How to minimise devastating domino effect of systemic risk
• Taxation could incentivise financial institutions and provide a reserve in the event of a crisis
The collapse of unsecured lender African Bank in 2014 provided a glimpse into the role of systemic risk in the South African financial system. As a consequence of the default of this small bank, at least 10 money market funds broke the buck — more than recorded anywhere in the world as a consequence of a single default.
Prudent and decisive action by the South African Reserve Bank and the Treasury ensured no further harm was done to the financial system.
Nonetheless, the African Bank episode, which cost South Africans roughly R10bn in total, brought back memories of the global financial crisis of 2007-08 when the insolvency of the US investment bank Lehman Brothers almost caused the collapse of the global financial system and led to the insolvency of the US-based Reserve Primary Fund.
What the two episodes have in common is the notion of systemic risk, which regulators abstractly define as “the risk of widespread disruptions to the financial system that result in negative consequences for the real economy”. To date, systemic risk has been notoriously difficult to measure, in particular before an event occurs.
An operational definition of systemic risk refers to the risk of the joint failure of financial institutions or markets that leads to the impairing of the financial intermediation process.
It is the risk of a collapse of the entire financial system rather than the failure of individual parts, caused by interconnectedness and common exposures. Systemic risk is different from systematic risk, which is a measure of undiversifiable risk that is inherent in the financial system. Hence, systemic risk could, in principle, be eliminated while systematic risk cannot.
There is no clear-cut answer yet on which financial institutions cause systemic risk. The Bank for International Settlements, the IMF and the Financial Stability Board provide three criteria for an institution’s systemic importance: size, interconnectedness and complexity.
Based on these criteria, South Africans should be concerned about systemic risk since our financial system is concentrated on only a few large, highly interconnected and exceedingly complex institutions.
Systemic risk comes at a huge cost to society. In 2009, the IMF estimated that the total cost of the global financial crisis was $11.9-trillion, or almost $2,000 for every man, woman and child on the planet.
Because the societal costs are so enormous, regulators and governments bail out institutions whose default would cause substantial systemic risk. These systemically important financial institutions are hence the beneficiaries of substantial implicit bail-out guarantees due to their systemic importance: since the institutions know the government will always bail them out, they are more likely to take on excessive risks.
The Occupy Wall Street movement, which protested against the fact that no banker was criminally charged after the financial crisis, while millions around the world lost their savings and their jobs, have described this principle as “privatise the profits and socialise the losses”.
Ideally, regulators would like banks to internalise their systemic risk. But to do so we need a measure of systemic importance that is transparent and can be easily updated. This is where academia comes in.
The measurement of systemic risk is a topic of intense debate in academia, with hallmark contributions from academics such as Princeton’s Markus Brunnermeier and Nobel laureate Robert Engle from the New York University’s Stern School of Business.
Engle and his colleagues have developed a simple and operational measure of systemic risk that they compute for the largest financial institutions in the US. The measure is called SRISK and is based on public data, which makes it transparent and easy to update.
In our research project, we have adapted the SRISK methodology to SA and compiled the first comprehensive systemic risk ranking of South African financial institutions.
We found that three institutions contribute almost 50% of total systemic risk, with Standard Bank being the biggest contributor at more than 25% at the end of 2016.
A key question for policy makers is how to curtail systemic risk, encourage competition and contain crises.
The Reserve Bank has developed a methodology for the identification of domestic systemically important banks (D-SIBS) based on the Basel Committee on Banking Supervision’s recommended methodology for the identification of D-SIBs and has adopted a macroprudential approach to regulation of systemic risk.
The Treasury has also issued guidelines on how it deals with the failure of systemically important financial institutions. However, these are passive approaches as they rely on the internal risk management structures of the institutions.
Multiple measures for the reduction of systemic risk have been proposed since the 2008 crisis, including leverage ratio caps and the adjustment of riskweight on specific asset classes or types of loans to discourage asset bubbles in certain sectors. All of these are being adopted in SA, which is why the probability of a systemic banking crisis is extremely small.
What is missing, though, is to set incentives for financial institutions to minimise their systemic risk contribution. The best way to achieve this is through a systemic risk tax. This would involve a Pigouvian taxation scheme designed to support a rescue fund to be used in the event of a crisis.
Our systemic risk ranking could therefore enhance supervision and monitoring, allowing regulators to easily identify systemically important institutions — and tax them accordingly.
Our proposed systemic risk tax would also help to tackle the high levels of concentration in our financial system, which have created an environment for collusion and misconduct, as we can see with the recent forex rigging scandal.
Even more importantly, though, our proposed systemic risk tax would force financial institutions to internalise the negative externality of systemic risk and protect South African taxpayers in the unlikely but not impossible event of a crisis.
The full systemic risk ranking can be found at http://www.systemicrisk.org.za
WE FOUND THAT THREE INSTITUTIONS CONTRIBUTE ALMOST 50% OF TOTAL SYSTEMIC RISK, WITH STANDARD BANK BEING THE BIGGEST CONTRIBUTOR
● Dr Georg is a senior lecturer. Dube and Kaya are students at the University of Cape Town’s African Institute of Financial Markets and Risk Management.