Andreas Dombret: Systemic risk analysis and crisis prevention
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, at the high-level Eurosystem seminar with central banks and monetary
agencies of the Gulf Cooperation Council, Abu Dhabi, 19 January 2012.
* * *
1. Systemic risk analysis and the Sybilline books
Dear colleagues,
Referring to the sovereign debt crisis in Europe the Minister of Finance of Poland, Jacek
Rostowski, mentioned that the negotiations remind him of the story of the purchase of the
Sibylline Books in Ancient Rome. Those books contained prophecies which were not an
exact forecast of future events but had to be understood as an aid to finding measures to
prevent and manage a devastating disaster.
The last king of Ancient Rome, the legendary Tarquinius Superbus, was eager to acquire
those nine Sibylline Books. But the price that Sibyl, the prophetess, demanded struck him as
too high, and the king declined to buy them. Either offended or shrewd, Sibyl burned three of
the nine books and offered him the remaining six books for the same price as before. But
Tarquinius again turned down the offer. So the prophetess burned three more books, again
offering the remaining three books for the original price. This time, Tarquinius accepted the
terms, and the books found their way into the Temple of Jupiter.
The books got lost in more recent times. But the questions remain: What advice did the
books would have had for modern policymakers? What kind of systemic analysis is
presented there?
2. First Sybilline book: Reducing complexity
Modern systemic risk analysis consists of many tools. Central banks, supervisory authorities
as well as national and international bodies of macroprudential supervision such as the
European Systemic Risk Board (ESRB) and the Financial Supervision Board (FSB) apply
these tools. Such tools start with the collection and description of a wide set of indicators,
most of them giving concurrent signals with regard to financial stability. In a further step it is
tried to extract those indicators with predictive power, which is rather difficult, conceptually as
well as statistically. Other tools are designed to condense the information into risk
dashboards, colour coded systems or web diagrams to present an overview of the highly
complex picture. More sophisticated methods include stress tests to study the effects of
different scenarios and specified econometric models capturing potentially destabilising
feedback loops and systemic effects.
Clearly, these tools are important and helpful in preventing and managing systemic risks. But
are they sufficient?
This seems questionable given the high level of complexity that has arisen in globally
integrated financial markets. This complexity leads to non-linear dynamics in the system
which are very difficult to handle both for the risk management of financial institutions and for
supervisors.
The complexity is also characterised by a phenomenon known as "Knightian uncertainty",
named after the famous Chicago economist Frank Knight. Knight argued: "There are known
knowns; there are things we know we know. We also know there are known unknowns; that
is to say we know there are some things we do not know. But there are also unknown
unknowns - the ones we don't know we don't know."
Let me illustrate this theory. Prior to the financial crisis a shadow banking system emerged
which found itself at the centre of the crisis a few years later. This shadow banking system
has aspects of "known unknowns" and "unknown unknowns". As a consequence, risks
stemming from this system were broadly ignored or underestimated. International
macroprudential bodies like the ESRB and the FSB are trying to fill this gap with knowledge,
but progress in this area is made at a snail's pace due to the lack of data.
Even if we are successful in the end we cannot be sure we have identified all relevant risks,
because "unknown unknowns" could also exist in another area of the financial system which
we do not observe. In my view, therefore, complexity reduction might be an effective
instrument for preventing systemic crises. I can imagine that advice such as this could have
been found in the lost Sibylline Books.
Again, let us be specific. There are a lot of regulatory target variables which involve the use
of complex risk-adjusting methods. For example, the core capital ratio is the ratio of core
capital to risk-weighted assets. But the models used for adjusting the risk did not perform
perfectly and underestimated the true risks stemming from CDOs.
As a result, financial institutions were undercapitalised when Lehman became insolvent. If, in
addition, we had had a robust target such as a leverage ratio which is not risk-adjusted,
financial institutions would have been better prepared on the eve of Lehman. Moreover,
according to the concept of RWAs, government bonds have zero weights. With a risk-robust
measure institutions would also have been better prepared for sovereign crises. The point is
that such robust targets are independent of risk assessment errors and provide additional
buffers to absorb risks stemming from the "known unknowns" and "unknown unknowns".
Another example of how complexity reduction can help prevent crisis is standardisation of
financial products. In the past, OTC contracts were created with unknown and very
hard-tohandle, non-normal probability distributions of random variables - which means creating
"known unknowns" via terms of contracts with potentially destabilising effects on the financial
system.
3. Second and third Sybilline Book: Communicating risk analysis
The second message we might have found in the Sibylline Books is this: "Be aware that risk
analysis has to be carefully communicated. Sometimes policy backups are necessary."
The example of stress testing immediately leads us to the third message of Sibylline Books.
In a setting in which financial analysis is communicated to the public it is important to find the
balance between making realistic assumptions about scenarios and avoiding devastating
self-fulfilling prophecies of the markets. Moreover, if stress tests detect capital needs private
and public recapitalisation has to be announced and implemented, thereby preventing
market uncertainty. In a systemic crisis recapitalisation has to be a part of a comprehensive
package including public aid for banks. This aid helps to restore confidence in the wholesale
markets, to overcome funding problems and ultimately to mitigate excessive deleveraging
pressure.
4. Fourth and fifth Sybilline Book: Building up institutions and credibility
The fourth message contained in the Sibylline Books could be: "Systemic risk analysis needs
an appropriate institutional set-up". As in Ancient Rome, where the Sibylline Books were
treasured by the priests of the Temple of Jupiter, modern-day risk analysis needs an
institutional framework. The EU has solved this problem by delegating systemic risk analysis
to the ESRB which can issue official warnings and recommendations. Other EU bodies and
the national authorities are responsible for implementing policy measures. Central banks
have an important role to play here given their analysis competence and expertise. But
monetary policy instruments are not in the first instance financial stability policy instruments.
Therefore, the institutional set up is not simply a matter of organisation but essentially a
matter of credibility of the institutions involved.
So the fifth Sibylline message might be this: "The risk analysis credibility of the various
bodies needs to be built up". In practical terms for the ESRB this means finding the right
balance in issuing warnings and recommendations. Too few warnings entail the danger of
missing systemic risks. Conversely, too many warnings could be missed by the addressees.
5. Sixth and seventh Sybilline Book: Taking into account the global economy
The sixth message of the Sibylline Books might read as follows: "Be aware of relevant
developments outside your own region."
Financial stability is a systemic and a global phenomenon. And as is well known global
imbalances play an important role. The savings glut is seeking safe and high yield assets.
And global players can help to solve the current crisis in Europe.
Sometimes, international investors ask me, "Why should we buy bonds from sovereigns in
crisis if their European partners are unwilling to do so to a larger extent?" My answer is
"Look, the European partners have to be aware of moral hazard implications, because they
are players in the European political game," the game, which is reminding us of the story of
the purchase of the Sybilline books. Investors outside Europe need not take into account
moral hazard implications. They can and should buy such bonds because they have
confidence in the long-term sustainability of the fiscal position of the countries in question,
and because they are interested in portfolio diversification.
Progress in the various countries can be seen in Ireland, for example, but also in Italy, where
the new government is going to implement fiscal measures. They can build on what is
essentially a sound economy. Therefore, my seventh and last message is this: "European
sovereigns deserve more confidence than markets are currently willing to give them."
These are seven of the possible messages of the lost or burned Sibylline Books. The
remaining messages may be "known unknowns" or "unknows unknowns".
Thank you.