. Similarly, the extent to which the proposed regulations have considered their likely impact upon transaction costs and price formation is also unclear.

 

Academics refer to these as “market microstructure” issues. Some of the granular detail behind them will be of limited appeal to most readers. Similarly, because some contributors may wish to “test run” their observations and proposals before making them publicly available, CreditUtility hosts an “off-line” discussion group. This discussion group focuses upon and develops these granular issues in support of specific policy proposals and transparency solutions. Contributors to this off-line discussion group are encouraged to submit summaries of (or electronic links to) their work for the benefit of all CreditUtility’s on-line readers.

 

Banking and shadow banking’s role

 

Traditional banking profitability, that is the risk/reward profile from the business of securing deposits and then recycling the deposited cash into profitable loans, has been eroded over the years. In the run-up to the 2007/8 financial crisis, many viewed this simple and long-established "buy-and-hold" banking model as out of date and inefficient. Larger banks in particular gravitated towards a newer "orignate-to-distribute" model which, in turn, boosted credit risk transfer volumes and securitisation[4]. The Shadow Banking sector was a major beneficiary from this operational shift by the larger banks.

 

The "originate-to-distribute" model has been championed for its ability to increase banking sector flexibility and to broaden the base of lenders beyond domestically regulated banks. The 2007/8 crisis also showed how it introduces many new risks to the market. An “originate-to-distribute” strategy also, potentially, shifts regulated banking's role from one of credit provider to that of an intermediary.

 

In response to the identified systemic risks, the Financial Stability Board (“FSB”) launched a consultation in 2012 setting out its proposed approach to Shadow Banking. CreditUtility’s two contributions to this consultation may be seen using the links on the right. The first of these submissions reviews Functional Regulation and proposes possible modifications to the FSB’s proposals. The second then extends this discussion to the Repurchase Agreement sub-sector within Shadow Banking.

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Is simple financial intermediation a role that regulated banks should assume going forward? Is our regulatory approach or is competition forcing banks to adopt such positioning? Similarly, what economic contributions would we like banks and shadow banks to make if systemic risks are to be managed more effectively? Where should lending risks reside in a more desirable economy[5]? These and similar topics remain to be considered.

 

[1] The original corporate logos and references in the "Prudential Regulation and Capital Formation" document have been removed as they are not relevant.

[2] And, from a systemic risk perspective, the key is to focus upon banking's "through-the-cycle" efficiency rather than potentially deceptive short-term profitability.

[3] “market” here refers to the collateralised risk transfer market

[4] Both the words “buy” and “originate” in the above “buy-and-hold” and “originate-to-distribute” phrases refers to the creation of loans. In the first one, the bank is buying and then holding on to an earning asset by extending a loan. In the “originate-to-distribute” phrasel the bank is originating credit risk in the form of issuing a loan and then transferring (distributing) the ownership of all or part of this loan to other financial investors.

[5] i.e. one less reliant upon government bailouts of the financial sector