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Symposium 2011

Proposal - Coping with Systemic Risk

The Challenge

The global financial crisis has revealed how systemic risk in the banking system can lead to huge economic downturns. Many of the problems leading to the crisis have been discussed and many suspects h ...

The global financial crisis has revealed how systemic risk in the banking system can lead to huge economic downturns. Many of the problems leading to the crisis have been discussed and many suspects have been identified (including investment banks, central banks, rating agencies, regulators and the economics profession).

Part 1: Why do regulators know so little about the empirical network structure of the interbank market? What data is needed to monitor the system? Is it possible to monitor systemic risk, based on market data only?

An important reason for the lack of knowledge (interest?) in detailed interbank networks, is the usage of mainstream economic models, of the Dynamic stochastic general equilibrium (DSGE) type. DSGE models neglect the importance of complexity and heterogeneity and policymakers thinking in terms of these models essentially assume a very robust banking system having no feedback on the macroeconomy and vice versa. In this way, it is not surprising that there are yet only few well-established "stylized facts" on the structure of interbank markets, additionally caused by severe data availability constraints. For example, recent findings (mainly by non-economists from the natural sciences) suggest that interbank markets are usually scale-free networks. Thus, the system is quite robust to random failures, but failures of the central nodes (hubs) will wreak havoc. The conclusions for systemic risk are straightforward.
The aforementioned data constraints include the absence of detailed data sets of interbank transactions data and/or reluctance to provide researchers with such data sets. The potential wealth of detailed information from interbank payment systems needs to be exploited. Interestingly, given the electronic structure of interbank payment systems, this data could be collected at very low costs.

Part 2: Which stability-enhancing regulatory measure can be realistically implemented? Should these measures be coordinated internationally to become effective of will national solutions suffice? Is there a risk of overregulation in the reform process?

There are numerous potentially stability-enhancing regulatory measures. While existing capital standards are mostly concerned with idiosyncratic shocks (capital and liquidity buffers), systemic risk is in fact not being dealt with accurately. In particular during the recent crisis, it became clear that homogeneity on banks' balance sheets had disastrous effects on the system's stability. Obviously, benefits of portfolio diversification become merits during times of distress when most asset classes are highly correlated. The solution therefore requires regulatory capital requirements to take into account the connectedness of banks, where the hubs clearly have to hold more reserves than isolated nodes. Enhancing the robustness of the hubs obviously increases the system's overall stability. In this sense, an internationally coordinated solution would be efficient given the globalized financial system. Nevertheless, setting up national solutions in the first place and letting a diversity of such solutions compete over time, will doubtlessly show how stable a particular banking system is under the regulatory setting. Thus, evolution may also tell good from bad solutions. Evaluation of these solution could be done by existing institutions, such as the BIS or the IMF. Concerning the risk of overregulation, up to now there is more of a risk of underregulation. The last decades were in fact a time of excessive deregulation and even nowadays the majority of mainstream economists doubts the benefits of market regulation. Thus the risk of underregulation still prevails. In fact, the Basel III accords are a notable exception, and until now essentially the only significant change in regulating banks. Still they lack a plausible incorporation of systemic risk issues.

Part 3: Should central banks aim at monitoring and providing financial market stability? How then can we define financial market stability?

Defining financial market stability is an important issue and this definition will also hint at whether central banks should aim at monitoring the stability of the financial system. In general financial stability describes a financial system's ability to efficiently allocate financial resources, reliably assess and tackle risks, and securely settle payments and securities transactions. A stable financial system generally fulfils these functions also in stress situations. Unlike price stability however, where the instrument under control is quite well understood, financial stability is therefore far less tangible. Of major importance is a robust set of indicators of financial distress, including bank- and system-specific variables. Many variables from network theory, including the connectivity and centrality of nodes, will be an important background information for defining these indicators.
Concerning the topic of central banks and financial stability, one should keep in mind, that contributing to financial stability is already part of a central bank's core area of responsibility, in order to ensure price stability and avert negative repercussions of the financial system on the real economy. Identifying asset price bubbles and acting against them is also an important future task.

Part 4: How should the trade-off be made between the assumed benefits resulting from increased stability of the banking system and the negative impact on global gdp growth that will follow from regulatory changes? How is the industry likely to respond to these changes?

Increased stability of financial markets in general and the banking system in particular, will have long-term efficiency-enhancing effects. First, reducing systemic risk makes large bail-outs less likely. Second, reducing banks' excessive activities on financial markets will bring the real and financial economy closer together. In this way, only periods of sustainable economic growth will emerge, leading to more efficient outcomes. Third, the negative impact on global gdp growth, if there is any, can be assumed to be rather short-term. Obviously the last two points are interrelated and the benefits of the former are likely to be larger than the merits from the latter.

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