SYSTEMIC RISK AND CRISIS IN BANKING SECTOR essay
Under the banking crisis has traditionally meant a steady failure of a large number of banks to fulfill their obligations to the counterparties, which is expressed as a breach of settlement and cash service obligations to depositors, holders of bank liabilities, in bankruptcy and liquidation of banks. If the banks are beginning to experience serious difficulties in carrying out the largest volumes of core banking operations, the crisis can be considered as a system that is threatening the entire banking system.
Experience of various countries shows that banking crises reflect the complex process of adaptation of banking systems to the new macroeconomic conditions. The liberalization of foreign economic relations and the deregulation of the banking sector in both developed and developing countries, globalization of the financial services market, market reforms in countries with economies in transition – all of these processes led to macroeconomic instability and economic imbalances and negatively affecting the state of bank balance sheets. Because of increased volatility the banking system proved to be highly susceptible to such traditional factors of banking crises, as the economic recession, turmoil in the real economy. The decline in production, the deterioration of the solvency of borrowing enterprises are the traditional causes of banking crises. The degree of impact of the crisis in the economy on the banking system depends on many factors. However, it is important to consider risks that accompany the activities of banks, especially systematic risks.
Risk as an integral part of economic, political and social life that accompanies all areas and activities of commercial banks operating in market conditions. At present, uncertainty of events and processes affect the fundamental socio-economic activities, that is why risk become an essential characteristic of economic activity. Of the variety of risks that exist in the market economy, systemic risks of commercial banks pose the greatest threat to economic and social stability of society. This is due to a special function of commercial banks, without normal operation of which it is impossible to maintain continuity of social reproduction, and the complexity of managing of systemic risk.
Systemic risks in commercial banks were particularly evident during the last global financial crisis, characterized by great depth and scope. Financial crises have a systemic effect on the financial system and change them, which determines the need to identify new approaches to the study of theoretical and practical problems of management of systemic risk in commercial banks to ensure their sustainability. Consequently, the ability to predict, prevent and manage systemic risk is a major and indispensable condition for the normal functioning and development of the economy. (Rosemberg, 2008)
The instability of the banking system and banking panics can be attributed to the institutional source of systemic risk, which is based on at least two reasons. The first follows from the model of banks as financial intermediaries that convert short-term liabilities into long-term loans, based on the assumption that not all account holders will use their right of withdrawal of funds. However, this assumption is no longer valid when the depositors, fearing for the safety of their money, tend to urgently recover their deposits. The second reason stems from the banking panic of the first and is for informational purposes. (Rosemberg, 2008)
Failure of one bank to meet its obligations could lead to “escape” of depositors from a number of banks and a series of bank failures due to lack of awareness of investors about the financial condition of the bank. It is believed that the system of guaranteeing the repayment of deposits “prevents” systemic risk, prevents the spread of panic through the system, if there are enough funds to meet the demands of depositors. (Williams, 2010)
In the financial market spread of systemic risk goes is associated with unexpected sale of assets, which greatly reduces their value. If these financial assets serve as collateral for interbank lending, which automatically leads to reduction in their quality and reduction in liquidity in the interbank market. Reduced market liquidity leads to an increase in interest rates in the credit market and cuts of active operations. In addition to external causes, the source of systemic risk may be internal problems of the financial sector. One such problem is a bubble of financial assets during the credit boom, which leads to an increase in imbalances in the financial sector and determines the “procyclicality” of the financial system. (Rosemberg, 2008)
The basis of the imbalances consists of the following reasons:
1) Tendency to similar behavior of market participants in financial markets leads to investments in instruments with similar risk profiles, based only on an analysis of the actions of other market participants.
2) Low interest rates in periods of credit “boom” encourage banks to take substantial risks and at the same time, increase the value of the collateral (due, for example, to the growth in property prices).
3) An increased level of borrowings and investments in the economy, resulting in increased rate of leverage (the ratio of capital to assets) in banks and other business entities.
4) The reason may be associated with mitigation of lending standards during the cycle due to the changing perceptions of investors (moral hazard).
The recent financial crisis has also demonstrated a lack of proper evaluation of the influence of a number of financial intermediaries in the systemic risk and financial stability. An example may be bankruptcy of investment bank Lehman Brothers. Despite that the bank was considered strong and “too big to fail”, in September 2008 it was decided not to save Lehman Brothers, that caused panic in the international financial markets. (Zhou 2010)
Financial crisis of 2008 has demonstrated the fact that the problem of “procyclicality” is present not only in the financial system, but also banks. In particular, the bankruptcy of British bank Northern Rock have revealed the presence of pro-cyclicality. This Bank before the crisis made assessment of the risk level of its assets and informed about the level of capital met the requirements of Basel, but also exceeded these requirements. Northern Rock announced an increase in the amount of dividends by 30%, the payment of which was planned in October 2007. However, the losses incurred by the bank in June 2007 led to a decrease in the cost of equity capital, the bank’s capital levels fall to a record 10,2%, and dividend payments were cancelled. Bankruptcy of Northern Rock was a shock to the entire financial system of Great Britain. (Williams, 2010)
These market failures of Northern Rock and numerous American banks, as well as other financial institutions allowed to systematize the reasons of crisis and take lessons both for market participants and regulators. For financial institutions a lesson was in proper organization of the risk management system, based not only on mathematical models, but also on the analytical ability of risk managers to anticipate and respond to market conditions. For the regulators the main lessons was the need to assess the internal risk management procedures, identify potential weaknesses and deficiencies. In addition, the need to regulate not only banks but also other financial institutions, financial markets, payment and market infrastructure, taking into account the potential level of system threats. (Praet 2010)
In contrast to the non-system risks that are present in the activities of individual actors or institutions, systemic risks affect the financial markets or the financial system as a whole and can not be mitigated by traditional methods. The structure of the assessment of systemic risk is an independent, but at the same time complementing macroprudential analysis and stress-testing of banks with assessment of strength of network relationships between banks and the probability of distribution of shocks between them. (Praet 2010)
Interdependence of factors of systemic risk shows that even the presence of small financial shocks can be sufficient for large imbalances in the economy. This indicates that the macroprudential supervision should cover a systemically important financial intermediaries, markets, infrastructure and tools. (Praet 2010)
Systemic liquidity risk has been at the epicenter of the past crisis, so central banks had to intervene using untested methods. It is therefore important to stress the need for a macroprudential system designed to reduce system-wide or systemic liquidity risk. Regulation of the financial system can be realized through:
– prudential regulation (micro-prudential regulation at the level of individual institutions and macroprudential – at the level of the financial system);
– tools to maintain financial stability;
– oversight of payment and settlement systems;
– regulation of certain activities in the financial market (business management).
Ensuring the stability of the financial system lies in deterrence of instability factors, preventing their influence on the economic system, that is, transition to the stage of systemic risk.
INVESTMENT AND COMMERCIAL BANKS IN THE U.S.
The idea of separation of the commercial and investment banking emerged in the mid 30s of the XX century and became a logical consequence of the financial crisis, known as the Great Depression. The separation was legally fixed in the Glass-Steagall Act. It pointed the main principle of risk sharing of investment banks and commercial banks, which worked with the public, and therefore their stability was very much a cornerstone of the stability of the financial system and economy as a whole. So the Glass-Steagall Act was passed in 1933 to divide the activities of investment and commercial banks. The act was a response to the speculative operations of commercial banks in the securities market, which served as a factor in default on U.S. exchanges in 1929. Consequence of the law is the emergence of specialized banks. In turn, the law has caused great dissatisfaction in a professional environment, and even banks stood for the abolition of the law, arguing that diversification reduces risk.
For many years the main source of income of investment banks was the brokerage: up to May 1975 there was a fixed fee, charged by banks to their customers. This fixed fee has allowed investment banks to successfully overcome the crisis in 1973 caused by the oil shock. Cancellation of the fixed brokerage commissions led to a decrease in the profitability of the brokerage activities of investment banks. In turn, it required compensation from the new sources of income, often more risky. Investment banks began to administer their own and borrowed capital.
For example, investment bank Salomon Brothers created the first department of trade in securities for own account (proprietary trading). In pursuit for super profits bank took greater risks. Certainly, among the various departments of investment banks soon appeared the so-called “Chinese walls” intended to ensure that confidential information about the status of companies, trades and upcoming releases would not be subject to those departments that are engaged in commerce and analytics.
Only in 1999 the Glass-Steagall Act was finally cancelled and replaced by the law Grammy-Leach-Bliley, which allowed the consolidation of commercial and investment banks, and preserved a number of restrictions aimed at preventing conflicts of interest. One of the first advantage of this law took Citibank, which merged with Travelers Group insurance company and formed a banking group that provides a full range of financial services including corporate and underwriting services under brands of Smith-Barney, Shearson, Primerica and Travelers Insurance Corporation.
However, over the last decade the investment banks began to experience serious difficulties. Increased competition in the sphere of investment activity resulted in a significant reduction in the relative profitability. Thus, the combination of the world’s largest banks, investment and commercial banks is becoming the leading trend in the global banking practice. In turn, this can be considered as part of a wider process of the formation of diversified financial and banking group with an expanded set of functions.
Financial innovations have made banks highly dependent on the development of stock markets. The policy of low interest, rates pursued by the Fed after the 2001 crisis, led to inflate the bubble of liquidity in capital markets and laid the foundation of the American mortgage crisis, which marked the beginning of the world financial crisis.
September 2008 was, probably, the most dramatic month in the history of modern finance. The banks that survived the crises of the nineteenth and twentieth centuries collapsed overnight. Thus, only in September 2008 became bankrupts such banks as Silver State Bank, Lehman Brothers, Merrill Lynch, AIG, Ameribank, HBOS, Washington Mutual, Bradford & Bingley. (Williams, 2010)
All of the above can be summarized according to the director of the International Monetary Fund Dominique Strauss-Kahn, who said: “The American model of independent investment bank collapsed. Henceforth, the investment component will exist in the universal banks. U.S. investment banks, including the most famous, were actively involved in speculative operations with dubious assets, and as a result have suffered enormous losses”. (Williams, 2010)
The crisis affected companies both in the financial and real sectors, but investment banking business suffered more, since many investment banks were unable to survive under new conditions, or were forced to seek for strategic partners. Among the investment banks managed to survive only those which had their own financial capital and the ability to use it.
Today, investment banks try to rebuild their business. The main thing is that they understand how important it is to have their own deposits, realized that relying solely on the investment banking market is very dangerous. Many banks applied for a banking license, first of all because deposits are more stable funding, respectively, the risks are much lower. Another advantage has the bank if it is universal and is engaged in corporate lending, because of more stable relationship between the company and the bank in this case, and the bank can offer a full range of services that the company may be required at any stage of its life cycle.
Nevertheless, it is still necessary to emphasize that today problems occur at all the financial institutions, and incorporation investment banking into the structures of a universal bank is not a panacea. The crisis has shown that problems have not only investment banks, but also commercial banks with significant retail business, such as: RBS, HSBC, etc. Almost all the banks faced with the problem of insolvency on the part of corporate borrowers, which business has suffered from the economic downturn.
Thus, all financial institutions came out of that crisis with different losses, that is why it is impossible to expect rapid growth, fast recovery of trading activity and risk operations of banks.
It is obvious that that crisis in many ways was unique compared to previous financial shocks. First of all because it can be regarded as the first crisis of the global economy and global financial system. Second, because of huge complex of anti-crisis measures taken by governments of developed and developing countries to overcome the effects of negative trends in the financial and real sector.
We can formulate few lessons of the crisis and recommendations:
1) The financial crisis, which is usually a consequence of the economic crisis, can be its primary cause. Therefore, to maintain sustainable development of the economy (or prevent its decline) it is important to ensure a stable and effective functioning of the banking system and financial markets, providing them with liquidity and security of the performance of their functions.
2) The systemic banking crises, as well as problems of individual banks (especially systemically important), must be prepared to in advance, giving the supervisor and other members of the system necessary powers to maintain financial stability, provide tools and sufficient resources, including mechanisms for early identification of problematic banks (the so-called early warning systems), the immediate supervisory action (such as prompt corrective actions), etc. (Rosemberg, 2008)
3) It is necessary to create a complex system of regulation and supervision, ensuring timely identification and adequate response to systemic risks and threats that arise due to the emergence of financial innovation, dissemination of new financial products, changes in business processes and practices of financial institutions. As example can be named the Council for Supervision of financial stability in the U.S., the European Council on systemic risks, the Council on financial regulation and systemic risk in France.
4) Large systemically important banks and financial groups require a special regime of prudential regulation and supervision. In this case no financial institution should be considered “too big to fail”. Lack of effective consolidated supervision can increase systemic risk, endangering the stability of the financial system as a whole. (Zhou 2010)
Systemically important institutions (such as banks) are the largest credit institutions of the country, which stability of the financial condition has an impact on the banking system as a whole. These institutions often claim to receive state support in the crisis years, or at times of lack of liquidity in the market. The main criteria for evaluation of systemically important banks may be the size of a credit institution and the volume of funds, including private contributions. (Zhou 2010)
The need for special attention to systemically important financial institutions is evidenced by the work of the Council of Financial Stability, published in November 2010 – a recommendations to strengthen oversight of such institutions.
Thus, the crisis has put a question of the effectiveness of the banking system, especially of the activities of investment and commercial banks.
