Janet L Yellen: Interconnectedness and systemic risk - lessons from the
financial crisis and policy implications
Speech by Ms Janet L Yellen, Vice Chair of the Board of Governors of the Federal Reserve
System, at the American Economic Association/American Finance Association Joint
Luncheon, San Diego, California, 4 January 2013.
* * *
Thank you, Claudia, and thanks to the American Economic Association and the American
Finance Association for the opportunity to speak to you on a topic of growing interest to our
profession and of great importance to understanding the causes and implications of the
financial crisis.1
Everyone here today, I'm sure, is familiar with the tumultuous events that introduced many
Americans to the concept of systemic risk. To recap briefly, losses arising from leveraged
investments caused a few important, but perhaps not essential, financial institutions to fail. At
first, the damage appeared to be contained, but the resulting stresses revealed extensive
interconnections among traditional banks, investment houses, and the rapidly growing and
less regulated shadow banking sector. Market participants lost confidence in their trading
partners, and, as the crisis unfolded, the financial sector struggled to cope with a massive
withdrawal of liquidity, the collapse of one of its most prominent institutions, and a 40 percent
drop in equity prices.2 The effects of the crisis were felt far beyond the financial sector as
credit dried up and a mild recession became something far worse. You are also, no doubt,
familiar with the political response to that crisis. After considerable debate, the Congress
passed sweeping reform legislation designed to place the nation's financial infrastructure on
a more solid foundation.
I'm referring, of course, to the banking panic of 1907. The legislation that President Wilson
signed in December 1913 created the Federal Reserve, providing the nation with a lender of
last resort to respond to such crises.3 As we approach the centennial of the Federal Reserve
System, it is striking how many of the challenges of that era remain with us today. In 1907,
the correspondent banking networks that helped concentrate reserves in New York and other
money centers also made the banking system highly interconnected. Today, our capability to
monitor and model financial outcomes is vastly greater, and the tools available to the Federal
Reserve are vastly more powerful, than the private capital and moral suasion that financier
J. P. Morgan summoned in 1907 to stabilize the banks and trusts. But as we learned during
the recent crisis, the financial system has also grown much larger and more complex, and
our efforts to understand and influence it have, at best, only kept pace.
Complex links among financial market participants and institutions are a hallmark of the
modern global financial system. Across geographic and market boundaries, agents within the
financial system engage in a diverse array of transactions and relationships that connect
them to other participants. Indeed, much of the financial innovation that preceded the most
recent financial crisis increased both the number and types of connections that linked
borrowers and lenders in the economy. The rapid growth in securitization and derivatives
markets prior to the crisis provides a stark example of this phenomenon. As shown in
between 2000 and 2007, the notional value of collateralized debt obligations
Figure 1,
outstanding increased from less than $300 billion to more than $1.4 trillion.4 From 2004, the
earliest date for which comprehensive data are available, to 2007, the outstanding notional
amount of credit default swap (CDS) contracts increased tenfold, from $6 trillion to
$60 trillion.5 This incredible growth in securitization and derivatives markets reflects a
significant increase in the number, types, and complexity of network connections in the
financial system.
Financial economists have long stressed the benefits of interactions among financial
intermediaries, and there is little doubt that some degree of interconnectedness is vital to the
functioning of our financial system. Economists take a well-reasoned and dim view of autarky
as the path to growth and stability. Banks and other financial intermediaries channel capital
from savers, who often have short-term liquidity demands, into productive investments that
typically require stable, long-term funding. Financial intermediaries work with one another
because no single institution can hope to access the full range of available capital and
investment opportunities in our complex economy. Connections among market actors also
facilitate risk sharing, which can help minimize (though not eliminate) the uncertainty faced
by individual agents. Yet experience - most importantly, our recent financial crisis - as well
as a growing body of academic research suggests that interconnections among financial
intermediaries are not an unalloyed good. Complex interactions among market actors may
serve to amplify existing market frictions, information asymmetries, or other externalities. The
difficult task before market participants, policymakers, and regulators with systemic risk
responsibilities such as the Federal Reserve is to find ways to preserve the benefits of
interconnectedness in financial markets while managing the potentially harmful side effects.
Indeed, new regulations required by the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 (Dodd-Frank Act) and changes in supervisory practices by the Federal
Reserve and other financial regulators are intended to do just that.
In my remarks, I will discuss a few of the major regulatory and supervisory changes under
way to address the potential for excessive systemic risk arising from the complexity and
interconnectedness that characterize our financial system. The design of an appropriate
regulatory framework entails tradeoffs between costs and benefits, and to illustrate them, I
will discuss in some detail proposals currently under consideration to mitigate risk in
over-the-counter (OTC) derivatives, which proved to be an important channel for the
transmission of risk during the recent crisis. I am quite aware that some reforms in the wake
of the financial crisis, including those pertaining to derivatives, have been controversial. In
connection with recent rulemakings - and, more broadly, in the arena of public debate -
critics have asked whether complexity and interconnectedness should be treated as potential
sources of systemic risk. This is a legitimate question that the Federal Reserve welcomes
and itself seeks to answer in its roles of researcher, regulator, and supervisor. Let me say at
the outset, though, that a lack of complete certainty about potential outcomes is not a
justification for inaction, considering the size of the threat encountered in the recent crisis.
Responsible policymakers try to make decisions with the best information available but would
always like to know more. With that in mind, I'll begin by briefly surveying research that
highlights ways in which network structure and interconnectedness can give rise to or
exacerbate systemic risk in the financial system.
The economics of interconnectedness and systemic risk
Academic research that explores the relationship between network structure and systemic
risk is relatively new. Not surprisingly, interest in this field has increased considerably since
the financial crisis. A search of economics research focusing on "systemic risk" or
"interconnectedness" since 2007 yields 624 publications, twice as many as were produced in
the previous 25 years.6 That's not to say that economists were blind to the importance of
networks before the financial crisis. In 2000, Franklin Allen and Douglas Gale, for example,
developed an important model of financial networks that provides insight into how networks
can influence systemic risk.7
In the model studied by Allen and Gale, systemic risk arises through liquidity shocks that can
have a domino effect, causing a problem at one bank to spread to others, potentially leading
to failures throughout the system. In their model, interbank deposits are a primary
mechanism for the transmission of liquidity shocks from one bank to another. Allen and Gale
compare two canonical network structures: a "complete" network, in which all banks lend to
and borrow from all other banks, and an "incomplete" network, in which each bank borrows
from only one neighbor and lends to only one other neighbor. panel A, presents an
Figure 2,
example of a complete network, and figure 2, panel B, an example of an incomplete network.
In the case of the complete network, banks benefit from diversified funding streams. A
liquidity shock at one bank is less likely to cause the bankruptcy of another bank since the
shock can be distributed among all banks in the system. In the incomplete network, funding
is not diversified. A liquidity shock at one bank is more likely to cause liquidity problems at
other connected banks because the same shock is spread over fewer banks and is therefore
larger and more destabilizing. The principle behind this result is familiar and basic to
economics: Diversification reduces risk and improves stability. While this idea is compelling,
both economic research and the events of the financial crisis suggest that it is incomplete.
In their classic paper on bank runs, Douglas Diamond and Philip Dybvig showed how rational
and prudent actions by individual depositors to limit their own risks may be highly
destabilizing to an institution designed to transform short-term liabilities into long-term
assets.8 Xavier Freixas, Bruno Parigi, and Jean-Charles Rochet show that a similar kind of
collective action problem can arise in a network akin to a modern check-clearing system in
which credit extensions among banks allow claims on one institution to be fulfilled by
another.9 Such a system is socially useful because it allows depositors to shift funds among
banks without forcing banks to sell illiquid assets, thus enabling society as a whole to
undertake more productive, long-term investment. But in times of stress or uncertainty, such
systems can be subject to coordination failures: A "gridlock" equilibrium can arise in which
depositors at each bank withdraw funds early in order to avoid losses arising from credit
extensions to other banks whose depositors are also expected to force an early liquidation of
assets. In Freixas, Parigi, and Rochet (2000), interbank credit extensions, while useful, can
result in institutions that are "too interconnected to fail." These models underscore that the
pattern of connections throughout a financial network determines the systemwide
implications of liquidity shocks or other financial stresses in one part of the network. This
finding is one reason why efforts to collect more and better data on the precise linkages
among financial institutions are so important. Without such comprehensive and detailed data,
it is simply not possible to understand how stress in one part of the network may spread and
affect the entire system.
Networks that are more interconnected are inherently more complex than those in which
market participants have fewer links to one another, and complexity can exacerbate the
kinds of coordination problems highlighted by Diamond and Dybvig and by Freixas, Parigi,
and Rochet. Of course, "complexity" is difficult to define in a completely systematic and
satisfactory manner, but one way emphasized in recent work by Hyun Song Shin is to
consider the number of links required to connect savers to borrowers.10
Shin's analysis of
interconnectedness among financial institutions is based on the idea that the ultimate amount
of lending and borrowing that can occur in an economy is determined by economic
fundamentals such as income growth, which change only slowly over time, whereas
interbank claims can grow or contract far more quickly. Of course, claims within the entire
financial system net out to zero, but they do affect the leverage of the institutions involved. In
Shin's model, financial institutions seek to take on more leverage during a boom, when
banks have strong capital positions and risks are perceived to be low, but can increase
leverage, in the aggregate, only by borrowing and lending more intensively to each other.
This causes the resulting network of intertwining claims to extend further and further.
Conversely, when fundamental conditions or market sentiments change and financial
institutions prefer to shed risk, they can deleverage in the short term only by withdrawing
credit from one another. Such deleveraging can be particularly destabilizing in longer
intermediation chains as debt claims that are called by one financial intermediary to shore up
its own assets adversely affect the liability sides of other institutions' balance sheets. As
deleveraging accelerates and more and more financial institutions hoard liquidity, other
institutions may become concerned that their own funding may dry up and may preemptively
withdraw funding from others. Fundamentally strong institutions are forced to liquidate assets
at fire sale prices, which results in more deleveraging and instability.
More-complex network structures are likely to be more opaque than less complex ones. For
example, as the number of intermediaries standing between borrowers and lenders grows, it
becomes increasingly difficult to understand how one member of the network fits into the
overall system. The well-publicized difficulties that some mortgage borrowers have had in
simply figuring out who owns their mortgages illustrates the extent to which lengthening
intermediation chains have increased the complexity of the financial system. Moreover, in
many cases, market participants may have strong incentives not to disclose their
connections to one another. If a bank has a profitable relationship with a borrower, it may be
unwilling to disclose it to other banks for fear that competitors will reduce or eliminate the
rents that it earns.
Ricardo Caballero and Alp Simsek illustrate how a lack of information can create systemic
risk in financial networks.11 In a model that is structurally similar to the incomplete interbank
network model of Allen and Gale, Caballero and Simsek examine how banks might respond
to news of a liquidity shock when each bank knows the identities of its own counterparties
but not the identities of its counterparties' counterparties. The authors posit that banks deal
with this uncertainty by appealing to the "maximin principle": Each seeks to maximize profits
under the assumption that the network is configured in the worst possible manner from its
own perspective. Because each behaves as though the network structure is "stacked against
it," when banks learn of an adverse liquidity shock, each tends to sell more of its illiquid
assets and withdraw more funding from its counterparties than it would if it had access to
complete information about the structure of interbank credit relationships. As in Shin's model,
this excessive deleveraging can create a vicious cycle, magnifying the effects of the initial
shock.
The four models we've discussed thus far are aimed at exploring general features of financial
networks. As such, they are necessarily somewhat abstract. With a few narrow exceptions,
they treat all market participants as similar in size and in range of activities, and they use
relatively simplistic network structures. In the past few years, research on financial networks
has moved beyond stylized models of interbank relationships to examine the propagation of
shocks in more-realistic settings. Recent research by Gai, Haldane, and Kapadia and by
Cont, Moussa, and Santos examines how shocks propagate in network structures in which
some banks are larger and more interconnected than others.12
Using numerical simulations, Gai, Haldane, and Kapadia show that, in concentrated
networks, contagion occurs less frequently and is less severe for low degrees of network
connectivity. Contagion is significantly more likely at higher levels of connectivity. In a
concentrated financial network with a few key players, and when liquidity shocks are targeted
at the most connected institutions, distress at highly connected banks spreads widely
through the rest of the system. In this sense, the intuition of Allen and Gale - that highly
connected networks are resilient to systemic shocks - can be misleading. In an empirical
study of 3,000 Brazilian banks, Cont, Moussa, and Santos find that, not surprisingly,
institutions with larger interbank exposures tend to be more systemically important. But,
critically, they also find that an institution's position within the financial network plays a
significant role. A bank that does business with a large number of relatively weak
counterparties may have greater systemic importance than an institution with a similar
number of counterparties that are better equipped to manage potential losses.
The work of Gai, Haldane, and Kapadia and that of Cont, Moussa, and Santos suggest that
detailed and comprehensive data on the structure of financial networks is needed to
understand the systemic risks facing the financial system and to gauge the contributions to
systemic risk by individual institutions. I will describe in a moment how the Federal Reserve
is using such data to enhance its understanding of the OTC derivatives market. This line of
research suggests that a one-size-fits-all approach to the regulation of financial
intermediaries may not be appropriate.
So, what have we learned from this brief tour through recent research on interconnectedness
and systemic risk? We have seen how interconnectedness can be a source of strength for
financial institutions, allowing them to diversify risk while providing liquidity and investment
opportunities to savers that would not be available otherwise. But more-numerous and
more-complex linkages also appear to make it more difficult for institutions to address certain
types of externalities, such as those arising from incomplete information or a lack of
coordination among market participants. These externalities may do little harm or may even
be irrelevant in normal times, but they can be devastating during a crisis.
The global policy response to reduce systemic risk
Governments around the globe have responded to the financial crisis by adopting a strong,
multifaceted, and coordinated reform agenda aimed at reducing systemic risk. At a meeting
in Pittsburgh in September 2009, governments in the Group of Twenty (G-20) endorsed work
already under way in the Basel Committee on Banking Supervision to improve capital and
the management of liquidity risk in the banking system.13 I'll briefly review several Basel
Committee initiatives that address interconnectedness and systemic risk, but first, let me
focus on one in particular: higher capital requirements for global systemically important
banks (GSIBs).
Enhanced capital standards for GSIBs serve to limit the risks undertaken by the largest, most
interconnected institutions whose distress has the greatest potential to impose negative
externalities on the broader financial system. A framework of higher minimum regulatory
capital standards for these institutions was issued by the Basel Committee in November
2011, and indicators of interconnectedness account for a significant proportion of the overall
score used to determine whether a bank will be subject to higher standards.14 As shown by
Gai, Haldane, and Kapadia, among others, highly interconnected firms can transmit shocks
widely, impairing the rest of the financial system and the economy. We saw, for example,
that when Lehman Brothers failed, the shock was transmitted through money market mutual
funds to the short-term funding and interbank markets. While some participants in each of
these sectors had direct exposures to Lehman, many more did not. Moreover, even in cases
in which direct exposures to Lehman were manageable, the turmoil caused by Lehman's
failure added stress to the system at a particularly unwelcome time. In this way, the failure of
a highly interconnected institution such as Lehman imposes costs on society well in excess
of those borne by the firm's shareholders and direct creditors. Accordingly, tying enhanced
capital requirements to interconnectedness improves the resilience of the system. Of course,
higher capital requirements are not costless; they may raise financing costs for some
borrowers, and they have the potential to induce institutions to engage in regulatory
arbitrage. An important ongoing agenda for research and policy is the design and
implementation of data-based measures of interconnectedness to ensure that our
understanding of financial system interconnections evolves in tandem with financial
innovation.
While enhanced capital standards for GSIBs are an important tool for managing systemic risk
that arises through interconnectedness, they are not the only tool. The Basel Committee's
program contains a number of initiatives that will help manage interconnectedness and
systemic risk. These measures include countercyclical capital buffers, liquidity requirements,
increased capital charges for exposures to large financial institutions, large exposure rules,
and deductions from capital for equity investments in banks.15 These and other initiatives will
all play a role in managing the effect of complexity and interconnectedness on financial
stability. In fact, the multifaceted nature of the reform program is an important design
principle. One of the lessons of the recent financial crisis was that capital alone is not
sufficient to prevent or stem a crisis. Multiple channels for reform initiatives will enhance
systemic stability.
Managing tradeoffs between reducing systemic risk and increasing costs: OTC
derivatives market reforms
In addition to the banking reforms I just discussed, the G-20 also committed to reduce risk in
OTC derivatives markets by enacting reforms to improve transparency and decrease
counterparty exposures among market participants. These policies must be considered
carefully, as they are apt to increase the cost of financial intermediation and that of hedging
risk. To illustrate the tradeoffs policymakers and regulators must manage when crafting such
policies, I'll next discuss in some detail a set of initiatives currently being implemented by
prudential, market, and systemic risk regulators around the world to address weaknesses in
OTC derivatives markets.
An OTC derivative is a privately negotiated contract between a pair of counterparties to
exchange future cash flows that depend on the performance of an underlying asset or
benchmark index. Unlike an immediate purchase or sale of assets, OTC derivatives require
one or both sides of the transaction to make payments in the future. Counterparty risk is
therefore a key element of OTC derivatives transactions. The scale and significance of
counterparty risks in the OTC derivatives markets are large and, as we saw, can have
economy-wide implications. The prudent management, regulation, and oversight of these
risks are critical to ensuring that derivatives markets serve to diversify, rather than
exacerbate, systemic risk.
Significant problems with the functioning, regulation, and oversight of derivatives markets
became apparent during the financial crisis. These problems are perhaps best exemplified by
the widespread effects of large losses by American International Group, Inc. (AIG), on its
OTC structured finance and credit derivatives positions. In the absence of government
intervention, AIG's failure would have exposed its counterparties to substantial losses at a
time of significant financial stress and uncertainty for them and the financial system. Indeed,
for a time, the prospect of AIG's failure exacerbated the already impaired functioning in
important segments of the OTC market, and, as that happened, it became more costly or
even impossible for firms to manage financial risks. Derivatives positions originally
undertaken by some firms to hedge risk could not be unwound and instead became sources
of risk. AIG's failure revealed, in stark and spectacular fashion, systemic problems inherent in
the structure and functioning of OTC derivatives markets that had increased the fragility of
the financial system, exposing the rest of the economy to unnecessary systemic risks.
Central clearing mandates, minimum margin standards, and data reporting requirements are
among the tools that regulators now intend to use to mitigate counterparty risk and improve
transparency, thus reducing uncertainty.
The September 2009 commitment of the G-20 to require that standardized OTC derivatives
be cleared through central counterparties is directly aimed at reducing systemic risk by
changing the structure of the network of derivatives counterparty exposures.16 In the absence
of a central counterparty, the network of counterparty exposures associated with a class of
OTC contracts might look something like panel A in Each market participant has
figure 3.
counterparty risk exposures to one or more other market participants. Although each
participant knows its own risk exposure, it is unlikely to have complete information on its
counterparties' exposures to others. Such opacity can engender the kind of
information-related gridlock that we observed in the fall of 2008 and that is explored in the
research of Caballero and Simsek. Moreover, because market participants commonly have
partially or fully offsetting positions with multiple counterparties, a fully bilateral network is
inefficient from a risk-management standpoint: Gains in the value of positions with one
counterparty cannot be netted against losses in the value of positions with other
counterparties.
By taking one side of every trade, a central counterparty serves to transform the mesh
network shown in panel A of figure 3 into something that looks more like the hub-and-spoke
network illustrated in panel B. This network structure has no effect on the exposure of
individual market participants to the assets or indexes underlying the derivatives contracts in
question, but it dramatically simplifies and improves the transparency of the network of
counterparty risk exposures.17
Central clearing can yield important advantages over a fully bilateral market structure. The
simpler hub-and-spoke network structure is more transparent, and the central counterparty is
well positioned to impose common margin requirements on all market participants. Central
clearing facilitates the netting of gains and losses across multiple market participants, which
has the potential to significantly reduce each participant's aggregate counterparty risk
exposure. Rather than managing its counterparty risk exposure to all other trading partners,
a market participant needs to manage only its exposure to the central counterparty. The
central counterparty acts as a pure intermediary and takes no net position in any of the
underlying contracts that it clears, so it can experience losses only when a clearing member
defaults and has posted insufficient margin to cover the cost of replacing its open positions.
Central counterparties are typically designed to distribute any losses they do incur in a
relatively predictable way across all clearing members. In this way, central clearing provides
for a transparent mutualization of counterparty risks among participants.
Central counterparties are designed to be narrowly focused on intermediation and not the
provision of credit and liquidity. This structure improves the chances that, in the event of a
significant market stress, market functioning will not be threatened by the failure of market
infrastructure itself.
Of course, the other side of this coin is that adding a central counterparty introduces a single
point of failure for the network, making it critical that the central counterparty itself be well
managed and well regulated. To help ensure this result, title VII of the Dodd-Frank Act
adopted stronger safeguards than in the past for central counterparties that clear OTC
derivatives. Title VIII aimed at strengthening the supervision of financial market utilities,
including central counterparties designated as systemically important, by requiring annual
examinations as well as ex ante reviews of material rule and operational changes. In April
2012, the international organizations that set standards for financial market infrastructures
such as central counterparties published new and stronger standards for these entities.
U.S. regulators, including the Federal Reserve, participated actively in this work and are
expected to make formal proposals for incorporating the new standards into U.S. regulations
as soon as possible.
More fundamentally, however, a central counterparty's ability to manage risk is determined
by its ability to accurately value the contracts it clears on a frequent and possibly real-time
basis and to rapidly replace open positions at or near current prices in the event that a
clearing member defaults. Requiring less-liquid and highly customized derivatives to be
cleared would likely increase systemic risks, as clearinghouses would not be well positioned
to manage the complex risks of such derivatives. The G-20 mandate explicitly recognizes
this important limitation on the benefits of central clearing, and it requires only that
standardized OTC derivatives be centrally cleared. Accordingly, the G-20 commitment has
effectively managed the costs and benefits of central clearing in establishing a global
clearing mandate.
However, limiting central clearing to standardized derivatives means that a significant
proportion of less standardized OTC contracts will continue to be written on a bilateral basis
without the benefit of a central counterparty. The International Monetary Fund estimates that
one-third of interest rate and credit derivatives and two-thirds of equity, commodity, and
foreign exchange derivatives will not be suited to standardization and will remain
non-centrally cleared.18 As more-standardized derivatives migrate to central clearing, it will
be important to remain vigilant in managing the risks from non-centrally-cleared derivatives
exposures.19 One important tool for managing the systemic risks of non-centrally-cleared
derivatives is margin requirements.20 Globally, regulators have been working on standards
for margin requirements on non-centrally-cleared derivatives that would provide for
harmonized rules and a level playing field, which is crucial given the global nature of
derivatives markets. In July, the Basel Committee and the International Organization of
Securities Commissions proposed a framework for margin requirements on
non-centrally-cleared derivatives.21 The finalized framework will inform rulemakings of the
Federal Reserve and other U.S. regulators.
The proposed framework would require financial firms and systemically important
nonfinancial firms to collect two types of margin. First, they would be obligated to collect
variation margin on a regular basis, so if a derivative loses market value, the party
experiencing a loss must realize the loss immediately. This requirement codifies current best
market practice, since the largest derivatives dealers already exchange variation margin
daily. However, and importantly, the framework extends this prudent risk-management
practice to other derivatives counterparties. Requiring timely payment of variation margin will
go a long way toward ensuring that an AIG-like event will not happen again, since current
exposures will not be allowed to build over time to unmanageable levels.22 Moreover,
variation margin requirements will ensure that market participants will know that
counterparties that they deal with will not be carrying large uncollateralized exposures that
could impair their ability to perform in the future. Those requirements diminish the likelihood
of the kind of information gridlock explored by Caballero and Simsek.
More controversially, the proposed framework requires the collection of initial margin. While
variation margin collateralizes current derivatives losses, initial margin collateralizes future
losses that could occur in the event of a counterparty's default. In essence, initial margin is a
kind of performance bond. In the event that a counterparty does not perform as required, the
initial margin is used to replace the position with a new counterparty.
It is here that some of the most significant policy tradeoffs arise, because higher initial margin
requirements will make it more costly for market participants to