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On Bank Systemic Risk, International Integration and Capital Requirement | Turner Discussion Paper

There has been much talk of systemic risk since the financial crisis hit. I see it more as a crisis of banking and banking confidence, and the debate on systemic risk is critical because it exists because of Government intervention and protections, implicit and explicit. The latest from Lord Turner of the FSA is a discussion paper, that reviews systemic risk and provides as good a discussion on that topic as I have seen.

What it particularly interesting is how the insights raise the prospect of penalising globally integrated banks over nationally independent organizations with higher capital requirements. Things just got more complex for decisions on integration.

DP09/4: Turner Review Conference Discussion Paper | FSA

3.18 In general terms, a firm is systemic when its collapse would impair the provision of credit and financial services to the market with significant negative consequences for the real economy. The factors which make firms systemically important fall into three categories (although firms may combine elements of these factors):

  1. systemic by size. This can be a function of the firm’s absolute size or in relation to a specific financial market or product in which a firm is particularly dominant. The channels through which systemic risks would crystallise as a result of the failure of such a firm include: losses to uninsured creditors and depositors through high bankruptcy costs and reduced recoveries; disruption to financial services (such as to payments, clearing and settlement, extension of credit); and losses to insured depositors because the DGS could not pay out sufficiently quickly or because the aggregate payout imposes unsustainable costs on those who fund the DGS. In addition and crucially, systemic risks can take a macroeconomic form, with the loss of credit extension capacity leading to, or exacerbating, a downturn in economic activity which then has consequences for the rest of the financial system.
  2. systemic by inter-connectedness. Links and inter-connections can include, inter alia, inter-bank lending, cross holdings of bank capital instruments, membership of payment systems, and being a significant counterparty in a crucial market. The channels through which such problems manifest themselves include:
  • interbank exposures. The domino effect where the collapse of one firm leads to
    major losses at others, and then in turn leads to their collapse. This can then
    trigger a chain reaction;
  • the confidence channel. The collapse of a systemically important firm leads to a
    crisis of confidence in financial markets. The confidence channel is particularly
    important to the ‘systemic as a herd’ category (see below), given the perceptions
    by the market that a number of firms are exposed to the same set of risks;
  • the asset margin spiral channel. Firms increasingly finance themselves through repo
    and reverse repo arrangements. The haircuts charged on the collateral underlying
    these contracts dictate the extent to which firms can leverage themselves. In a crisis,
    both funding conditions and credit concerns will lead counterparties to increase
    haircuts, triggering a deleveraging process. This will in turn be disruptive, through a
    self-reinforcing spiral between lower market liquidity and funding liquidity.
  1. systemic as a herd. The market can perceive a group of firms as part of a common group (for example, because they have a similar business model, such as building societies in the UK and the savings and loans banks in the US), or common exposures to the same sector or type of instrument. A single firm in this group may not be systemic in its own right, but the group as a whole may be.

turner discussion paper oct 09 dp09_04.pdf

Written by Colin Henderson

November 2, 2009 at 20:15

Posted in regulation, UK

Tagged with , ,

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