9/3/2022
Introduction to Systemic Risk and Financial
Stability
WEEK 1
Main reading:
JD chapter 1.
Tallman, Ellis. John Moen. “Lessons from the Panic of 1907” Economic Review, Federal Reserve Bank of Atlanta, May 1990.
OECD „COVID-19 and Global Capital Flows” Talking Coronavirus. July 3. 2020.
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
1
1
Information
Sigga Benediktsdottir  sigridur.benediktsdottir@yale.edu
55 Hillhouse office #202
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
2
2
1
9/3/2022
Information
Grading
a) Class participation and class presentation (40%)
◦
◦
(20%) Presentation on a question connected to a topic in a given week. Students will choose a topic before the
fourth class (September 9th) and the first presentation will be in the fifth class, third week, September 14th.
The presentation will be 10 minutes (max 7 slides), followed by 5 minutes of discussions. It may be good for
you to have this connected to the paper to deepen the research and get feedback from your peers on
it.Discussions in class and cliffhanger notes.
(20%) Cliffhanger notes and 2-4 relevant questions about the material.
b) Paper (40%), 8-10 pages
◦
◦
(10%) Prospectus, 2 pgs with 2-4 key references due Wednesday October 18th.
(30%) Paper due last week of classes after thanks giving break
c) Final (20%)
◦
Open book policy notes on the scheduled day of finals.
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
3
3
Information
The paper is due December 6th and should be 8-10 pages. Students will hand in a one page
prospectus for the paper on October 18th. The prospectus should include four or more good
references.
◦ It could be good for the workload if the paper is on the same topic as the short presentation
Exam is to write a short policy note on 2-3 policy question
Important to read the material and I will ask students questions from the material in class
◦ I may pose questions to think about on Canvas
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
4
4
2
9/3/2022
Banking crises and financial stability
Outline of course:
Main readings is the book:
◦ Danielsson, Jon. Global financial systems: stability and risk. Pearson, 2013.
◦ I will post chapters, but the book is available online
◦ Website for the book: http://www.globalfinancialsystems.org/
Other readings will be primarily academic papers or material from the IMF,
OECD, BIS and Central Banks (FED, ECB, BoE, BoJ etc.)
The syllabus is in draft as this field is developing fast and some emphasis may
change as the semester goes on. We will follow current events from the
viewpoint of financial stability
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
5
5
Other interesting readings…
Financial stability reports from different countries:
http://www.centerforfinancialstability.org/fsr_reports.php
Note this website is not updated often enough
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
6
6
3
9/3/2022
Important
There are many interesting viewpoints, but in this class the point of
view we are taking is financial stability
I will motivate that viewpoint
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
7
7
This week
Outline of course
Case study crises 1907 and 1914
JD Chapter 1 (Systemic risk)
Introduction, systemic risk
JD Chapter 1 (Systemic risk) and BIS systemic risk how to deal with it
https://www.bis.org/publ/othp08.htm
Current events
OECD: COVID-19 and Global Capital Flows
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
8
8
4
9/3/2022
Outline of course
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
9
9
Outline of course
First part: Introduction to systemic risk and financial
stability. Banks Capital
Topic 1. Introduction to financial crises and definition of
systemic risk
◦ Case: Panic of 1907 and financial crises of 1914
◦ Case: Capital flows and EMEs during COVID
Topic 2. Banking, balance sheet, capital and liquidity
Topic 3. Motivation for supervision. Bank Runs and Deposit
Insurance.
◦ Case: Great depression
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
10
10
5
9/3/2022
Outline of course
Second part: Financial Stability. Underlying reasons for financial instability and banking crises
1. liquidity (fractional banking)
2. structural weakness and
3. leverage cycles
Topic 4. Market liquidity and banking liquidity. Role of Central banks in liquidity crisis.
◦ Case. Current crisis and dash for cash.
Topic 5. Financial stability and structural weakness. Financial deepening in emerging economies.
◦ Case. Savings and loans crisis in US
Topic 6. Endogenous risk, Credit cycles and leverage cycles, theory. Introduction to counter
cyclical capital buffer. Growth at Risk
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
11
11
Outline of course
Third part: More emphasis on global factors
and capital flows
Topic 7. Capital flows, leverage and financial
instability I. Short primer on Balance of
payments.
◦ Case the Asian crises and Mexican financial crisis
crisis
Topic 8. Capital flows and financial instability II.
Evaluating risks. Sudden stops and capital
flights.
◦ International comparative studies
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
12
12
6
9/3/2022
Outline of course
Fourth part: Lessons learned. Global financial crisis of 2007-2008, a motivation for a change and connect to
how it may be working now in COVID times.
Topic 9. Global financial crises of 2007-2008, lessons learned.
◦ Case. Iceland
Topic 10. Policy responses, microprudential policy.
Topic 11. Macroprudential policy, intermediate objectives and early warning indicators
Topic 12. Capital flows, resilience and
Capital flow management in emerging
economies
Topic 13. Lessons learned and
preventing current health crisis and the
resulting inflation from escalating into
financial crisis
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
13
13
The US Panic of 1907
THE CREATION OF THE FEDERAL RESERVE
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
14
14
7
9/3/2022
Panic of 1907
World on the verge of economic collapse*
“The Bank Panic of 1907 was so serious that it became a
catalyst for the creation of America’s central bank”
(Tallman and Moen 1990,)
Listen to NPR from August 2007…
https://www.npr.org/templates/story/story.php?storyId=14
004846
*Tallman, Ellis. John Moen. “Lessons From the Panic of 1907” Economic Review, Federal Reserve Bank of Atlanta, May 1990.
“Panic of 1907”. Federal Reserve Bank of Boston.
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
15
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
16
15
16
8
9/3/2022
Run up to the crises
Global interconnectedness.
US
◦ Booming economy
◦ High leverage
◦ …. and growth of trust companies
which were unregulated… structural
vulnerabilities
◦ Knickerbocker Trust Company
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
17
17
Run up to the crises
Liquidity
◦ No central bank so money fluctuated with agriculture…. money flowed out of the city in the
fall,
◦ Interest rates increased
◦ … in past years it had been partly replaced by foreign funds … but gold trade disputes with UK,
further drained liquidity in NY in the fall of 1907
◦ … the earthquake in San Francisco (April 1906) exuberated these flows out of NY in 1907.
First 9 months of 1907 stocks declined almost 25%
Fertile grounds for a crisis…
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
18
18
9
9/3/2022
Events
Dry up the supply of shares
… driving up the price
Heinz attempted to corner the stock of United Copper and
failed…
Oct. 14, 1907
United Copper Co. increased in value from $39 to $60
◦ The high was due to a leveraged driven manipulation of the
shares…
The short squeeze did not work since supply of shares
increased as price went up
Oct. 16, 1907
Value had declined to less than
$15
◦ Many banks lost money due to the share price decline.
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
20
20
Events
Ownership and board membership interconnectedness became a
focus… Otto and Augustus Heinze with Charles Morse
Oct. 21, 1907
Deposit run on Knickerbocker Trust Company
Knock on effects to other deposit institutions
That evening J.P. Morgan organized a meeting for trust company
executives … not enough information on the financial health of
Knickerbocker so J.P. Morgan did not aid that trust
Oct. 22, 1907
Run on Knickerbocker results in closure in the afternoon after a
payout of $8 million
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
21
21
10
9/3/2022
Events
Oct. 22, 1907
J.P. Morgan pledges to save Trust Co. of America
Oct. 23-25, 1907 … anchor US GDP $30 billion
US Treasury deposits $25 million in several NYC banks
Rockefeller kicks in $10 million
JPM pressures bankers to contribute an additional $25 million
rescue pool
◦ made available to the NY stock exchange to prevent its collapse
Trust Co. of America pays out 70% of its $50m in deposits but did
not close
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
22
22
Events
Deposit run was tempered by the New York Clearing House Association with
currency substitutes and suspension of deposit payments via increasing
transaction costs.
◦ Both illegal
Oct. 29, 1907
New York City was running out of money and did not find any buyers for their
bonds. Morgan and friends underwrote $30 million of the $500 million bond
issuance.
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
23
23
11
9/3/2022
Aftermath and lessons
Uneven regulations of banks and trusts may have increased risk due to less diversification.
JPM heralded for saving the economy
Senator Nelson Aldrich of RI introduces legislation for a central bank 1910
1913: Federal Reserve Act
Severe economic costs costs:
Motivation
◦ Production fell by 11%,
◦ Imports fell by 26%,
◦ Unemployment rose to 8% from under 3%
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
24
24
Typical financial crisis
Run up of systemic risk and existing structural risks
◦ Structural … no Central Bank, seasonality in liquidity and hence fluctuating interest rates,
gold and the gold dispute with the UK
◦ Run up of Systemic Risk … risks in trusts due to lack of diversification and growth, increased
leverage in trusts, interconnectedness between trusts and the more systemically important
banking system, governance interconnectedness in the financial industry and even into large
firms
Catalyst …
◦ Failed attempt at market manipulation, which was heavily leveraged, increasing volatility and
exposing weaknesses and leading to a run on the trust that funded the failed market
manipulation
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
25
25
12
9/3/2022
Typical financial crisis
Amplification and contagion,
◦ Runs  Failure of one trust leads to a run on all trusts and banks Fire sale of assets leads to asset
price decline  Further liquidity need and default  resulting in Liquidity Spirals and Fire Sale
Externalities
◦ Rapid loss of confidence in the financial system
Run on Banks
Banks forced to sell assets
Banks call loans
Investors
Asset price
decline
Investors forced to sell assets
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
26
26
Typical financial crisis
Attempts to halt the crisis … swift
◦ Increase in money supply or QE … here currency substitution.
◦ Slow deposits payout
◦ Try to install confidence.
◦ The New York Clearing House said the banks were fine, JPMorgan vouches for Trust Company of America.
◦ Announce liquidity support of the NY stock exchange
◦ Often public/private cooperation
Repercussion
◦ Usually very costly in decline in GDP and Consumption
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
27
27
13
9/3/2022
COVID 19
28
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
28
COVID
Economy shut down
Produc on ↓
Na onal income ↓
Layoffs
Banks
Financial markets
Risk
Loan loss account …
future expected losses
Banks solvency
Credit
Crunch
Defaults and
Loan losses
Asset prices 
Typical firesale
banking market crisis
feedback loop
Bank Liquidity
Fire
sale
29
14
9/3/2022
COVID
Economy shut down
Produc on ↓
Na onal income ↓
Layoffs
Banks
Financial markets
Risk
Loan loss account …
future expected losses
Defaults and
Loan losses
Asset prices 
Five types of
messures
1. Capital relief
2. Liquidity support
to banks
Banks solvency
Credit
Crunch
3. Massive asset
purchases
Bank Liquidity
4. Liquidity rule
relaxation
Fire
sale
5. Guidance on
Expected Credit
Losses
30
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
31
31
15
9/3/2022
COVID-19 and Global Capital Flows
OECD JULY 3 RD
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
32
32
Disruptions in exchange rates
The COVID-19 crisis triggered major disruptions for exchange rates and global capital
flows…
◦ Depreciation. Brazilian real (BRL), Mexican peso (MXN), Russian rouble (RUB), South African
rand (ZAR), and later the Indonesian rupiah (IDR) and the Turkish lira (TRY)
◦ Appreciation. USD, EUR, JPY and CHF
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
33
33
16
9/3/2022
Capital flight
Cross-border portfolio investment stopped in many emerging markets as well as
in some advanced economies in March 2020.
◦ Repatriation and safe haven flows
◦ USD 103 billion were drawn from
EMEs between mid-January and
mid-May 2020 … equity flows
then debt flows.
34
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
34
40000
30000
20000
10000
0
-10000
-20000
-30000
-40000
-50000
South Africa (transactions on capital market; converted to USD)
Brazil
Chile
India (converted to USD)
Korea
9/1/2021
2/1/2021
7/1/2020
5/1/2019
12/1/2019
3/1/2018
10/1/2018
8/1/2017
1/1/2017
6/1/2016
4/1/2015
11/1/2015
9/1/2014
2/1/2014
7/1/2013
5/1/2012
12/1/2012
3/1/2011
10/1/2011
8/1/2010
1/1/2010
6/1/2009
4/1/2008
11/1/2008
9/1/2007
2/1/2007
7/1/2006
5/1/2005
12/1/2005
3/1/2004
10/1/2004
8/1/2003
1/1/2003
-60000
Poland
35
17
9/3/2022
Impacting External Funding for EMEs
Tightening in dollar funding markets
Sovereigns not the main focus … dollar denominated corporate debt has been
increasing, driven by historically low borrowing costs and various (including tax)
incentives favoring debt over equity.
Differences across countries increases complexity
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
36
36
Policy responses
Sudden stops in capital flows are typically associated with decreases
in global risk appetite and contagion
Policy to stand against capital outflow is difficult to formulate …
options
◦ Monetary policy … increase interest rates?
◦ Interventions
◦ Brazil has conducted interventions in the spot currency and derivative markets, to support the BRL,
which had depreciated by 15% since mid-February 2020. The magnitude of Brazil’s intervention
amounted to USD 23 billion, corresponding to 6.4% of Brazil’s gross reserves, as of April 2020.
◦ Depends on Reserves and external position.
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
37
37
18
9/3/2022
Policy responses… cont.
◦ Federal reserve board made explicit swap agreements with large CB and opened a REPO
facility to any CB holding US Treasuries Securities
◦ Macroprudential policy …
◦ Relax rules on capital inflows, f.x. India raised the limit for foreign portfolio investors’ investment in corporate
bonds and China relaxed some controls on inflows for foreign institutional investors.
◦ Many lowered banks reserve requirement on FX funding (deposits)  increase banks FX liquidity.
◦ Relaxation on liquidity requirements for banks (LCR) in foreign currency
◦ Korea relaxed macropurdential levy on non-deposit FX liabilities.
◦ Iceland … pension funds
◦ Capital controls … outflow controls
◦ Countries have not resorted to capital controls.
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
38
38
Systemic risk
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
45
45
19
9/3/2022
Systemic Risk
Systematic risk
◦ Systematic risk: Non-diversifiable risk factor
◦ Systemic risk: Danger of the entire financial system collapsing
Systemic risk, IMF, BIS, FSB definition
the disruption to the flow of financial services that is (i) caused by an impairment of all or parts of the
financial system; and (ii) has the potential to have serious negative consequences for the real economy.
Systemic risk (definition 1.1.)
The risk that the entire financial system may fail, causing a general economic collapse, as opposed to
risk associated with an individual part of the system.
Systemic risk arises from the interlinkages present in the financial system, where the failure of an
individual institution may cause cascading failures, bringing down the entire financial system.
The conditions for systemic risk tend to be created when all outward signs point to stability and low risk
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
46
46
Where is systemic risk the highest
Countries that base their economies on finance and are exporters of
financial services are often more vulnerable to systemic risk, other
factors also matter
◦ Bank concentration
◦ Openness also matters
In every country, except US, almost all financial intermediation is via
banks
◦ 84% in UK, 92% in Germany, 96% in Spain. Same in Asia and Latin
America
◦ In the US it is 34%
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
47
47
20
9/3/2022
Size of the
banking sector
% of GDP
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
48
48
Size and growth matter
The size of the banking system matters
for systemic risk
… and also the growth of it
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
49
49
21
9/3/2022
50
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
50
US Commercial Banks
25000
Commercial
bank assets in
the US
100%
20000
80%
60%
% of GDP
15000
Billions dollars
About 5000 commercial banks
and saving institutions
◦ $23 trillion in total assets in
August 2022
◦ 6 largest with about $11.7
trillion, 50%
120%
10000
40%
5000
20%
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
Total Assets
2021-03-01
2018-05-01
2019-10-01
2015-07-01
2016-12-01
2011-04-01
2012-09-01
2014-02-01
2008-06-01
2009-11-01
2005-08-01
2007-01-01
2001-05-01
2002-10-01
2004-03-01
1998-07-01
1999-12-01
1997-02-01
1995-09-01
1992-11-01
1994-04-01
1991-06-01
1988-08-01
1990-01-01
1985-10-01
1987-03-01
1981-07-01
1982-12-01
1984-05-01
1978-09-01
1980-02-01
1975-11-01
1977-04-01
http://www.federalreserve.gov/releases/h8/current/default.htm
0%
1973-01-01
1974-06-01
0
Total assets % of GDP
51
51
22
9/3/2022
DATA…
A lot of good data in the FRED database at the St. Louis FED,
◦ See for example on US banks https://fred.stlouisfed.org/categories/93
Federal Reserve Board also has a lot of good data
◦ http://www.federalreserve.gov/releases/h8/current/default.htm
A website called global banking has good graphs but lacks the most current data often
◦ http://www.globalbanking.org/globalbanking.taf?section=key-charts&theme=too-big-to-fail&chart=7a
BIS has many good data series
◦ e.g. data series with credit to GDP gap, http://www.bis.org/statistics/c_gaps.htm?m=6%7C347
World bank also has data series, especially about developing economies
◦ http://databank.worldbank.org/data/reports.aspx?source=global-financial-development
IMF and the World bank have a database about financial crisis and banking crisis – paper about it and
access.
◦ www.imf.org/en/Publications/WP/Issues/2016/12/31/Systemic-Banking-Crises-A-New-Database-22345
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
54
54
Origins of systemic risk
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
55
55
23
9/3/2022
Systemic Risk
When is systemic risk usually created?
Former head of the BIS, Andrew Crockett in 2000:
“The received wisdom is that risk increases in recessions and falls in booms. In contrast, it may be
more helpful to think of risk as increasing during upswings, as financial imbalances build up, and
materializing in recessions.”
Profit–maximizing behavior can cause financial institutions to take on considerable
risk.
Minsky (1992)
“stability is destabilizing” because financial institutions have a tendency to extrapolate stability
into infinity, investing in ever more risky debt structures, followed by an abrupt correction
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
56
56
Fundamental origins of systemic risk
1. Fractional reserve banking
2. Pro-cyclicality
3. Information asymmetries
4. Interdependence and common risks
5. Perverse incentives
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
57
57
24
9/3/2022
1. Fractional reserves: Fragility
Deposits are usually “on demand”
Banks lend out some large percentage (e.g. 95%) of the deposits – and loans are usually long
term
If a sufficient number of depositors want their money, the bank can’t pay the depositors, this is
called a bank run
Bank runs are contagious
◦ If depositors lose confidence in banks they will withdraw at unpredictable rates which can cause bank
failure and hence financial instability and systemic crises
Usually now referred to as term mismatch between liability (deposits and other) and assets
(loans) of financial institutions
◦ Issue for non-bank-financial-institutions (NBFIs) as well
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
58
58
1. Fractional reserve banking:
Example US money supply
What is money? Cash, your balance in you debit card account -- what about other liquid assets such as
money market funds
No clear one definition of money
◦
◦
◦
◦
M0 Currency in circulation and reserves
M1 Narrow money: M0 + checkable accounts
M2 M1 + plus saving accounts
M3 Broadest measure of money:
M2 + large time deposits + institutional money market funds
+ short term repurchase and other larger liquid assets
M2 and M3 are a good indication of inflation and credit expansion.
◦
They increase in booms and fall in recessions
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
59
59
25
9/3/2022
https://fred.stlouisfed.org/series/M2
Trillions
US Money supply
20
18
16
14
12
10
8
6
4
2
0
Nov 05
Jul 20
Base
M1
M2
M3
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
60
60
Money supply through COVID …
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
61
61
26
9/3/2022
2. Pro-cyclicality: Capital and leverage
Process that is positively correlated with economic cycle is said to
be pro-cyclical
Built into our current system, fx.
◦ Risk weighted capital, mark-to-market accounting and pro-cyclicality of financial regulation … see next class
Banking is inherently pro-cyclical
In good times
◦ banks have surplus funding and capital and lending increases. The lending growth tends to be increasingly to
lower quality borrowers. This increased lending leads to more economic activity.
In bad times
◦ Funding opportunities decrease, capital decreases and hence lending decreases. Leading to less economic
activity.
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
65
65
2. Pro-cyclicality: Capital and leverage
Borrowers also behave pro-cyclically
In good times:
◦ they borrow too much and increase leverage, leading to increase in economic activity
In bad times:
◦ They deleverage, increasing the economic slump
We will discuss leverage cycles later in the course and also fire sale externalities
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
66
66
27
9/3/2022
3. Information asymmetry
Those who fund financial institutions have only limed information on the banks assets they are
funding, this matters especially for depositors and other providers of short term funding
◦ Risk of runs
The quality of banks assets is difficult to evaluate
◦ Lending portfolios
◦ Other assets
A loss in confidence can lead to bank failure through deposit run, wholesale funding runs, and
other information related problems irrespectively of whether this is due to unfounded rumors or
real negative information.
We will discuss funding and liquidity in later classes
67
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
67
4. Interdependence and common risks
Financial system is a network of interwoven obligations where institutions can have direct and
indirect connections
This gives rise to potential for domino–style failure
Common exposures
Bank B
Bank A
A is dependent on D through B and C
Bank D
Financial institutions often also
have common exposures, so if
one is in trouble another is
likely to also be in trouble …
leading to multiple failures
Bank C
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
68
68
28
9/3/2022
5. Pervasive incentives
Many potential examples here
In the subprime mortgage crises in the US it was thought that some banks did
not have “proper” incentives to monitor the quality of the borrower due to
them immediately selling the loan to other institutional investors. The bank
hence had no incentive to minimize the likelihood of a default.
◦ Some banks even used teaser rates on the loans so that the borrower would take a loan
which they obviously could not service.
We will discuss this in examples later in the course.
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
69
69
Amplification of risk  systemic risk
Across different financial institutions and across time.
Amplification across financial institutions.
◦ Common exposures
◦ Interconnectedness … exposures within the system
◦ Structure of financial system
Across time
◦ Financial cycle … build up of risk and the pro-cyclicality of the financial system
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
70
70
29
9/3/2022
Systemic Risk – Some remedies
1. Central bank liquidity provision
◦ Lender of last resort and day to day liquidity
2. Higher capital requirements such as countercyclical capital
3. Higher liquidity requirements
4. Addressing too big to fail
◦ Not diversified but all systemically important
◦
Narrow banking
◦ Volkers rule (Glass-Steagall) – commercial v.s. investment banking
◦ Vickers  national v.s. international
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
71
71
Systemic Risk – Some remedies
5. Resolution Regimes / living wills
◦ Good bank bad bank division
6. Market risk … Central counterparty (CCP), other?
◦ Trading halts
◦ Pro-cyclical margins.
◦ Swing pricing, redemption gates, liquidity requirements for funds.
7. Other Macroprudential policies
◦
For example for mortgages and Capital flow management tools
8. Leaning against the wind… use Monetary policy to address systemic
risk
◦ Too low interest rates in good times?
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
72
72
30
9/3/2022
Other policies can support
Monetary policy, microprudential policy and fiscal policy
Institutional framework matters a lot also
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
73
SIGGA BENEDIKTSDOTTIR. GLBL 311 / ECON 480
74
73
Thank you
74
31