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ACHIEVING SUPERVISORY CONTROL OF SYSTEMIC RISK |
THE RETHINK
“The flaw is that in the face of systemic market failures the market is inefficient. Risk is mispriced, with consequences that are all too evident today.”25 Thirdly, the crisis shows the mainstream economics on which regulators and central bankers relied so heavily for macroeconomic management provided little or no capacity to incorporate perverse behaviour among economic agents or firm failure as a source of risk. Because it could not incorporate strategic behaviour by banks (or ‘gaming’ regulations), or reflect properly the risks emerging in the shadow banking system – off the balance sheets of the regulated banks – mainstream macroeconomics was of limited use in understanding the risk building up in the system. The shadow banking system was largely ignored by central bank analysts whose models could not, and did not, reflect its risks.26 Fourthly, standard macroeconomic modelling did not model feedback in the financial system nor allow for surprises to emerge endogenously from firms’ behaviour and reaction to other agents’ behaviour. The models did not reflect reality. More sophisticated and realistic models are needed. Prior to the emergence of the financial crisis, not only were several countries’ central banks routinely publishing reviews of financial stability, a number were working on the network exposures – interconnectedness of the financial system. Network analysis was underway at Oesterreichische Nationalbank (OeNB), National Bank of Belgium, Deutsche Bundesbank, Banco de México, De Nederlandsche Bank (DNB), Monetary Authority of Singapore and the Swiss National Bank.27 According to UK officials, the best developed of these (outside the UK itself) was at OeNB in Vienna. Beginning in 2002, a team at OeNB launched a series of projects to “develop modern tools for systemic financial stability analysis, off-site banking supervision and supervisory data analysis”.28 The Bank of England (BoE) developed a new model for analysis of financial stability just in time to have it put to the test: it was ‘unveiled’ in the BoE’s Financial Stability Review (FSR) in July 2006, nine months before the crisis began to unfold29. The work underway at the Bank of England30 appears to have been the most advanced supervisory work on systemic risk being undertaken globally. The point has been acknowledged elsewhere by the IMF, FSB and BIS in their joint report to the G20 finance ministers and central bank governors in October 200931. In that sense, the BoE work was considered to be the ‘supervisory state of the art’. The BoE’s July 2007 Financial Stability Review presented two (exogenous) crisis scenarios: a large supply-side shock and a generalised adjustment in asset prices. The BoE working paper introducing the revised modelling approach32 noted “a wide range of potential sources of error and uncertainty associated with these preliminary quantitative impact estimates” including:
25 John Eatwell, ‘Greater transparency’ is the mantra of the ignorant, The Guardian, Friday 19 September 2008 26 Gary Gorton (2009), Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007, Federal Reserve Bank of Atlanta’s 2009 Financial Markets Conference: Financial Innovation and Crisis, May 11-13. 27 International Monetary Fund, Bank for International Settlements, Financial Stability Board (2009), Joint report to G20 finance ministers and central bank governors 28 Michael Boss et al., (2006), Systemic Risk Monitor: a model for systemic risk analysis and stress testing of banking systems, OeNB Financial Stability Report, 11. 29 We have chosen to time the onset of the financial crisis from the failure of New Century Financial Corp which filed for bankruptcy on 2 April 2007 30 Haldane, A., Hall, S., & Pezzini, S.,(2007), A new approach to assessing risks to financial stability, Bank of England Financial Stability Paper no. 2 31 Staff of the International Monetary Fund and the Bank for International Settlements, and the Secretariat of the Financial Stability Board (October 2009), Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations Report to the G20 finance ministers and central bank governors. The report states at para 32ff: ‘Countries are increasingly focusing on macro financial linkages in their analysis of systemic relevance, although work in this area remains in its early stages. One leading example is the BoE’s RAMSI, which is being developed to inform its assessment of institution-specific and system-wide vulnerabilities. The analytical foundations of RAMSI draw from the stress testing and the network literature. It takes into account interbank linkages and macro-banking linkages by analyzing three areas of interconnectedness: funding feedbacks, asset fire sales, and a real sector-financial sector feedback loop.’ 32 Haldane et al. (2007)