Jean-Claude Trichet: Systemic risk
Text of the Clare Distinguished Lecture in Economics and Public Policy by Mr Jean-Claude
Trichet, President of the European Central Bank, organised by Clare College, University of
Cambridge, Cambridge, 10 December 2009.
* * *
Ladies and Gentlemen,
I am delighted to have been invited by Clare College, Cambridge, to give this lecture in
economics and public policy.
One of the greatest challenges for economics and public policy at this time is to restore
financial and economic stability, and to improve the future functioning of financial systems. A
pre-condition for meeting this challenge is a deep understanding of the nature of systemic
risk. And that is the topic I have chosen for this lecture.
Systemic risk in Europe's financial system is a very important issue for the European Central
Bank. And as an institution of the 27, through its General Council in particular, the ECB is
one of the continent's guardians of economic stability. We are charged in particular with
maintaining price stability in the euro area over the medium term. But the ECB is also an
active participant in the new agenda of financial stability. As you will be aware, restoring
financial stability and containing systemic risk in the future are at the heart of the supervisory
and regulatory reforms currently being discussed here in Europe and elsewhere.
I am particularly pleased to give this lecture at Cambridge University, which has been an
intellectual "powerhouse" for centuries. It is said that the university has more Nobel Prize
winners associated with it than any other institution.
Perhaps the most well known Nobel Laureate from Clare College is James Watson, who,
together with Francis Crick, derived the structure of DNA. DNA incorporates the building
blocks of life. As the recent instability illustrates, we economists still need to achieve as clear
an understanding of the building blocks of financial systems - not simply the institutions
small and large that populate them, but also the fundamentals of the rules and incentives that
drive their behaviour; and, particularly, how they combine and interact with each other in the
presence of amplification mechanisms stemming from leverage and other forces.
Let me mention two more recent Nobel laureates in economics whose work relates to my
topic today. In 1996, James Mirrlees of Trinity College won the Nobel Prize for his
contributions to the economic theory of incentives under incomplete information. In 2001
Joseph Stiglitz, who spent time in Cambridge in the 1960s, won the Prize for his analysis of
the functioning of markets when information is asymmetrically distributed.1 I shall argue in my
lecture that such information problems and the incentives that they provide for economic
behaviour are one important element in the phenomenon of systemic risk, and therefore in
the wide transmission of financial instability.
The nature of systemic risk
So what is systemic risk? In the context of our natural environment, it is the threat that the
actions of millions of individuals, all acting in pursuit of their own interests, can cause a
breakdown of the world's ecosystem, a global catastrophe which will ultimately damage
everyone. This, of course, is the topic of the international climate change negotiations this
week and next in Copenhagen.
Similarly, in the context of our economic environment, it is the threat that developments in the
financial system can cause a seizing-up or breakdown of this system and trigger massive
damages to the real economy. Such developments can stem from the failure of large and
interconnected institutions, from endogenous imbalances that add up over time, or from a
sizable unexpected event. A seizing-up of the financial system ( or large parts of it ( is what
we experienced last autumn. The consequence was an economic freefall, a surge in
unemployment and a massive increase in public debt.
So what is it about financial systems that make them prone to systemic risk?
The financial system is composed of intermediaries, markets and the infrastructure of
payment, settlement and trading mechanisms that support them. Intermediaries are
connected with each other through direct transactions, as in interbank markets, and through
similar investment and financing decisions with third parties such as other intermediaries or
end investors.
Financial markets, in turn, are connected with each other through the trading activities of
financial intermediaries and through end investors active in more than one market. Systemic
risk within the financial system relates to the risk that these inter-connections and similarities
render emerging financial instability widespread in the system. Even if the original problem
seems more contained, important amplification mechanisms can be at work.
This complex network of financial connections is extended through the savings and financing
needs of all economic sectors, notably non-financial firms, households and the government.
By reallocating savings from individuals and sectors with a surplus of funds to individuals and
sectors in need of funds, the financial system plays a central role in the economy. So,
systemic risk, in a broader sense, relates to the risk that widespread instabilities in the
financial system translate into adverse effects on growth and welfare in the economy at
large.
How is it that financial instability can be triggered by initially self-contained events, which are
then transmitted so widely that the fallout ultimately reaches systemic dimensions?
ECB research by Philipp Hartmann and others, which has investigated systemic risk for at
least a decade, suggests that there are three particularly important ways in which this can
happen.2
The first is contagion. The failure of one financial intermediary can lead to failures of other
financial intermediaries, even when the latter have not invested in the same risks and are not
subject to the same original shock as the former.3
Second, widespread financial imbalances can build up over time and then unwind abruptly.
Hyman Minsky described how in good times consumption and investment increase,
generating income, which fuels the financing of more consumption and investment but also
the neglect of increasing risks. Even small events can then lead to a re-pricing of risk and an
endogenous unravelling of the credit boom, which then adversely affects many
intermediaries and markets at the same time.4
Third, negative aggregate shocks can adversely affect intermediaries and markets
simultaneously. Historical research has shown that many banking crises were related to
economic downturns.5 Note that the three mechanisms can happen independently or they
can reinforce each other.
There are a number of features of financial systems that make them particularly prone to
these forms of systemic risk. Let me just highlight three key ones.
The first pervasive feature of financial systems is what we call externalities. They particularly
relate to the complex and dynamic network of exposures among major intermediaries. What
in tranquil times is an efficient mechanism to share risk, can, in times of stress, become a
dangerous channel for transmitting instability. Two contracting parties do not have an
incentive to take account of the effects of their risk-taking on third parties. As a consequence,
the risk at the level of the system may be higher than the sum of individual risks.
The second key feature of financial systems is asymmetric information. Financial systems
allocate funds from agents who have them but possess no specific knowledge about
promising investment opportunities, to agents who have knowledge about the opportunities
but not the funds to engage in them. This creates an agency problem between the two
parties, which may be handled more or less well through the underlying financial contracts. If
contracts are incomplete and negative news arrive on some of the investment projects, but
information asymmetries do not allow lenders to judge whether this also affects other
investment projects, funding may evaporate for all projects alike.
The special nature of financial systems is not simply characterised by the presence of these
two imperfections. Externalities and information problems are also present in other economic
sectors. The additional problem in the financial system is that they can result in the third
feature: powerful feedback and amplification mechanisms, which render their implications
more severe and widespread. Illiquid assets, maturity mismatches between assets and
liabilities and leverage amplify the force with which problems of one intermediary are pushed
through the complex network of exposures. Sizable amounts of debt relative to capital and
short-term funding have more dramatic effects in situations of stress.
For example, intermediaries' losses can trigger "fire sales" of already largely illiquid assets,
which reduce their values and cause losses to other intermediaries, as for example
described in research on contagion by Hyun Shin and his co-authors.6 Moreover, funding
and market illiquidity can reinforce each other, leading to vicious liquidity spirals multiplying
the initial shocks.7
These effects are further amplified due to asymmetric information. In the aggregate, they
lead to the nonlinear adjustments that are so characteristic of financial instability. The fact
that such adjustments are nonlinear is particularly important for research and makes
modelling extremely difficult.8 Such adjustments may cause violent regime changes, pushing
the system from a state of tranquillity to a state of turmoil.
One key element in phases of turmoil and crisis is speed. The rapidity of unfolding
developments is often not modelled explicitly, but it is one of the greatest challenges for
policy makers. Financial crises are by no means new phenomena, but the speed of their
transmission has accelerated tremendously over the past few decades. While the unfolding
of the sovereign debt crises in the 1980's occurred over the course of years, the Asian
Financial crisis developed, at its peak, over months rather than years. The last intensification
of the present crisis, starting in mid-September last year, has spread around the globe in the
course of half-days. Many factors have contributed to this acceleration, including the process
of global financial integration, the increasing leverage in institutions, the technological
advancements that allow for an instantaneous transmission of information world-wide and
the accumulation over a long period of time of unsustainable global imbalances.
In the eco-systems of our natural environment, feedback mechanisms are often prevalent,
too. As soon as one part of the system is adversely affected, this can take the form of an
adverse feedback look destabilising the system as a whole.
Amplification effects are not only important in the transmission of instability, but also in the
build-up of imbalances that sow the seeds of systemic risk. A very important phenomenon in
this regard is herd behaviour in investment. For example, investment managers and loan
officers may sometimes ignore valuable private information in order to mimic others when
their own evaluation, their own remuneration or their own external reputation depends on
their performance relative to the rest of the market.9
This behaviour is individually rational but socially wasteful. Here at the University of
Cambridge, the famous analogy that John Maynard Keynes made between newspaper
beauty contests and financial market behaviour comes to mind.10 I am also convinced that
one of the main reasons behind herd behaviour in financial markets in general, particularly in
times of crisis, is a lack of transparency. The fostering of transparency as concerns financial
institutions, financial markets and financial products is therefore one essential policy lesson
from the present crisis.
Our latest experience with systemic risk
Let me now apply the relevant elements of this framework on how to think about systemic
risk to the present crisis. A particularly relevant source of systemic risk was the build-up of
widespread financial imbalances - the second form of systemic risk I described - in the
period of 2003 to 2007. The years prior to 2007 were characterised by low financial market
volatility and risk premia, rapid financial innovation in credit markets, low interest rates across
the maturity spectrum and ample liquidity conditions.
In particular, rapid financial innovation led to securitisation techniques with thus far unknown
complexities and to long and uncontrollable chains of intermediaries between originators and
final investors. Ratings agencies gained global power as the pricing of securitisation tranches
was largely based on their assessment, while leverage mounted ever higher and a shadow
banking system developed up largely unregulated.
At the same time, mark-to-market accounting rules became increasingly widespread, while
unsustainable external deficits and surpluses in some major economies paved the way for
macroeconomic imbalances at the global level. Information began to flow instantaneously
around the globe and raised competitive pressure on all financial market participants.
In this environment, banks and other investors engaged in a "search for yield" with the help
of the new credit products and investment vehicles, circumventing existing regulations. The
pace of this herd behaviour into ever more complicated forms of securitisation far exceeded
the market's capacity to solve a number of open issues of valuation, risk management and
incentives.
The result were widespread financial potential instabilities in the form of a highly complex,
opaque and - as it turned out later - illiquid system of credit risk distribution. Many investors
were either ignorant or imprudent with regard to the risks that they had acquired. Contrary to
conventional wisdom, this distribution led to much less diversification than thought and to
some surprising concentrations of risks in a number of large and complex financial
institutions. While mortgage market exposures, including those in US sub-prime mortgages,
were part of the problem, it later turned out that the problem of bad assets was much more
widespread.
The underlying risks started to materialise when house prices declined, delinquencies in US
sub-prime mortgage markets rose, and the so-called "special purpose vehicles" that held
highly concentrated exposures to these markets came under pressure. In June and July
2007, credit default swap premia started to increase sharply, rating agencies downgraded a
large number of asset-backed securities and collateralised debt obligations. Even AAA-rated
CDO index tranches declined below par value.
The eventual instability became systemic for the first time when money markets became
impaired in early August 2007. The re-pricing of risks made the major intermediaries active in
interbank markets aware that they might experience further losses in the future and that the
same might apply to their counterparties. Given the lack of transparency of the credit risk
distribution system, asymmetric information was omnipresent. It became difficult for
intermediaries to distinguish good assets and counterparties from bad ones.
This led banks to hoard liquidity as a protection against the risk of their own assets and
counterparties becoming illiquid, rather than lending available funds in money markets.11
Such malfunctioning of the interbank markets makes the problem immediately systemic, as
all major banks depend on those markets. For central banks, there was no alternative to
making sizable liquidity interventions aimed at keeping the system afloat.
While this first phase of what we described at the time as "market turmoil" was indeed very
challenging, the dramatic transition to a full-blown systemic crisis happened in September
2008. The failure of a very large US investment bank, in conjunction with other news and a
series of events that increased uncertainty, led to a widespread loss of confidence in the
financial system.
As a consequence, the economic outlook worsened dramatically. The economic models in
use were not able to predict the sharp downward revisions of growth figures that followed
over the subsequent seven months.
The events of September 2008 clearly showed that in economic policy, we have no good
understanding of the very rapid transition to an eventual systemic crisis. In this sense, we
were left alone. Policy-makers had to rely on informal information, real-time data releases
and their own wisdom and judgements on how the situation was evolving.
What have we learned from this experience in terms of identifying those structural trends in
financial systems that are important for systemic risk?
First, we need much more analysis of the implications of the business models of major
intermediaries for the system as a whole. Some of the crucial factors, whose relative
importance has shifted over time, include originate-to-distribute models, rising maturity
mismatches and the combination of proprietary trading and investment advice.
Second, in line with previous experiences we have been reminded that the very fast growth
of innovative financial instruments and new financial intermediaries, in particular off-balance
sheet vehicles, can imply significant risks.
Third, financial integration needs to be accompanied by reform of supervisory and regulatory
approaches and institutions. Major reforms in this area are currently being discussed in the
European Council and European Parliament, including the establishment of a European
Systemic Risk Board.12
Fourth, advancing financial consolidation raises the question of how to regulate and, in the
event, wind down large and complex financial intermediaries whose disorderly failure could
pose systemic risks.
Fifth and finally, as financial sectors develop, households may take greater risks, for example
in mortgage markets and, more broadly, in their pension investments. While this also raises
issues of consumer protection, from a systemic perspective, it becomes increasingly
important to know how resilient the household sector and consumption can be in such a
situation.13
Macro-prudential supervision: a policy response to systemic risk
I have discussed the nature of systemic risk and our latest experience of it in the present
crisis. Let me now turn to the question of how policy-makers can respond to systemic risk.
Today, I want to focus particularly on the challenges for policy-makers of detecting risks of
systemic instability materialising in the future, and of then containing these risks.
Detecting systemic risks early is the task of macro-prudential supervision. I would like to
focus on the analytical issues underlying this policy and stress three approaches, linking
them to the three forms of systemic risk I discussed at the start of my lecture.
First, there are large and complex financial intermediaries, or like-minded clusters of financial
institutions, that play prominent roles in the financial system. We can describe them as
particularly important "nodes" in the financial network, which stand out through their risk, size
and interconnectedness.14 The full understanding of their individual on- and off-balance sheet
exposures and their lending and borrowing to each other is a crucial element in assessing
and containing risks of contagion.
Second, the extent and diversity of investment practices across all segments of the financial
system requires particular attention. For example, fast-growing credit to similar sectors or
regions could be a sign of vulnerabilities building up. The imbalances might become
unsustainable later and unravel in a disorderly fashion. This risk requires looking at
earlywarning signals in current market data. For example, aggregate credit might grow at a pace
that is disproportionate to the credit required to finance sustainable investment and
consumption. The complete set of important intermediaries, markets and instruments also
needs to be checked for early-warning signals, since similar risks could be hidden in different
parts of the financial system.
Third, current market data may not give the full picture of all relevant future scenarios.
Detecting systemic risks early also requires stress-testing the system against extreme events
and shocks that would surprise markets. Such macro-stress tests help to make an
assessment of the resilience of financial systems against shocks that have a low probability
but a highly destabilising power.15
Compared to the vision of systemic risk that I have outlined so far, two weaknesses of the
supervisory and regulatory approach that we had before the crisis stand out.
For one thing, the old approach focused too much on individual risks and too little on
interconnections across intermediaries and markets.
For another thing, it generated a lot of information about some types of intermediaries but
much less on others (including the shadow banking system). This made it difficult to
understand fully the pro-cyclical behaviour of the system in the aggregate.
Even if we understand the nature of systemic risk and know the basic approaches for
detecting its different forms, there are very important challenges for macro-prudential
supervisors.
One challenge is to be able to collect all the information that is necessary to identify systemic
risks early. It requires combining some micro-level data with and aggregate data from
components of the financial system. This means covering major types of intermediaries, in
particular large and complex ones, key markets and wholesale market infrastructures. To
contain systemic risk, macro-prudential supervisors need to have a good understanding of all
parts of the financial system that are relevant for the risks of contagion, the endogenous
build-up and unravelling of widespread imbalances and macro shocks.
Some of these data are more difficult to compile and bring together than others. There are
some financial sectors about which considerably less is known than about others. Compare,
for example, banks or insurance companies with non-listed highly leveraged institutions.
Although nowadays individual hedge funds do not seem to be a source of significant
systemic risk, it is very important that the relevance of this industry for the overall cyclicality
of the financial system is assessed. A particularly complicated topic is measuring the
interconnectedness among the systemically most important intermediaries.
The implication is that an effective exchange of information between the functions of
macroprudential supervision and micro-prudential supervision is an essential element of identifying
and containing systemic risk. There will be strong demands on micro and macro-prudential
supervisors to ensure smooth exchange of information under the post-crisis regulatory and
supervisory regime we are striving to establish.
Another challenge is more of an analytical nature. The economic models we have at our
disposal at present do not capture necessarily all relevant dimensions of systemic risk. For
example, despite progress in developing macro-stress testing frameworks, there are still
limitations in how economic analysis captures the two-sided interaction between financial
instability and the performance of the broader economy. Standard macroeconomic models
often do not have a well developed financial sector and are linear in nature. As I have noted,
systemic instability involves major nonlinearities and, in any case, cannot be analysed
without proper representation of the financial sector.16
There are many good finance approaches to the topic of financial instability, but they are
often not aggregate enough to capture realistic features of the macroeconomy, including for
example the conduct of monetary policy. Speaking here in the intellectual "powerhouse" of
the University of Cambridge, I therefore call on the academic research community to make
major efforts towards a better integration of financial and macroeconomic analyses to
address these limitations.17
A final challenge is given by the policy instruments available to contain systemic risks beyond
monitoring and warning about them. Macro-prudential regulation is a relatively new policy
area. We have much experience of how micro-prudential regulation affects the stability of
financial intermediaries and markets. A much more complex matter is using regulatory tools
to stabilise the financial system as a whole.
Having said that, I nevertheless see very encouraging discussions and progress on this front.
For example, the 2009 Geneva Report on the World Economy on "The fundamental
principles of financial regulation" points the way to how regulators can determine higher
capital requirements for financial intermediaries that exhibit features enhancing systemic
risk.18 Additional capital for interconnectedness, leverage, maturity mismatch and asset
growth will limit the scope for the externalities I was discussing before.
New initiatives are also under way to enhance the transparency of financial activities. These
will help to limit the adverse effects of imperfect and asymmetric information on systemic
stability. Overall, a great deal of work is going on at the Financial Stability Board, the Basel
Committee on Banking Supervision and at other competent bodies to strengthen the
macroprudential dimension of financial regulation.
As with climate change, an effective policy response demands international coordination.
Global warming has been called the biggest market failure ever; the present crisis has been
perhaps the biggest financial market failure ever. We know from basic theory and practice
that addressing market failure requires a major and coordinated policy response, both
immediate and in the longer term.
Systemic risk and macroeconomic stabilisation policies
I have identified the endogenous build-up and subsequent unravelling of financial
imbalances, as driven for example by herd behaviour in investment, leverage to finance
investment exposures and complex and opaque financial contracts, as a particularly relevant
16
It should be mentioned that the macroeconomic currency contagion literature discussed the transmission of
breakdowns of fixed-exchange rate regimes with some nonlinear elements. See, for example, Eichengreen,
B., A. Rose and C. Wyplosz (1996), Contagious currency crises: First tests, Scandinavian Journal of
Economics; Buiter, W., G. Corsetti and P. Pesenti (1998), "Interpreting the EMS crisis: Country-specific and
systemic issues", Princeton Studies in International Finance; Masson, P. (1999), "Contagion: Macroeconomic
models with multiple equilibria", Journal of International Money and Finance; Drazen, A. (2000), "Political
contagion in currency crises", Krugman, P. (ed.), Currency Crises, National Bureau of Economic Research
and Chicago University Press. Exchange rate surveillance as such, however, is typically outside the scope of
macro-prudential supervision.
17
The Economist (2009), The state of economics, 16 July; Krugman, P. (2009), "How did economists get it so
wrong?", New York Times, 2 September.
18
Brunnermeier, M., A. Crockett, C. Goodhart, A. Persaud and H. Shin (2009), The fundamental principles of
financial regulation, 10th Geneva Report on the World Economy, July.
BIS Review 165/2009
form of systemic risk. While macro-prudential supervision is at the forefront of preventing
severe asset bubbles from emerging, this may not be sufficient, given the macroeconomic
components of cycles. Therefore, macroeconomic stabilisation policies need to make their
contribution to reducing pro-cyclicality.19
Macroeconomic authorities have faced the challenge posed by financial booms and busts in
two ways.
First and foremost through solid institutions: the pre-emptive arm against system instability.
Stability-oriented macroeconomic frameworks have ensured price stability and economic
prosperity in all developed countries for the last quarter of a century. Demand and real
incomes have grown steeply, but steadily. Their steady course has instilled a wide sense of
security in investors and savers.20 The European stability culture can be seen as vindicated
by the crisis.
However, macroeconomic stability has not been a sufficient condition for financial stability. It
cannot eliminated systemic risk altogether. Macroeconomic authorities have therefore been
frequently called on to provide remedial action, once booms have turned into busts. The aim
of their action has been precisely to avoid the transformation of individual financial risks into
systemic risk.
Ex post remedial action has often been activated as soon as the financial firestorm has
threatened the stability of the economic system. But such action risks raising expectations
that macroeconomic policy will always insure against tail risks, no matter how large.
Expectations of this sort can contribute to an under-pricing of financial risk in subsequent
phases of the financial cycles. They can encourage concentration of market positions in the
financial scene.
At the same time, the instruments of counter-cyclical policy have been used so intensely -
and more so from one financial cycle to the next - that authorities might have tested the
extremes of their control procedures. I am borrowing here from dynamic control theory.
Repeated attempts to fine tune a mechanical or electronic system after a shock sometimes
leads to "instrument instability" that makes the system spiral out of manageable bounds.21
Economic and financial systems, I suspect could have some structural similarities with
physical systems, leading to the same kind of "instrument instability".
Moral hazard and policy instrument instability pose questions to which we are not in a
position to a firm answer at this point in time. I would like to see these questions studied and
debated in eminent academic institutions like this.
Turning to actual developments, as I mentioned already, we saw perhaps the most appalling
manifestation of such a threat in the autumn of 2008. In the early phase of the present
financial crisis, precautionary hoarding of liquidity brought to a complete seizure of many
segments of the market for credit. At the same time, panic sales of assets made market
liquidity disappear. Market liquidity is high when traders can easily find a price, and that price
19
See also Viñals, J. (2009), "On Monetary and Financial Stability - Past, Present And Future", keynote speech
delivered at the at the 28th SUERF Colloquium on "The Quest for Stability" at the Utrecht University School of
Economics.
20
I have discussed the two-way interactions between steady macroeconomic conditions and trends in financial
prices elsewhere. See Trichet, J.-C. (2008), "Risk and the Macro-economy," keynote address at the
Conference "The ECB and its Watchers X," Frankfurt, 5 September 2008.
21
I am referring in particular to control theory as applied to economics by the engineer A. W. Philips in the
1950s. See Philips, A.W. (1957), "Stabilisation policy and the time form of lagged responses," Economic
Journal, 67, 265-277. But I do not forget that a very early attempt to import the phase transition notion into
social science resulted in Friederick Engels' famous "law of the transformation of quantity into quality",
described in his (circa 1883) work Dialectics of Nature, which provides some insight into early attempts to
grapple with concepts now considered reasonably well understood.
BIS Review 165/2009
is very close to what every other trader pays for the same asset at the same time. In early
October 2008 the market could simply not find a value for many of those securities that had
been so highly priced only few weeks before.
To avoid a cascade of counterparty defaults, governments offered generous financial
guarantees and injected fresh capital into the system. Central banks increased their lending
to replace the withdrawal of private lending - in interbank transactions and, sometimes, in
the broader market for capital. This concerted intervention very much attenuated the
downward part of the cycle and blocked channels of financial contagion. In short, it provided
catastrophe insurance.
There is no doubt that macroeconomic policy-makers' interventions have had a stabilising
effect. Market compensation for risk has gradually returned to more normal levels. The
freefall of the economy has been halted and turned around. The financial crisis has not
precipitated the extreme spiral of falling prices, rising debt burdens and chain bankruptcies
that some economists had feared.
For what concerns monetary policy, co