Nigel Jenkinson: Promoting financial system resilience in modern global
capital markets - some issues
Speech by Mr Nigel Jenkinson, Executive Director, Financial Stability, Bank of England, at the
conference, Law and Economics of Systemic Risk in Finance, University of St. Gallen, St. Gallen,
29 June 2007.
This speech has been prepared with my colleague Mark Manning. I am very grateful to Mark and to Joanna Perkins for her input
on legal risks, and to Ben Norman, Victoria Cleland and Andrew Bailey for their comments.
* * *
The changing nature of risks
Spurred by rapid innovation, we are currently witnessing a period of major structural change in
financial intermediation and the global financial system. Financial market activity is growing at a
tremendous pace. For example, over the past five years, the credit derivatives market has grown
spectacularly from around $1 trillion notional amount outstanding in 2001 to around $20 trillion in 2006
(Chart 1) and the issuance of leveraged loans has increased almost three-fold (Chart 2). The balance
sheets of the major global financial institutions (the so-called large complex financial institutions or
LCFIs) have more than doubled since 2000, fuelled by an increase in trading assets (Chart 3).
Turnover in the UK and US foreign-exchange markets has risen by around 50% in only the last couple
of years. And capital market integration is rising rapidly as barriers to cross border flows have come
down. Taking a longer sweep, over the past 35 years cross border asset holdings having risen more
than six-fold in terms of world GDP (Chart 4).
Financial innovation has delivered considerable benefits. New products have improved the ability to
hedge and share risks and to tailor financial products more precisely to user demand. That has
enabled financial intermediaries and users of financial services to manage financial risks more
effectively, and has lowered the costs of financial intermediation. And innovation and capital market
integration have facilitated the wider dispersal of risks, which may have increased the resilience of the
financial system to weather small to medium-sized shocks.
Innovation has also delivered new challenges and vulnerabilities. Dependence on capital markets and
on sustained market liquidity has increased, as banks and other intermediaries place greater reliance
on their ability to "originate and distribute" loans and other financial products, and to manage their risk
positions dynamically as economic and financial conditions alter. In turn that places additional
pressure on the robustness of financial market infrastructure to handle large changes in trading
volumes and to cope with periods of strain. And the greater integration of capital markets means that if
a major problem does arise it is more likely to spread quickly across borders. So as highlighted by a
number of academics and authorities,1 the flip side to increased resilience of the financial system to
small and medium-sized shocks may be a greater vulnerability to less frequent but potentially larger
financial crises.
Benign economic and financial conditions in recent years have kept credit losses at low levels.
Combined with buoyant returns from capital market activity, the profitability of major financial
institutions has been strong. And capital levels are high. But as highlighted in Financial Stability
Reports by the Bank of England and others, this benign environment has encouraged an increase in
risk-taking and a "search for yield" which has lowered the compensation for bearing credit risk and
market risk to very low levels. The vulnerability of the system as a whole to an abrupt change in
conditions has consequently increased.
Against this background, I would like to focus my comments today on some of the implications for the
management and reduction of risks to the financial system as a whole. More specifically, how can the
public policy goal of promoting systemic financial stability be best achieved? I will not provide a fully
comprehensive answer to this question but will touch briefly on four aspects; improving the
assessment of vulnerabilities that might threaten stability; developing appropriate buffers for capital
and liquidity within the financial system that take due account of the changing nature of risks;
strengthening the core market infrastructure; and lowering legal uncertainty.
Systemic stress-testing
As financial markets evolve and new vulnerabilities are exposed, it becomes increasingly important
that both market participants and the public authorities improve their understanding and assessment of
threats to financial stability, and take steps, where appropriate, to contain and lower them.
The Bank of England has been active in the development of models to identify and assess potential
sources of major vulnerability to the UK financial system2 and is, with the Financial Services Authority,
engaged in a dialogue with practitioners, both to understand better current approaches to measuring
risks under stressed conditions and to encourage improvements and the sharing of best practice in
stress testing techniques.
Recent distress in the US sub-prime lending market, and the collapse of the hedge fund, Amaranth,
have exposed weaknesses in risk management, including in the management of contingent, or
offbalance sheet, exposures. Although developments in the sub-prime market of course continue to
unfold, the impact on conditions in broader financial markets has to date been relatively contained.
But, in a more severe stress scenario, perhaps in a more significant market such as corporate credit,
or one in which several areas of vulnerability were exposed in combination, the impact could have
more serious consequences for the financial system.
This highlights the potential value of a more rigorous assessment of tail-end risks. In particular,
stresstests by financial institutions should attempt to incorporate the behavioural responses of other firms
which may have a substantial impact on market conditions. For instance, scenarios should take
account of the extent to which many firms might respond to a common shock in a similar way, with
potential implications for market prices or market liquidity. The likely amplification of price moves as
financial institutions attempt to exit "crowded" trades and liquidity dries up is an important example.
Indeed, given the importance of market liquidity for the efficient execution of banks' dynamic hedging
strategies and for their activities in the wholesale funding and credit risk transfer (CRT) and
securitisation markets, it is essential that stress tests factor in extreme, yet plausible, scenarios for
liquidity conditions in these markets, recognising that market liquidity can evaporate very quickly,
particularly for complex structured financial instruments. And it is also essential to factor in increased
liquidity needs linked to contingent calls, associated, for instance, with funding margin payments.
Capital and liquidity buffers
A sizeable buffer of capital and liquidity can help a bank to withstand a shock that threatens its
solvency or would otherwise leave it with insufficient liquidity to meet its obligations as they fall due.
But a bank's private choice as to the size of its capital or liquidity buffer may not be aligned with the
socially optimal choice, as firms will not naturally take account of (or "internalise") the implications of
their distress or failure on the financial system more broadly - for example through the possibility of
contagion to other firms and impairment of the financial intermediation system. That provides the
justification for prudential regulation.
I will not dwell here on the value and importance of capital adequacy standards in containing systemic
risks - enough has been written on the Basel Accord and Basel II, such that this is well understood.
However, consistent with my earlier comments on stress-testing and the importance of modelling
behavioural responses, it is crucial the authorities understand banks' likely responses to changes in
minimum capital requirements over the business cycle. In this regard, the Bank and the Financial
Services Authority (FSA) have recently developed a framework for monitoring the potential for
procyclicality in credit conditions. The Basel Committee on Banking Supervision and the Committee of
European Banking Supervisors are working on similar frameworks internationally.
Capital adequacy standards are usefully complemented by "large exposures" rules. In particular, the
application of such rules recognises the importance of addressing the risks from an unforeseen event
that could cause a bank to incur serious loss, and that major problems could spill over from one bank
to another given the network of interconnections. A European Union-wide review of the Large
Exposures Directive is underway, offering the opportunity to improve the resilience of the financial
system to such spill overs, including in the inter-bank market.
Rather less has been written about liquidity buffers and prudential liquidity standards. Given their
balance-sheet structure, funding liquidity is a key risk for banks: the transformation of short-term
liabilities into long-term assets leaves them structurally vulnerable to liquidity pressures. Banks
therefore need to position themselves so as to be able to withstand extraordinary demands on their
liquidity. If capital markets work efficiently, a solvent bank in need of liquidity should, in principle,
always be able to rely on the market to obtain funds. However, in practice, the interbank market may
not always work perfectly; asymmetric information and coordination failures are among the most
severe potential frictions. Banks may, therefore, find themselves unable to access normal sources of
funding liquidity. The measures to which a bank in this situation would have to resort, such as large
scale asset sales, could have major adverse spill over effects through the system, as could the most
extreme case of an outright failure to meet obligations as they fall due. Liquidity buffers may help in
this regard: a bank holding a buffer of assets that is reliably liquid under conditions of stress, perhaps
with a core component that is eligible as collateral at the central bank, should always be able to
access liquidity in a way that avoids precipitating severe market disruption.
The trends described at the outset are also important here. First, a shift to greater reliance on
wholesale funding and greater involvement in capital market activity more broadly perhaps makes
banks more exposed to funding liquidity pressures than in the past: they are at the mercy of nimble
wholesale lenders. And with internationally active banks managing multi-currency balance sheets, a
local approach to liquidity regulation is becoming less relevant. It is for this reason that the Basel
Committee for Banking Supervision decided to convene a Liquidity Working Group to take stock of
prudential approaches internationally and to explore whether there is a case for greater consistency.
The critical role of infrastructure
The financial market infrastructure - exchanges and the systems used to clear and settle market
trades or cash obligations - also plays a critical role here. Market participants rely on such
infrastructure to implement their desired portfolio allocation; to execute risk management strategies; to
raise liquidity, both in normal course and in times of stress; and to manage contingent exposures and
cash-flows. It is therefore important for financial stability that these systems function efficiently and
continuously, and do not introduce unnecessary costs, risks or frictions to trading and post-trade
processes. Frequent interruptions to pre- or post-trade processing, or excessive costs in accessing
core components of the market infrastructure, can impose significant welfare costs. Under such
circumstances, agents may be forced to deviate from their desired portfolio allocations and risk
exposures, or indeed may be prevented from meeting their obligations as they fall due. With markets
for credit risk transfer (CRT) growing rapidly, there has been an expansion in the range of transactions
for which robust, resilient and well-designed infrastructure is essential.
Market failures in infrastructure provision and single points of failure
It is instructive to consider why providers of the market infrastructure and their members might, left to
their own devices, invest too little in resilience and risk-mitigation. The answer lies in the
microeconomics of infrastructure provision, and, in particular, the presence of market characteristics
such as network externalities, increasing returns to scale and coordination failures.
network
By externality, I refer to the incremental benefit derived by existing owners of a particular good
or service when another party purchases that good or service. For instance, the broader the
participation in a particular exchange or trading facility, the more extensive the trading opportunities
and the deeper the liquidity; as a result, the greater the potential benefits from membership of that
exchange. Equally, in the case of post-trade infrastructure - clearing and settlement systems - the
greater the volume of transactions cleared or settled, the greater the potential for netting exposures
and/or cash-flows (or in gross payment and settlement systems, the more efficiently liquidity can be
recycled).
Increasing returns to scale reflect the fact that infrastructure provision is, by and large, a fixed-cost
business: once an investment has been made in the information technology supporting the trade,
clearing or settlement of a given volume of transactions, the marginal cost of each transaction up to
the capacity of the system is very low.
But the market characteristics imply a tendency towards natural monopoly in the provision of
infrastructural services and hence dependence on a single, non-substitutable provider: often termed a
"single point of failure". A monopolist provider of infrastructure services may face insufficient incentive
to innovate - including in risk-reduction - and, importantly, may not fully internalise the potential
effects of a disruption to its services on the financial system as a whole, thereby undervaluing system
resilience from a public policy perspective.
But couldn't the users of the infrastructure ensure that the monopoly provider invested more heavily in
risk mitigation? And with many infrastructures being user-owned cooperatives, would there not be a
natural mechanism for this?
Perhaps - and indeed there is evidence of effective risk-mitigation among user-owned providers, for
example the throughput guidelines on payment flows to lower liquidity risk in CHAPS, the UK high
value RTGS payment system, was led by member initiative. But such risk mitigation may still not be
enough to meet social welfare goals fully.
First, the effects of a disruption are likely to be felt beyond what may be a narrow group of direct users
of the infrastructure. That is, the effects may be systemic; for instance, there may be an interruption to
the flow of liquidity via dependent markets or systems, or among participants relying on the system
indirectly, for example through a correspondent banking relationship.
Second, users may place insufficient value on systemic stability because material operational failures
are low-probability events and difficult to anticipate. Their assessment horizon may also be shorter
than the social optimum.
And, crucially, coordination failures may be a factor: users of a particular infrastructure, many of whom
may compete in underlying markets, need to coordinate their actions if they are to influence decisions
on the future strategy of the infrastructure provider. Investment in the reduction of operational risk will
be one such decision. Difficulties in organising effective bargaining among users may leave them
unable to coordinate, particularly in the face of differences in their information, expectations or
preferences. Potential welfare-increasing actions may, therefore, not be carried out.
These market failures may justify intervention by the public authorities: either via a continuous
oversight or regulatory regime; via targeted intervention; or maybe even via public ownership, as is
often the case in respect of large-value payment systems and sometimes with securities settlement
systems. An alternative strategy when faced with a monopoly provider might be to promote (or even
set up) alternative, competing suppliers, to improve market contestability while ensuring adequate
interoperability and substitutability across systems. Of course, given the existence of network
externalities and increasing returns to scale, the cost of this form of risk mitigation may well be higher
than the cost of regulating a natural monopoly on an ongoing basis.
Most typically, public intervention would seek to address the vulnerability stemming from single points
of failure by the imposition of minimum standards of resilience on monopoly (or near-monopoly)
systems, either to reduce the probability of operational failure; or to mitigate the impact of such failure
by improving contingency arrangements - for instance, via increased investment in back-up facilities.
Steps might also be taken to improve general risk management practices and mitigate the risk of exit
of a key infrastructure; financial resilience and business risk is an important consideration here.
A regulator or overseer might also (or alternatively) seek to narrow the gap between the choices of a
monopoly provider and the social optimum by encouraging more effective and inclusive governance
arrangements. User- as opposed to external-ownership might be promoted, though, as previously
noted, this might not be enough. Other measures might include steps to clarify the scope of the
system's activities, admissions criteria, voting rights, transparency, and the role of external
stakeholders.
For instance, in the UK, overall governance of payment systems is carried out via the newly-formed
Payments Council. This body is headed by a governing board comprising a (non-voting) independent
Chair, four independent directors, and eleven directors from the payments sector. The board is
expected to consult with key stakeholders before determining strategy, and before making important
decisions. Transparency is also enhanced via the publication of an annual report, with a separate
contribution by the independent directors, and the publication of board minutes.
Finally, we should not underestimate the importance of users themselves building resilience within
their own operations to single points of failure in infrastructures. For the very same reasons that
monopoly infrastructure providers may tend to under-invest in resilience from a public policy
perspective, even where run as user-owned cooperatives, financial institutions might also need
supervisory encouragement to invest in work-around measures to deal with disruptions at the level of
the core infrastructure.
Other sources of systemic risk
The existence of single points of failure is not the only manifestation of systemic risk in infrastructures,
as the behaviour of agents within the systems can lead to problems spilling over to other participants
given the interconnections and strategic interactions. For example, if a large net provider of liquidity to
a real-time gross settlement payment system were to face severe operational difficulties which left it
unable to make payments, other banks within the system might find themselves short of liquidity, and,
in extremis, some might be unable to meet their own payment obligations. Behavioural responses,
such as payment delays and liquidity-hoarding, might then exacerbate the problem within the payment
system, potentially also spilling over to activity in other systems and financial markets. And, where a
system is integral to the implementation of monetary policy, a disruption could directly affect a central
bank's ability to set overnight rates and maintain confidence in the currency.
Although this variant of systemic risk does not originate directly in infrastructures, system design can,
nonetheless, help mitigate the impact. Features of the design and operation of an infrastructure can
help to lower risks of this type - for example, by introducing collateralisation and loss-sharing rules,
net sender limits and throughput guidelines to promote efficient liquidity recycling - so that failures do
not give rise to financial contagion. Again, left to their own devices, users will lack an incentive to take
into account fully the costs imposed outside of the system and they again face acoordination
challenge in effectively implementing system design or rule changes to reduce such effects.
Infrastructure robustness and the changing nature of risks
Some of the financial market trends identified earlier have placed additional pressure on potential
shortcomings in the financial infrastructure, attracting the interest of the public authorities and, in some
cases, prompting targeted intervention. I would like to discuss two of these: financial market
innovation; and the global linkages and system interdependencies that arise from the emergence of
large cross-border banking groups.
Financial market innovation
Taking the first of these, over-the-counter (OTC) derivatives markets have grown rapidly in recent
years, particularly in the credit sector, driven in part by the shift towards an "originate and distribute"
model of banking finance and by greater recourse to credit risk transfer to manage and hedge risks, as
well as increasing activity by insurance companies, hedge funds and institutional investors in this
sector. The infrastructure for OTC derivatives has, however, lagged behind.
Notwithstanding the emergence of new automated vendor services in recent years, OTC derivatives
trades continue to be cleared and settled on a predominantly bilateral basis. Hence, a party to such a
transaction is dependent upon the ongoing creditworthiness, liquidity and operational robustness of its
counterparty over the life of the contract. A sound legal basis for the trade is, of course, also critical.
Rising volumes (and values) and the development of new, and often more complex, products have
placed a strain on existing arrangements, exposing capacity constraints in existing procedures.
Questions have also been raised over the risk implications of deficiencies in post-trade processes,
most notably in the assignment of credit derivatives contracts.
Progress towards addressing these deficiencies was initially relatively slow, held back by coordination
failures in the dealer community, until the regulatory community took an interest in 2005. The issue
was noted in the Bank of England Financial Stability Review and the UK's Financial Services Authority
helped to bring the issue to public attention. The Federal Reserve Bank of New York (FRBNY) later
convened a group of 14 dealers and their regulators, encouraging them to set targets for the reduction
of processing backlogs in credit derivatives and to put in place mechanisms for speedier post-trade
processing going forward. The dealers were encouraged to embrace existing automated services for
the delivery and matching of confirmations, and the industry was propelled rapidly towards the
adoption of a Protocol for communicating trade assignments. The group was also encouraged to work
with vendors, notably the Depository Trust and Clearing Corporation (DTCC), to implement solutions
providing a framework for ongoing processing efficiency and data integrity. The result was the launch,
in November 2006, of DTCC's Trade Information Warehouse.
In parallel, the Basel Committee on Payment and Settlement Systems has been investigating
developments in the OTC derivatives space more generally, updating work carried out in 1998 to map
the landscape and identify risk issues. The Committee published a report in March 2007.
The report recognises that the clearing and settlement infrastructure has been strengthened
significantly in recent years, noting, in particular, the progress in automating and centralising key
posttrade functions. But the report also highlights that there is more to be done. For instance, while
processing backlogs in credit derivatives have been reduced substantially, they remain sizeable in
other product lines. Recognising that the group convened by the FRBNY has been effective in
resolving co-ordination problems, the report argues that momentum from the credit initiative should be
carried across to other products. An initiative is already under way in this regard, with the FRBNY
group having been expanded to 17 firms and a broader range of products. Firms are working towards
targets for backlog reduction. Automation is a key element of this initiative, although it is recognised
that there needs to be interoperability between core vendor services if the benefits are to be realised.
One implication is that further public intervention might be required should coordination problems
undermine the incentives to deliver such interoperability. And, as the OTC derivatives market becomes
more dependent upon centralised providers of post-trade services, public authorities will need to
consider whether established international standards for operational reliability of infrastructures should
be applied to emerging new systems.
Global linkages and system interdependencies
The rapid growth of capital market integration and of large cross-border banking groups (often termed
large complex financial institutions or LCFIs) and the increased international linkage between
infrastructure providers also has significant implications for the assessment and reduction of systemic
risk arising in or from the financial infrastructure. Specifically in an Anglo-Swiss context, for instance,
we have seen Switzerland's SWX Group establish in London back in 2001 the recognised investment
exchange, virt-x, as a cross-border trading platform, which offers central counterparty (CCP) clearing
with both LCH.Clearnet Ltd and SIS x-clear AG, and settlement through CrestCo Ltd, Euroclear Bank
and SIS SegaInterSettle AG. The Swiss CCP, x-clear, also plans to join LCH.Clearnet Ltd in clearing
the London Stock Exchange.
Infrastructure providers have responded positively to the demands of an increasingly internationally
oriented customer base by offering settlement links - which facilitate cross-border collateral and
liquidity management - and clearing links - which allow margin offset with respect to positions held in
related assets in different centres.
Cross-border mergers between infrastructures are also becoming more common. For example, in
recent years, the UK's central counterparty for derivatives, London Clearing House (LCH) Limited
merged with Clearnet SA, while the Euroclear Group acquired CREST, the securities settlement
system for the UK and Ireland. The Euroclear Group currently provides domestic securities settlement
services in 5 European countries as well as international settlement services. Such tie-ups are of
course an international extension of the microeconomics of infrastructure provision outlined above,
exploiting economies of scale and network externalities. But, at the same time, they introduce common
business risks and cross-border dependence on core systems, thus providing another channel for
problems to spill across borders. Such cross-border linkages consequently add a layer of complexity
to supervisory arrangements, making international coordination among the public authorities essential.
Linkages arising at the user level are again important here. As banks operate in multiple markets,
there is increasing scope for shocks to propagate across borders. That may arise from the increased
centralisation of banks' liquidity risk management. To the extent that banks use the foreign exchange
markets to recycle surplus liquidity in one system to meet a shortfall in another, or else take advantage
of settlement links between securities settlement systems to transfer collateral across borders, liquidity
risk may be reduced. But, to the extent that banks respond to the availability of mechanisms for
reallocating liquidity between systems by reducing their aggregate holdings, a bank may be more
vulnerable to simultaneous liquidity demands across markets or to operational disruption to such
mechanisms.
The Basel Committee for Payment and Settlement Systems has again been looking closely at issues
arising from international integration of banks and infrastructures. In recent years, the Committee has
published a report exploring mechanisms for the cross-border use of collateral, and in the context of a
broader report on central bank oversight of payment and settlement systems, has established a set of
principles for international cooperative oversight. Work is also continuing to map more formally the
nature of international interdependencies between systems, and thus of cross-border risks.
Legal certainty
No matter how safe and resilient the market infrastructure, a sound legal basis for transactions is
essential if the financial markets are to fulfil their role in effectively allocating scarce capital.
Financial markets operate within legal systems that not only regulate the behaviour of participants for
the good of the markets as a whole, but also safeguard the property and contractual rights of those
participants. Prospective market participants will have greater confidence to invest or to seek finance if
they feel confident, first, that the regulatory obligations and sanctions imposed upon them are
predictable and, second, that the contractual rights/obligations which they acquire/undertake can be
identified with certainty.
Furthermore, market discipline is likely to be enhanced if participants' legal/contractual rights and
obligations are precisely defined; the introduction of an ambiguity into the law can unsettle financial
markets or exacerbate existing instabilities. Legal/contractual uncertainty is therefore a potential
source of systemic risk. Two aspects of legal certainty are particularly crucial:
Contractual certainty
One key element of a stable legal framework is contractual certainty. Systems of contract law that
show respect for formal agreements help to drive down commercial risk and therefore to promote the
efficient allocation of capital. And uncertainty as to the enforceability of contracts is likely to be
particularly damaging to financial markets. Against this background, contracts are becoming longer
and more complex as financial innovation continues apace: the documentation for a structured finance
product can often run into several hundred pages, thus raising the important issue of "documentation"
risk.
Legal and regulatory stability
Another key element is legal and regulatory stability. This is very important to the financial markets,
where the ability to form complex plans with a degree of confidence as to the stability over time of
external influences (such as legal rules) impacts directly on risk, price and, ultimately, the efficient
allocation of capital. A stable planning environment is conducive to investment and, therefore, market
growth. Examples of harmful consequences of ambiguities in legal/regulatory frameworks include
uncertainty as to the extent and scope of regulatory obligations or sanctions, and uncertainty as to
how old laws will apply to dynamic and fast-changing market practices.
The Financial Markets Law Committee (FMLC)
In recognition of this, a number of countries have established groups of experts to promote greater
legal certainty in financial markets. In the UK, the Financial Markets Law Committee was established
in 2002. Its objective was to identify issues of legal uncertainty which might give rise to material risks,
and to consider how such issues might best be addressed. The Committee seeks to meet this
objective, first, via liaison with industry and market participants to identify those areas of legal
uncertainty with potentially adverse impacts, and, second, by working with market experts to propose
solutions.
One area in which the FMLC has been active in recent years is in encouraging the development of a
smoothly functioning legal framework for cross-border transfers of intermediated securities. In 2005,
the Committee undertook a thorough analysis of the advantages and disadvantages of harmonisation
of the private international law in this area, as reflected in the Hague Convention. It was, and still is,
widely accepted that such harmonisation would con