Systemic risk or diversifiable risk

Systemic risk; commonly known as market risk or un-diversifiable risk, is risk which affects the entire market and cannot be avoided through diversification. Events such as recessions, wars, significant political events, and interest rate fluctuations (to name a few) are all believed to be sources of systemic risk. A banking panic is where large scale withdrawals from banks occur, whereby the customer believes that there is a high probability of them losing their money due to banks collapsing. As the quantity of withdrawals increase the likelihood of the banks collapsing increases. This has knock on effects, whereby liquidity is severely reduced resulting in inabilities to acquire future loans and other forms of capital from the banks. “A banking panic is a systemic event because the banking system cannot honor commitments and is insolvent.”[1]

The National Banking Era, a period from 1863-1913 where there was no central banks in existence with very little regulation of banks, shocks to house prices were often the stem of banking panics during this era; the 2007-2010 banking panic is believed to be very similar. The current banking panic happened in the shadow banking system and not in the regulated banking system. This occurred because the falling house prices caused a shock in subprime related products offered by shadow banks. It was believed by many analysts that “the huge run-up in U.S. housing prices was not at all a bubble, but rather justified by financial innovation (including to sub-prime mortgages), as well as by the steady inflow of capital from Asia and petroleum exporters.” [2]. The shadow banking system was built up in conjunction with the regulated banking system, with their main aim of trying to make credit widely available and the make credit cheaper for the customer. Regulators in some way encouraged the idea of shadow banking as it allowed them to remove certain risks from the traditional banking systems by packaging these risks into loans, securitizing them and selling them on (eg. Credit, liquidity and interest risks). Little did they realise they weren't getting rid of the risks; they were simply just shifting it to a different place.

These loans were insured and given a AAA rating. This allowed them to borrow nearly 100% of the value of the loan/CDO tranche (a type of asset backed security) in the overnight repo market. The repo market is a trade mechanism whereby there is a simultaneous sale and repurchase of an asset with fixed interest rates and time constraints associated with it. By availing of low overnight rates on the repo market and by leveraging the asset up, they were able to make money on the margins. Problems that began to arise due to the collapsing housing bubble and with over a trillion dollars being pumped into the US subprime market alone; some people began to question the credibility of these AAA assets and whether it is big enough to undermine the entire financial system. Because no one really knew the real value of these assets, what would be deemed a fair value for them?

The Asset Backed Securities index became a proxy for calculating the market price for these assets. The index is made up of 20 CDO tranches which is a traded index. The asset's market price was based on the performance of the index; when the index fell, the amount you could borrow on the repo market also fell. This has led to a downward spiral in asset prices. This is a result of the number of overdue debts in the subprime market which begun to increase quite noticeably due to the bursting of the residential property bubble. Property prices began to fall dramatically nationwide, and this has put the shadow banking system in severe financial difficulty.

It is also believed that credit rating organisations (CRO's), the likes of Standard and Poors and Moodys, have played a big part in the causing of this current systemic crisis. Up until late 2007 investors were quite satisfied to allow CRO's to calculate risk on their behalf, thinking that they were purchasing fairly priced and accurately rated assets as well as substituting for their own due diligence. With the number of downgrades and defaults of highly rated assets on the increase; the volume of risk-management mistakes was becoming quite evident.

An accurate CRO rating benefits both the issuer and the investor alike. Issuers, having the responsibility of obtaining an accurate rating and the burden of paying large CRO fees, they have an incentive to play different CRO's against each other and by doing so they can hold out until they find the most favourable credit rating from a well established reputable credit rating organisation. Surely one would think that this is counterincentive and would lead to inaccurate rating of assets. With so few CRO's operating in the industry, “major ratings organizations do not compete either in the models they use to assess credit risks or in the criteria they use to map the forecasts their models produce into different rating classes. This similarity in methods means that errors are likely to be similar” [3] The CRO's had very little incentive to update their poorly tested models over the years. This also begs to question whether CRO employees have been entirely truthful when rating assets or have they been tempted to chase down big issuers in order to obtain large bonuses putting the CRO reputation at stake? Without accurately rated and priced assets, surely we have been staring a systemic crisis right in the face.

Some would suggest that regulators should be made accountable for providing a stable economy in an effort to steer away from systemic crises. Increased competition amongst banks in different regulatory systems was brought about by system deregulation and increased asset securitization resulting in decreased supervision in the banking sector. To counteract this lack of supervision, the Basel committee had been formed to try and eliminate inequalities amongst competitors and to improve stability in the financial sector.

With Basel 1 being implemented in 1988, initial steps proved to be successful with the generation of loan supplies but it wasn't soon after that cracks began to emerge in the system. With shortcomings in the formulation of the risk-weighted assets formula, arbitrage opportunities began to surface. Basel 2 was then created in 2004 to try and improve on the proponents of Basel 1 and to prevent such arbitrage opportunities which inevitably have led us into this current economic crisis. With Basel 2 still in the initial stages of implementation, is it a case of too little too late? With improvements in minimum capital requirements and supervisory reviews; will it be enough to steer away from further systemic crises having overlooked on how to improve on the capital measurement and ratio weaknesses set out in Basel 1. Basel 2 still remains to be viewed as a major step forward for banks.

“While risk-management mistakes, low interest rates and some kind of asset-price bubbles are features of most crises, this crisis may be remembered as one in which long successful systems for using debt ratings to control institutional risk-taking failed massively.”[4] Going forward increased supervision and accountability in the banking system needs to be put in place as well as being enforced. Expectations of government bail outs also needing dissipation. With ongoing deregulation of the banking system authorities need to update their methods of monitoring liquidity issues within banks and generate newly devised resolutions to suit.

[1] Gorton, G. (2009). Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007. Yale and NBER. (1), pg 1-52.

[2] Rogoff, K.S., Reinhart, C.M. (2008). Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison. NBER Working Paper No. W13761. (Draft) pg: 1-12

[3] Caprio, G., Demirgüç-Kunt, A., Kane, E. J.. (2008). The 2007 Meltdown in Structured`Securitization: Searching for Lessons not Scapegoats. The World Bank: Policy Research Working Paper. 4756, pg: 1-39.

[4] Caprio, G., Demirgüç-Kunt, A., Kane, E. J.. (2008). The 2007 Meltdown in Structured`Securitization: Searching for Lessons not Scapegoats. The World Bank: Policy Research Working Paper. 4756, pg: 1-39.

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