Manuel Sánchez: Systemic risk - policy challenges
Remarks by Mr Manuel Sánchez, Deputy Governor of the Bank of Mexico, at the MFI
International Harper Lecture, Milton Friedman Institute, Mexico City, 11 May 2011.
* * *
It is a pleasure and an honor to participate in this panel of the MFI International Harper
Lecture. For me, this conference is particularly relevant as the key note speaker is
distinguished economist, Lars Peter Hansen, my former professor, a member of my thesis
committee and a good friend. As in the days when I took courses from Lars at the University
of Chicago, today I have learned a lot from his interesting presentation on systemic risk.
I would like to comment on some policy challenges related to systemic risk, hoping that they
may complement Lars' deep empirical insights on this issue. In my remarks, I will emphasize
three points: first, that the available definitions of systemic risk are dependent on judgment in
an environment of uncertainty; second, that we need a deeper understanding of the causes
of systemic risk, particularly regarding the distinction between root factors and symptoms;
and third, that policy measures should be clearly designed to mitigate the causes of systemic
risk. I would like to mention that these comments are entirely my own and do not necessarily
reflect those of the Bank of Mexico.
The notion of systemic risk
Let me begin by recognizing that there is no widely accepted definition of systemic risk.
However, any overview of research and policy reports in this area uncovers a frequently held
notion of systemic risk as the possibility of a disruption affecting the normal functioning of the
financial system.
There are at least three noteworthy elements of this common concept. One is the reference
to the financial system. This definition implies a potentially large scope, as the referred
system can comprise all financial intermediaries, regulated and unregulated; the markets of
all financial assets; the infrastructure that the financial system uses to perform its tasks,
including payments and settlements; and, the regulatory framework.
The second element is the allusion to normal functioning. The activities of any well operating
financial system are many, but they can be summarized as intermediating payments,
converting savings into lending usually through maturity transformation, and managing risk.
However, to my knowledge, there are no clear indicators of what normal functioning is meant
to be, which makes this qualification subjective, as it calls for the judgment of the observer or
the policy maker.
For instance, do stock-market crashes or sudden and substantial currency depreciations
constitute interruptions to normal functioning? What must be the depth of these adjustments
in order to consider them deviations from normality? When does a "credit crunch" become
disruptive? Unfortunately, neither economics nor experience gives an unequivocal answer to
these questions. Still, any answer has necessarily policy implications.
The subjective characteristic of this notion does not disappear by resorting to the opposite
concept of financial stability. Here again, although there is no universal definition, stability is
usually interpreted as a situation in which the financial system is resilient to disturbances that
may threaten its normal functioning. In both concepts, sometimes disruptions are meant to
be turbulences that may have a substantial negative impact on the real economy. Yet, this
qualification only translates the vagueness from one term to another - i.e., when is the
impact substantial? - maintaining the nature of the assessment subjective.1
The third element is the reference to a probabilistic world, as risk refers to the possibility of
incurring in a negative outcome. For example, The Oxford English Dictionary defines risk as
"the possibility of loss, injury, or other adverse or unwelcome circumstance; a chance or
situation involving such a possibility". However, any risk definition assumes all possible
outcomes and their associated probabilities as known. As the unprecedented nature of the
recent global crisis reminded us, prior knowledge of the probability distribution of the different
kinds and degrees of disruptions can easily be incomplete. Hence, some potential negative
events may be truly "unknown unknowns" and fall into the realm of uncertainly, not risk, as
defined by Knight. In uncertainty, not all possible outcomes and their associated probabilities
are known.2
The conclusion from this analysis is that available concepts of systemic risk are vague and
too wide to be operationally useful. If any policy framework is to be designed and applied in a
meaningful way to counteract systemic risk we need to narrow this concept and make it more
precise.
In this sense, precision implies measurability. As correctly stated by Lars Hansen, unless we
are able to measure systemic risk objectively, quantitatively, and regularly, it is impossible to
determine the appropriate trade-off between such risk and its rewards and, from a policy
perspective and social welfare objective, how best to contain it. Lars' concern regarding the
challenges of monitoring these risks in terms of modeling, measurement and data
accessibility is of prime relevance.3
Sources of systemic risk
While the notion of systemic risk is vague, our knowledge about its possible causes is also
limited. The inherent vulnerabilities of the financial system are relatively well understood.
Examples are the term mismatches and leverage of individual financial intermediaries, and
the imperfect information about risk exposure and soundness of particular banks and assets.
Imperfect information and the interconnectedness of the different agents can transform
individual vulnerabilities into systemic weakness. It is possible that a difficulty occurring in
one component of the system could be extended to other elements. For example, economic
agents interact with each other and an asset in one institution may be a liability in another,
giving rise to interdependence and to a counterparty risk. Financial institutions, such as
banks, usually carry out analogous transactions that could also lead to similar risk
exposures.
Instability is often thought to originate from a shock, triggered by a piece of information or
rumors that may lead to a loss of confidence and panic. For instance, if a given intermediary
is in trouble, there could be certain worries, derived from incomplete information, about the
financial shape of other intermediaries. Although there may be cases of flawed news, usually
this kind of shocks uncovers truly high risk exposures on the part of the intermediaries and
participants being questioned. Furthermore, the unknown buildup of imbalances within the
system, like maturity mismatches and excessive leverage, might become evident once such
rumors begin to affect the financial intermediaries.
The design of policy measures to strengthen the financial system against systemic risk
requires identifying the root causes of the excessive risk taking that typically precedes
financial disruptions. This diagnosis is obscured because symptoms, such as poor credit
evaluation by rating agencies and massive securitization, are often mistaken for causes.
In order to find causes, economics suggests searching for incentives. In this attempt, it is
convenient to begin by verifying that no government policies induce excessive risk
exposures. Factors with possibly unintended consequences may include policies to maintain
low interest rates for too long; measures to promote borrowing under artificially favorable
conditions, perhaps in the pursuit of social objectives such as home ownership; and,
government's guarantees for bailing out private risk exposures. These policies have the
potential of promoting moral hazard.
In particular, when a market or infrastructure is capable of suffering difficulties that may lead
to a disruption in the financial system, they are classified as "important". One problem with
this categorization is that the possible systemic importance of institutions varies in time; an
entity which is not considered systemic today may become one in the future. However, a
deeper limitation of such classification is that it may exacerbate the risk taking of the agents
involved, if they know in advance that, in case of difficulties, the government will protect them
against losses.
Two factors currently stressed as important contributors to the emergence or aggravation of
the recent financial crisis are global imbalances and sovereign risk. However,
notwithstanding their importance, it is not clear if they can be considered root causes of the
crisis.
Global imbalances come from the hypothesis that a "saving glut" during the years prior to
2007 caused interest rates to fall in the United States, thus promoting excessive risk taking
on the part of economic agents. The existence of a "saving glut" has been debated.
Arguments against it include historically low saving rates during those years and a possible
negative effect from expansionary monetary policy on the U.S. low saving rate. Additionally,
one must recognize the fact that open economies naturally exhibit current account
imbalances as a reflection of investment opportunities and saving motives.4
Nevertheless, while their relevance is still under debate, somehow global imbalances have
taken a prominent role in risk diagnosis, ranging from threats to the world economic growth
to the eventual emergence of a financial crisis. Consequently, the need for balancing current
accounts in the world has gained ample acceptance. A potential dangerous outcome of this
prescription is a movement toward protectionism and the implementation of a variety of
distortive measures. Some of this has been evidenced in the capital controls imposed by
some emerging economies experiencing currency appreciation.5
As for sovereign risk, the unsustainable path of certain euro member countries' public debt
has threatened the stability of the European Monetary Union (EMU). The main reason is that
banks and other financial institutions are substantial holders of the debt of troubled
governments, and the associated default probabilities implicit in market debt prices are
already too high and rising.
While there has likely been a negative effect from sovereign to systemic risk, one should not
exclude causation in the other direction. Among other factors, financial institutions took
considerable exposure on the public debt from different countries because they rated all
EMU sovereign issuers virtually risk-free. Apparently, they assumed that in case of
difficulties, fiscally strong governments would bail out the weak ones, as it has been the case
until now.
Policy measures
In light of the limited knowledge about the possible taxonomies of systemic risk, economic
policy has to be both preventive and reactive to problems. In both cases, it is preferable not
to introduce additional uncertainty. Hence, to the extent possible, it is advisable to rely on
pre-announced rules rather than discretion.
On the preemptive front, any design should begin by eliminating incentives for excessive risk
taking that might stem from economic policy itself. Once this is cleared, the regulatory
framework should be strengthened to mitigate the built-in fragilities of the financial system
and further align private incentives toward prudent risk taking.
For individual intermediaries, stringent capitalization and liquidity requirements are
necessary. Also, as the crisis revealed, systemic risk is a super-additive phenomenon where
the risk of the system is greater than the sum of risk of its parts. Therefore, these standards
should be complemented with macro prudential regulation. For example, regulatory
standards can be proportional to the institution's potential contribution to estimated systemic
risk and may include also countercyclical buffers such as those incorporated in the Basel III
Accord. Additionally, public information about markets and institutions should be enhanced.
On the reactive front, authorities face the dual challenge of trying to opportunely detect
possible systemic problems and, if they arise, attempt to neutralize them, without
suppressing market discipline. Examples of macro prudential policy actions are lower
loanto-value ratios, securitization restrictions, and more stringent capital and liquidity
requirements. It is convenient that these measures deal with the problem of systemic risk
and not with other objectives, such as targeting certain values of a currency exchange rate,
under the guise of a macro prudential approach.
A major challenge in accomplishing this task is the timely identification of systemic crisis
signs. One should remember that recurrence of financial crises has been the norm and many
of them have come as a surprise to supervisors, as it dramatically was the case with the
recent financial debacle. Hence, it is important to avoid excessive expectations about what
macro prudential policy can achieve, since this comfort could lead to distortive measures and
moral hazard.
The final role refers to crisis management. This includes supplying liquidity on good collateral
at penalty rates, according to the prescription of Bagehot, and the design and implementation
of expedient resolution mechanisms, including "living wills", for insolvent financial
institutions.6
Concluding remarks
Preventing and counteracting systemic risk poses important challenges for policy making. A
more specific notion of systemic risk is much needed and, as put by Lars Hansen, leaving
the concept vague may become a justification for regulatory discretion. Also, understanding
the sources of systemic risk is essential. Certainly, it would be quite inconvenient to combat a
phenomenon that is not a root cause of systemic risk, generating inefficiencies such as
protectionism. Finally, policy measures must avoid producing inadequate incentives and be
both preventive and reactive, without removing the market discipline that is necessary for
prudent risk taking.