Global Systemic Risk: Insuring Against Meltdowns

The internationalization of securities markets, advances in electronic technology, and innovations in financial engineering have made markets more competitive and efficient than ever. But these same factors have heightened the possibility of global market failure through the "contagion effect" among closely linked markets.

The headline grabbing failure of Barings Securities was a wake up call to the perils of the internationalization of capital markets and the potential consequences of derivatives and ill-advised leveraged positions on these markets. Today investors create global market linkages through their positions in cash and derivatives markets around the world as they swap into the currency, interest rate or security of their choice. Most market observers have concluded that while this does not necessarily increase the volatility within markets, it clearly has increased the ability of a failure in one market to spread to others.

What is Systemic Risk? The Classic Failure
The history of finance is replete with examples of financial crisis ranging from the Dutch Tulip Crisis to the Great Depression. Although there is no "typical" crisis, there is a common pattern. Financial crises are usually preceded by a period of easy money that encourages an excessive accumulation of debt by consumers, businesses or governments. Financial asset prices are bid too high, usually through leverage that pushes the ratio of debt to equity to dangerous levels. Just when balance sheets are at their weakest, there is a shock, such as a jolt to the real economy through a disruption in commodity supply or war scare or a tightening of monetary policy. The ensuing recession causes bankruptcies and depresses asset prices.

The steep decline in securities prices can be severe enough to cause the failure of one or more large banks or securities houses. This, in turn, threatens the national payments mechanism of the banking system and can be rapidly transmitted to international markets, ultimately contributing to the breakdown of financial transactions worldwide or what is called "systemic failure."

Modern Cases of Systemic Failure
Although there has been no worldwide systemic failure since the Great Depression, there have been brushes with catastrophe. In the early 1980s, when the developing country debt crisis was full blown, the adverse impact on the balance sheets of international banks raised fears of systemic failure, until banks were able to provision against these losses and writedown the debts. Recent sources of stress have been related to the speed with which money can move in and out of markets. For example, the devaluation in Mexico and investor losses on Tesobonos again raised the possibility of a contagion among emerging markets. Another recent source of stress has been the losses caused by outsized derivatives positions, as exemplified by Barings.

Sources of Systemic Risk
Shocks to the financial system can originate from a variety of sources, but are usually categorized into four types of risk: 1) market, 2) credit or counterparty, 3) operational, and 4) regulatory arbitrage.

Securities market participants are exposed to market risk from a sharp break in overall asset prices. While this usually results from a fall in prices, a sharp run up in securities prices can cause casualties among those who have sold short (i.e. sold a security for future delivery without owning it in the hope of buying it later). The widespread use of derivatives to hedge cash market positions, however, is believed to stabilize these markets. Yet, unsettled cash markets, as in the stock market collapse of 1987, can undermine confidence in the derivatives markets causing a destabilizing cycle of cash sales and a further fall in prices. A first line of defense against sharply falling securities prices are the so-called "circuit breakers" on organized exchanges. Circuit breakers are triggered by falling prices and automatically suspend trading for a short period of time to give markets time to digest new information. A second line of defense is to raise the required margin (i.e. the down payment needed to buy a security on credit). This reduces the amount of leverage in transactions and forces speculators out of the market temporarily. Finally, strong capital adequacy requirements for financial institutions enhances their ability to survive market losses.

Credit or counterparty risk refers to the exposure that market participants have with each other. Given the rapid pace of transactions in cash and derivative markets that span multiple markets, currencies and time zones, the true extent of intra-day exposure among large banks and securities houses is frequently unknown. The safeguards against counterparty risk are the same as for market risk, namely to ensure that counterparts have adequate capital, collateral or guarantees and that assets prices are updated ("marked to market") at least daily, so that additional collateral can be required as needed.

The everpresent risk of human error in a market transaction is captured under the concept of operational and settlement risk. This occurs where management fails to establish and enforce operational procedures that prevent or guard against employee malfeasance or error. The Barings failure occurred, in part, because of operational risks when the same employee was given responsibility for trading as well as oversight and accounting. On the other hand, there is settlement risk due to breakdown in the payment and delivery mechanism for securities. In 1974, the Herstatt Bank failed because it delivered foreign exchange in one time zone but failed to receive "good funds" in a later time zone. This type of "time zone" settlement failure is now known widely as "Herstatt" risk.

Regulatory arbitrage is the tendency for some market participants to seek the most permissive jurisdiction in which to register their businesses or securities. Regulators sometimes participate in this process by competing for securities business by offering minimal oversight as an inducement. Organizations such as the Basle Committee, International Organization of Securities Commissions (IOSCO), and regional bodies such as the Council of Securities Regulators of the Americas (COSRA) are attempting to coordinate regulatory standards and practices across jurisdic-tions worldwide to avoid this evasive behavior.

Attempts to Control Systemic Risk
At the technical level, securities industry associations (Group of 30, International Swaps and Derivatives Association, Futures Industry Association, etc.) and the regulatory authorities have all moved in the direction of controlling and containing risks. The private sector has been working on risk management control systems including "value at risk" (VAR) models that attempt to give management an indication of how much of the firm's capital is at risk given different potential shocks to the portfolio. In addition, the private sector is also examining "enhanced reporting" of bilateral trading positions in the Over-The-Counter market (OTC) to regulators, reviewing capital to risk standards, and guidelines for judging the suitability of counterparties.

In the wake of the Barings failure, regulatory authorities from the leading capital markets met in May 1995 and agreed to the "Windsor Declaration." Through enhanced regulatory cooperation, the authorities sought a means to put a "fire wall" around the failure of a single participant or market. The methods proposed are cooperation in information sharing to identify large exposures in individual markets, segregating customer funds and assets from those of a securities house, and the establishment of default procedures that rapidly stabilize threatened markets. All of these actions demonstrate a concerted effort by the private and public sectors to contain systemic risk and at the same time enjoy the benefits of financial innovation and market integration.

-Jesse Wright, Infrastructure and Financial Markets Division

Last updated: 01/16/07