Good for One, Bad for All: Watching Out for Systemic Risk
The global financial crisis has triggered a wave of regulatory reform to stabilize the banking sector. Most of the policies proposed under the framework of Basel III are concerned with individual bank solvency rather than with the possible spillovers and risk transfer between banks. As a result, systemic risk may be exacerbated.
In their article "Good for One, Bad for All: Determinants of Individual Versus Systemic Risk," published in Journal of Financial Stability, co-authors Germán López-Espinosa of University of Navarra, Antonio Rubia of the University of Alicante, Laura Valderrama of the IMF and IESE Professor Miguel Antón aim to fill the gap between "micro-prudential" policies (to mitigate the risk of individual banks) and "macro-prudential" policies (to mitigate systemic risk) by identifying how they overlap and interact.
Mistakes of Basel III
Following the global financial crisis, the Basel Committee on Banking Supervision (BCBS) introduced new regulatory initiatives, known as Basel III, that seek to enhance individual banks' resilience by strengthening their capital buffer and their capacity to absorb liquidity shocks.
The BCBS adopted supplementary measures in December 2011 to address systemic risk, including the proposal of a methodology to identify "Global Systemically Important Banks" and the calibration of the additional loss-absorbency capacity they should have.
The methodology is based on five categories that measure size, interconnectedness, substitutability, cross-border activity, and complexity of the bank. The same relative importance is given to these factors and they are implicitly treated as if they were independent. That is an oversight and a strong assumption, in the authors' view.
The authors believe that a bank should be regulated as a function of both its joint risk with other banks and its individual risk. Also, the potential conflict between the variables that mitigate each type of risk should be formally addressed.
Taking a step toward filling this gap between "micro-prudential" and "macro-prudential" policies, the authors analyzed a sample of 47 large international banks in major advanced economies from 2001 to 2010. They examined how the main systemic factors outlined by the BCBS contribute to individual risk and the spread of systemic risk in the global banking industry.
The authors identify the determinants of systemic risk focusing on bank-specific variables, such as funding model, trading activities, cross-border exposure and approach to liquidity management.
They find that a bank's contribution to systemic risk can successfully be predicted by firm-specific variables related to the BCBS categories. Two liability-related variables – funding risk (measured by short-term wholesale funding) and the loan-to-deposit ratio – are strong determinants.
Two asset-related variables – business model (measured as trading profits over net revenue) and cross-border exposure (measured as foreign assets over total assets) – seem to be crucial factors in destabilizing the financial system.
Investment banking (for trading profits) or international diversification alone does not seem sufficient to trigger systemic risk; it is their interaction that exacerbates instability.
The article reveals potential trade-offs between the determinants of systemic risk and of individual resilience.
The only factor that emerges as a generator of both systemic and individual risk is the loan-to-deposit ratio. This suggests that a micro-prudential policy based on the loan-to-deposit ratio of constraining banks may complement a macro-prudential approach to financial regulation.
By contrast, a bank's business model and its liquidity management appear to have conflicting effects on individual and systemic risk. Specifically, higher investment banking activity lowers the probability of an individual default, while decentralized liquidity management works the same way. However, both activities appear to build up risk for the system.
The results call for a cautious approach to the design of regulatory standards that aim to increase the resilience of the overall financial system. Macro-prudential regulation should focus not only on scaling up micro-prudential measures but also on enabling the efficient transfer of risk between financial institutions, the authors find.