Understanding systemic risk, the key to minimising bank bailouts

May 18, 2010 5:27 PM

What we really missed during the financial crisis, and what we really need now to stop it happening again, is an effective way of "attributing systemic risk to individual institutions".  Fortunately, the Bank for International Settlements have a new Working Paper out called Attributing systemic risk to individual institutions, which might help.


To leave behind the jargon for a minute, what that means is working out how dangerous banks are to the wider financial system.  How likely are they to fail and, if they fail, how much will they contribute to the possibility of the whole system coming crashing down.


During the crisis, there was a vital debate over whether it was necessary to bail out each bank.  Clearly the stakes were huge.  Governments needed to avoid doing two things:



  • Stepping in when it wasn't necessary.  That would be an irresponsible use of vast amounts of taxpayers' money and would encourage risky behaviour by bailing out shareholders and/or bondholders, by confirming in many people's minds that the banks are Too Big To Fail.  Dan Hannan has argued that the bailout was unnecessary and a disastrous mistake.

  • Not stepping in when it was necessary.  Many have argued that letting banks fail would undermine other institutions, ending in a collapse of the financial system.  Anatole Kaletsky has argued that the US authorities made the crisis worse than it needed to be by not bailing out Lehman Brothers.


In order to step in only when it was really needed, the authorities needed a yardstick by which to assess whether the collapse of a bank would cause instability at other institutions, the amount of systemic risk that it posed.  A clear understanding of when a bank's failure threatened to bring down others would also limit unnecessary market panic.


Unfortunately, they didn't really have that, they had advice from economists and bankers but it is hard to choose between experts and not be led by special interests without some kind of empirical evidence.  As no one was exactly keen on running an experiment to work out what it took to bring down the global economy, we didn't have that.  Without a clear evidence-based standard, policy became a bit random.  It was satirised beautifully in this little section from the television series South Park:



We need a better idea of when a bank poses a danger to the rest of the system, so that we can make better decisions in the event of a crisis.

A better understanding of systemic risk will also help us avoid future financial crises.  Some people argue that the modern financial system is inherently unstable.  But that is hard to square with the fact that there were no serious deposit bank failures through more than a century of wars, recessions and depressions after 1878, when the City of Glasgow Bank and the West of England & South Wales District Bank failed.

In order to make the system more sound, we need to understand what makes a bank dangerous.  The Bank for International Settlements report gives us a start on that.  Their findings suggest that bigger banks produce an increase in risk more than proportionate to their size.  So we might want to look at things like the mergers that governments encouraged during the crisis - which produced even bigger banks - and the way implicit government guarantees encourage concentration into a smaller number of bigger institutions.

More work is needed - in particular, the BIS work may not sufficiently account for how interconnected firms are - but this is the kind of thing that will help produce a more stable financial system.  Not the posing that we are currently getting from the EU.


What we really missed during the financial crisis, and what we really need now to stop it happening again, is an effective way of "attributing systemic risk to individual institutions".  Fortunately, the Bank for International Settlements have a new Working Paper out called Attributing systemic risk to individual institutions, which might help.


To leave behind the jargon for a minute, what that means is working out how dangerous banks are to the wider financial system.  How likely are they to fail and, if they fail, how much will they contribute to the possibility of the whole system coming crashing down.


During the crisis, there was a vital debate over whether it was necessary to bail out each bank.  Clearly the stakes were huge.  Governments needed to avoid doing two things:



  • Stepping in when it wasn't necessary.  That would be an irresponsible use of vast amounts of taxpayers' money and would encourage risky behaviour by bailing out shareholders and/or bondholders, by confirming in many people's minds that the banks are Too Big To Fail.  Dan Hannan has argued that the bailout was unnecessary and a disastrous mistake.

  • Not stepping in when it was necessary.  Many have argued that letting banks fail would undermine other institutions, ending in a collapse of the financial system.  Anatole Kaletsky has argued that the US authorities made the crisis worse than it needed to be by not bailing out Lehman Brothers.


In order to step in only when it was really needed, the authorities needed a yardstick by which to assess whether the collapse of a bank would cause instability at other institutions, the amount of systemic risk that it posed.  A clear understanding of when a bank's failure threatened to bring down others would also limit unnecessary market panic.


Unfortunately, they didn't really have that, they had advice from economists and bankers but it is hard to choose between experts and not be led by special interests without some kind of empirical evidence.  As no one was exactly keen on running an experiment to work out what it took to bring down the global economy, we didn't have that.  Without a clear evidence-based standard, policy became a bit random.  It was satirised beautifully in this little section from the television series South Park:



We need a better idea of when a bank poses a danger to the rest of the system, so that we can make better decisions in the event of a crisis.

A better understanding of systemic risk will also help us avoid future financial crises.  Some people argue that the modern financial system is inherently unstable.  But that is hard to square with the fact that there were no serious deposit bank failures through more than a century of wars, recessions and depressions after 1878, when the City of Glasgow Bank and the West of England & South Wales District Bank failed.

In order to make the system more sound, we need to understand what makes a bank dangerous.  The Bank for International Settlements report gives us a start on that.  Their findings suggest that bigger banks produce an increase in risk more than proportionate to their size.  So we might want to look at things like the mergers that governments encouraged during the crisis - which produced even bigger banks - and the way implicit government guarantees encourage concentration into a smaller number of bigger institutions.

More work is needed - in particular, the BIS work may not sufficiently account for how interconnected firms are - but this is the kind of thing that will help produce a more stable financial system.  Not the posing that we are currently getting from the EU.


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