Systemic Risk in the Financial Sector

1. MPI Collective Goods Martin Hellwig Systemic Risk in the Financial Sector Lessons from the Crisis

2. How does risk management work? • Research 1992/3: Why are banks so exposed to interest rate risk? (EER 1994) • „Interest rate risk“? That is a market risk! Irrelevant for assets in the bank book! • „But we are not so exposed! We use asset and liability management for maturity matching! … well, almost.“ • … using the money markets! • (Result 1994: Liquidity provision should not be combined with assumption of interest rate risk!)

3. Does risk management work? • Example 1: Three banks, A,B,C. Each bank has 1 bn. EUR deposits and 1 bn. EUR 40-year fixed-rate mortgages. In addition, bank A has made a short-term loan X to bank B, bank B a short-term loan X to bank C, bank C a short-term loan X to bank A. • If X is large, each bank is almost perfectly maturity-matched. • The system as a whole…

4. Does risk management work? • Example 2 (Swiss Journal 1995): 480 institutions 1,2,3,… • Institution i borrows at maturity i-1 months and lends at maturity i months. • Maturity mismatch at any institution: 1 month. • System maturity mismatch: 40 years.

5. Does risk management work? • Where is the system risk? • Role of correlations of counterparty credit risks and underlying • Typically neglected in risk assessments • Can market discipline correct the problem? How would the information become available?

6. Are the examples surreal? • Repo borrowing and lending as mechanism for blowing up short positions • Transactions chain: • Investor – money market fund – structured investment vehicle (sponsored by a bank) – special purpose vehicle 1 (creation of MBS CDO) – special purpose vehicle 2 (creation of MBS) – mortgage bank – mortgage borrower – real estate • Delusions about maturity transformation • Delusions about liquidity risks – due to neglect of systems effects

7. Summary Assessment of Crisis • The extent of the crisis was due to flaws in system architecture • The prevailing system of regulation is contributing to these flaws and needs to be substantially reformed. • Risk weighting in capital regulation is a major problem, enhancing procyclicality, lack of capital, interconnectivity and distortions in capital allocation

8. Puzzles • Market value losses on subprime were too large to be explained by expected losses on the debt service of mortgages. • Market value losses on subprime were too small to explain the tsunami that has brought down a global financial system with more than 80.000 bn. $ in bank assets.

9. Solution • The crisis has not one cause, but several: • Subprime mortgage crisis as an initial shock (sovereign debt crisis as a new “intial” shock) • Fragility of financing structures as initial magnifier: excessive maturity transformation, liquidity transformation and leverage • Self-enforcing downward dynamics based on the interplay of asset price declines, fair-value accounting, inadequacy of bank capital, deleveraging, asset price declines….

10. Fragility of Banks and the Crisis • Examples: • Sächsische Landesbank: Commitments to Conduits and SIVs amounting to more than 40 bn. EUR; conduits holding ABS and ABS CDOs with maturities in excess of 5 years, refinanced by commercial paper. Own equity less than 4 bn. EUR. • UBS Investment Bank holds Super Senior Tranches of MBS CDOs in its own portfolio, hedging credit risk through CDS with monoline insurers, without capital backing. UBS has equity of 40 bn. CHF on a balance sheet of 1600 bn. CHF

11. Shadow banks • Many banks, US investment banks, but also state-owned German banks, financed investments in MBS through conduits and SIVs • No equity, refinancing through commercial paper • Supported by liquidity assistance guarantees of sponsoring banks • Not on the books of the sponsors • Far in excess of anything permitted under large-exposure regulation. • Yield Panic – Gambling for survival!

12. Twin shocks of August 2007 • Downgrades of ratings of MBS etc. by several grades at once • Price Declines, market breakdowns • Breakdown of refinancing of SIVs • Liquidity assistance guarantees called in, generate equity scarcity, in some cases even solvency problems • Estimated volume: 1 trillion US $ • For comparison: Volume of securitized subprime mortgages 1.1 tr. US $, volume of securitized mortgages altogether: 5.6 tr. US $

13. System Reaction: Implosion • Price declines needed to adjust to shocks, • Particularly pronounced in malfunctioning markets • Go immediately into the banks’ books under fair-value accounting for market risks • Force banks to recapitalize (UBS= United Bank of Singapore) • … or to deleverage… • Putting further pressure on markets and asset prices.

14. Insuffiency of Bank Equity I • Buffers in excess of required capital practically nonexistent • Write-downs under fair-value accounting lead directly to an insufficiency of regulatory capital. • Corrective actions: - Recapitalization (limited in scope) - Deleveraging (enormous multipliers)

15. Insufficiency of Bank Equity II • Under the 1996 Amendment to Basel I (as well as Basel II), required capital had also been much reduced • „10 % core capital“ really means 2 % equity share in the balance sheet • Write-downs raise questions about bank solvency • Market Mistrust, Lack of Refinancing, Breakdowns of interbank markets • Repo runs on Bear Stearns, Lehman Brothers

16. Systemic impact of Lehmans • Domino effects on money market funds (Reserve Primary) • Run on money market funds (stopped by government provision of „insurance“) • Defensive retrenchment of money market funds from banks – threatens breakdown of other investment banks, European banks • Defensive retrenchment of banks induces price implosion • Domino effects on AIG, necessitate bailout

17. Misbehaviour 1 • Investors’ yield hunger • Excessive maturity transformation • Investment bankers focussing on growth, market share, yield, without properconcerns for risk • Improper risk modelling: Lack of understanding of nonstationarities, correlations • … in particular between credit risks and underlying factors • Lack of understanding that there are risks not captured in the models • Improper risk control

18. Misbehaviour 2 • Regulators tolerating loopholes in regulation and reporting, not using the second pillar to ban unprofessional behaviour • Politicians creating a legal framework and an atmosphere where regulators worried of being accused of putting sand into the wheels of the politicians’ champions • Politicians see banks as a source for funds … and rely on the central banks to deal with stability problems

19. Flaws in System Design 1 • Lack of accountability and liability in mortgage origination and securitization • Creation of further rounds of securitization … motivated by regulatory arbitrage • Intransparency of conduits, SIVs, and hedge funds due to a lack of regulation • Biases in internal governance and market discipline of private banks – Focus on RoE • Failure of governance in public banks

20. Flaws in System Design 2 • Capital regulation enabled an insufficiency of bank capital: • No “free” capital: Deleveraging induced by losses • Very little regulatory capital under the model-based approach: 10 % core capital means 2 – 3 % of unweighted assets • Procyclic effects of Deleveraging … large when capital is only 2 % of the balance sheet • Deleveraging has large systemic feedbacks in markets in which there are no buyers

21. Flaws in System Design 3 • Lack of conceptual understanding of the effects regulation • The notion that if one takes care of solvency of an individual bank, one has taken care of the system is flawed • No consideration of dynamics of implementation • … deleveraging by selling assets at prices below expected present values of returns can harm solvency • … deleveraging can also harm solvency by putting pressure on asset prices and thereby on other banks, with possible repercussions on the first bank

22. Systemic Concerns Today Sovereign Debt Crisis • Where are we today? • Lack of capital (too little recapitalization 2009) • … deleveraging as a way to avoid recapitalization demands • … procyclical dynamics • Solvency problems?

23. Macroprudential elements in regulation • Proposals to add a macroprudential element to capital regulation are important, but must avoid being mechanical • As yet there is no theoretical or empirical analysis of what the effects of the regulation are or will be. • Such an analysis requires concepts of general-equilibrium theory (not just risk management methods!) in order to encompass changes in markets.

24. Systemic Risk and Macro Risk: Are they the same? • Systemic Risk: • Risk to the system due to common exposure? • Risk to the economy from the system? • Risk to the system from systemic interdependence? • Systemic Interdependence: • Information contagion • Dominos through contracts • Dominos through fire sale effects on asset prices • Loss of market making functions

25. Risks are not „measurable“ • Model Based „Economizing on equity capital“ has been a reason why solvency became an issue so quickly. 10 % “Core Capital” or 1 – 3 % of the balance sheet – which number is more meaningful? • … in the crisis, we have seen the realization of risks that had not been accounted for in the models!

26. Risks are not measurable 2 • … Correlations of MBS due to a common dependence on the same underlying factors (Interest Rates, Real Estate Prices) • … Correlations between counterparty credit risks and underlying risks in hedge contracts • … system risk exposure due to excessive maturity transformation and leveraging at investment banks, conduits, etc.

27. Risks are not measurable 3 • These deficits are fundamental: • Time series are nonstationary, some of them much too short to provide a reliable basis for statistical analysis (contrast the papers of the Basel Committee on Backtesting!) • Credit risks are endogenous • … and change over time • Correlations of underlying and counterparty credit risk can hardly be measured • Incentives for better models are missing

28. Risks are not measurable 4 • These concerns apply equally at the macro level • Lack of information about system risk exposure • Interplay between deleveraging, asset prices and bank balance sheets involves a compley nonlinear system • In the absence of system counterparts, it is not clear that an equilibrium even exists (problem of adjustment at the level of stocks)

29. Towards Regulatory Reform • Eliminate the notion that risk control in the bank and risk control by the regulators are pursing the same objective • Develop a proper conceptual framework for thinking about regulation • Introduce elements of regulation that are independent of whether models are „right“ or not • Reduce or eliminate the crisis (or bubble) enhancing elements of regulation. • Have much higher capital ratios so as to reduce their procyclical impact.

30. Towards Regulatory Reform 2 • Macroprudential Approach: Observe buildups or dissolutions of aggregates of positions across banks in order to get some notion of liquidity/pricing risks • Adapt regulatory requirements to the macroprudential constellation, e.g., raise capital requirements in a boom, lower them in a crisis – do not rely on mechanics, allow for judgment • Can we rely on judgment of supervisors? • What is the role of Pillar 2? • Problem of governance of supervision