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Assess the Systematic Risks in the International Financial Sector

Xinhua Financein CFBOND
2018-10-10 14:46

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Liu Ming, Deputy Chief Editor of the Outlook Media Group, Xinhua News Agency, who published his book The Global Financial Crisis: Challenges and Opportunities for Sustainable Development in 2016, reminds us always to focus on "Contagion" when assessing the systematic risks in international financial sectors.

By Liu Ming

The assessment whether systematic risks exist directly affects the decision-making of regulatory authorities as to whether they should intervene (judgment on the problems and the nature of risks), how to intervene (selection and combination of measures), when to intervene (action timing as well as possible expectations of market and supervision), and to what extent to intervene (disposal efforts). However, in this round of financial crisis, policy-makers often found it difficult to decide whether a particular situation was of systematic importance and whether the regulatory authorities should “take actions.”

At the micro level, it is hard to evaluate in isolation the systematic impact of a financial institution and a financial incident. Even the bankruptcy of Lehman Brothers, the landmark event of this round of financial crisis, was merely part of a series of major financial events. At the macro level, it is hard to estimate the systematic significance of a financial system according to an isolated indicator. For example, the proportion of the American banking industry in the US GDP was not higher than that of Europe, but its “capacity” of generating “great damage” in “wider range” was far more powerful. Combining both the micro and the macro levels, in the context of certain public policy and market anticipation, some seemingly unimportant institutions or incidents might cause the “butterfly effect”, form the downward spiral and finally trigger systematic risks.

According to financial theories, systematic risks are generally divided into two types: contagion and aggregate shocks. In fact, these two types are just different “screen shots” of the research objects in terms of time and region. “Contagion” will finally develop into “aggregate” and shocks of “aggregate” might continue the “contagion".

The key of discovering and preventing systematic risks is to evaluate the possibility of the future development of a specific incident. That is to say, contagion will be reduced or held back by judging its possible contagion effects.

Based on the facts and the logic of this round of financial crisis, the contagion that we need to study and focus on involves sectors such as market risks, credit risks, operation risks and liquidity risks, etc. These include how the unsustainability of the profit models, the devaluation of assets and default anticipation trigger payment crisis; how the liquidity crunch triggers the surge of interbank market interest rate which leads to the emergence of counterparty risks among major financial institutions; whether various non-systematic functions including off-balance sheet shadow banking, unessential services and their potential risks might pose a threat to the continuous operation of the systematic functions and essential services of important financial institutions; how the choice of public policies (whether the government would provide emergency liquidity assistance and its timing) will stabilize market anticipation, or in turn cause the spread of panic; how the important financial institutions spread risks and crises to the sectors outside their own institutions, systems and economic entities through the complicated connections and interdependency among their domestic and international branches and various business as well as highly related assets; how various phenomena of financial crisis, like the fund shortage, unusual changes in the bill market, hectic selling of risk assets and the slump of the stock and the bond market, might be transmitted to the real economy and bring about an all-around economic crisis; what changes the “imbalance of global economy” might bring to the international economic environment, such as the shift of the monetary policies of major economies, the change of international liquidity adequacy, the fluctuation of the value of major currencies in the world, and the possible impacts they might have on international capital flows, changes of asset prices, global inflation, adjustment of exchange rates, etc.; meanwhile, what kinds of the “rebalancing of the global economy” will take shape, and what impacts and shocks they will have on emerging economies, etc. It is important to make instant evaluation and reaction on the direction, manner, channel and intensity of the development of the above-mentioned circumstances based on the grasp of the overall situation. Otherwise, it might cross the critical point at unexpected time, bringing about a systematic crisis unsymmetrical to the overall assessment of economic fundamentals.

American economist Hyman Minsky described the tendency of capitalist financial system to generate endogenous crisis, and the critical point when the asset value collapses described by him was also called Minsky moment. In practice, moments like this often appear unexpectedly, and will soon gain systematic importance. “Tail risk” thereby became a buzzword in financial theories. For instance, until the mid-2007, the international financial market had been unusually calm, with the fluctuation of asset prices and the risk premium hitting the low. Yet a seemingly unexpected crisis swept across the globe with the speed and intensity once-in-a-century. People exclaimed, “The incident once-in-10,000-year predicted by models was happening every single day in the past three days.” Just because of this, behaviorism economics particularly emphasizes the critical impacts of “the self-fulfilling prophecy,” “sheep-flock effect” and “self-amplification,” etc. on risk contagion. Information dissymmetry might intensify this kind of contagion.

Similar with bubble economy, systematic risks possess the unity of opposites between absoluteness and relativity, knowability and unknowability as well as ambiguity and tangibility of symbols. 

Therefore, in terms of systematic risks, we are unable to provide a certain kind of absolute quantitative standard or an invariable formula. Accurate econometric models could only answer the question of, under certain situations and conditions (parameters), the risk probability of certain institutions’ problems causing systematic collapse, the corresponding policy options or strategy portfolios, and the anticipated cost and earnings. Econometric models can add, reduce or adjust parameters, but parameters have no limits. Their greater value lies in the fact that they provide a kind of analyzing logic under certain circumstances, not just the specific conclusions this logic has deduced with given parameters.
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