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6. Systemic Risk and Contagion

I. Systemic Risk: A Definition

„Systemic risk“ is any risk that affects the banking system (or the financial system) as a whole.

A „systemic crisis“ may occur due to • a common shock that affects all or large parts of the

system, • contagion, or • a combination of the two.

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An Example of a Common Shock: The Regional Bank Crisis in Switzerland

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80

90

100

110

Number of Banks

House Price Index

1989 = 100

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• The microprudential dimension of financial stability might not coincide with the macroprudential dimension of financial stability

• Actions that ensure the soundness of one institution may not be consistent with ensuring the soundness of another

• The microprudential dimension of financial stability might not coincide with the macroprudential dimension of financial stability

• Actions that ensure the soundness of one institution may not be consistent with ensuring the soundness of another

Individual Risk vs. Systemic Risk

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Assets Liabilities Assets Liabilities

Claim

Obligation

Bank 1 (borrower)

Bank 2 (lender)

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Assets Liabilities

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Financial Regulation

• Purpose of financial regulation: Ensure the stability of the finance system as a whole

• In a system context, actions taken by financial institutions have spillover effects

• System stability is like a public good that is undersupplied by the market

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Mitigation of systemic risks • If policymakers could engineer the initial conditions

through appropriate regulation, so that the fundamentals of a bank were stronger and the creditors less jittery, they could induce the stable, non-run outcome, instead of the run outcome

• Example: liquidity requirements on banks may reduce the potential for runs through two channels: they make debtor banks more robust to withdrawals, and they make creditor banks less jittery.

• Any institutional feature that constrains creditors in the direction of curtailing lending in reaction to events will undermine system stability.

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Riskiness of an asset and its systemic importance

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Assets Liabilities Assets Liabilities

MBS Repos

Assets Liabilities

Reverse

Repos

Repos

Repos Repos

• There is an important distinction between the fundamental riskiness of an asset and its systemic importance

• Even if an asset is very safe from the point of its credit Risk profile, it may have a large impact on the stability of the system as a whole.

• Example…

Reverse Repos

Reverse Repos

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Systemic risks in practice

• “The fate of Bear Stearns was the result of a lack of confidence, not a lack of capital. When the tumult began last week, and at all times until its agreement to be acquired by JP Morgan Chase during the weekend, the firm had a capital cushion well above what is required to meet supervisory standards calculated using the Basel II standard. Specifically, even at the time of its sale on Sunday, Bear Stearns’ capital, and its broker-dealers’ capital, exceeded supervisory standards. Counterparty withdrawals and credit denials, resulting in a loss of liquidity - not inadequate capital - caused Bears’ demise.” (Letter by Christopher Cox to chairman of the Basel Committee on Banking Supervision)

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• Example: Bear Stearns

- Role of triparty repos that Bear Stearns entered with money market mutual funds

- Bear Stearns pledged illiquid securities as collateral, in return for which the money market funds provided Bear Stearns short-term funding. The transaction was overseen by a central counterparty that held the collateral and administered the payments

- Problem: Most money markets funds are prevented from holding illiquid securities under their charter

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- Thus: if Bear Stearns had become illiquid, and the assets pledged as collateral reverted to the money market funds, they would have been forced to sell those assets quickly, possibly at a large loss

- This could have led to the result that their assets might have fallen below per value

- The Fed was concerned that such losses could lead to a rund by retail investors on the entire mutual fund sector, by changing their perception of the funds safety

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Policy Implications of Systemic Risk

• Regulation and supervision which only focuses on individual institutions may not be able to prevent systemic crises. – Stable banks ≠ stable system – Role for “macroprudential” policy

• A level of regulation that is appropriate from a systemic

perspective may seem excessive from the perspective of individual institutions.

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II. Contagion

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Contagion Through Direct Exposures

Source: Jeannette Müller (JFSR 2006): „Interbank Credit Lines as a Channel of Contagion “

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The Dominance of UBS and Credit Suisse in the Swiss Banking Sector

Source: Jeannette Müller (JFSR 2006): „Interbank Credit Lines as a Channel of Contagion “ 14 Chapter 6

Information-Based Contagion

• Problems at one bank may signal potential problems at other, similar banks.

• Such an interpretation of signals may be either – correct (efficient bank runs), or – incorrect (inefficient self-fulfilling prophecies).

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Contagion Through Asset Prices

• Banks in distress may be forced to sell assets to meet liquidity or solvency requirements. These “fire sales” depress asset prices, which in turn may put otherwise stable banks under pressure.

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An Example of a Systemic Crisis: The Subprime Crisis

• Fire sales („deleveraging“) depressed asset prices. – Market liquidity dried up and problems spread to other

banks and asset classes.

• Intransparent products and highly leveraged balance sheets reduced trust between banks. – Interbank liquidity evaporated.

• Large financial institutions were rescued for fear of

causing contagion. – High risks and costs for taxpayers.

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Subprime Crisis: The Initial Shock Price Indices of US Subprime MBS (ABX-HE 06-2)

Source: Markit.

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100

01.01.07

22.01.07

12.02.07

05.03.07

26.03.07

16.04.07

07.05.07

28.05.07

18.06.07

09.07.07

30.07.07

20.08.07

10.09.07

01.10.07

22.10.07

12.11.07

03.12.07

24.12.07

14.01.08

04.02.08

25.02.08

17.03.08

07.04.08

28.04.08

AAA AA BBB

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Subprime Crisis: Tensions in Interbank Market

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Subprime Crisis: Fall in Liquidity Liquidity Index

Source: Bank of England.

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

2003 2004 2005 2006 2007 2008

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Subprime Crisis: Spillovers Risk Premia (US Corporate Investment Grade)

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50

100

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1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

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Where Do We Stand Now?

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Where Do We Stand Now? (2)

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Where Do We Stand Now? (3)

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Where Do We Stand Now? (4)

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Where Do We Stand Now? (5)

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Where Do We Stand Now? (6)

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Where Do We Stand Now? (7)

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Recommended Readings

• Olivier de Bandt and Philipp Hartmann (2000): “Systemic Risk: A Survey”, Working Paper No. 35, European Central Bank.

• James Dow (2000): “What Is Systemic Risk? Moral Hazard, Initial Shocks, and Propagation”, Monetary and Economic Studies.

• Stephen Morris and Hyun Song Shin (2008): “Financial Regulation in a System Context”, Brookings Papers on Economic Activity.

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