Coping with Financial Fragility and Systemic Risk

The questions of how fragile the banking and financial system is and, if it is fragile, what are the consequences for the stability of the system (‘systemic risk’) and how should public policy cope with it in order to protect the economy, are among the most important economic issues of the day. The rash of bank failures and large and well publicized losses in the securities and newly developed derivatives markets in the 1980s and 1990s in many countries throughout the world have refocused attention on these questions for the first time since the widescale bank failures during the Great Depression of the 1930s.

The conference’s title, “Coping with Financial Fragility: a Global Perspective,” implies that financial fragility is a meaningful economic concept. Its existence, not always but from time to time, is accepted as an attribute of capitalist economies. However the structure of the dominant macro-and microeconomic theories of our time, which are built upon the modern version of Walrasian general equilibrium theory, ignores the financial dimensions of capitalist economies.¹ If economic theory is to be relevant, for the intensely financial world in which we live, then an economic theory which fully incorporates financial factors into the determination of the behavior in the economy is needed. Such a theory should not hold that financial factors are “exogenous shocks” to the economy or explain whatever malfunctioning of the economy that takes place as the result of the incompetence of central bankers.²

In his introduction to The Risk of Economic Crisis, a compilation of papers presented at a conference sponsored by the National Bureau of Economic Research (NBER), Martin Feldstein (1991, p. 1) recognizes that, despite the inability of less developed countries to service their debts, the massive collapse of savings and loan associations in the United States, wide swings in currency exchange rates, the increase in corporate and personal debt, and the stock market crash of 1987, we have not suffered an economic crisis in recent years. Nevertheless, he asserts:

But the risk of such an economic collapse remains. As Charles Kindleberger’s distinguished and fascinating book (Manias, Panics and Crashes: A History of Financial Crises [Basic Books,19781) has ably demonstrated, economic crises have been with us as long as the market economy. At some point, greed overcomes fear and individual investors take greater risks in the pursuit of greater returns. A shock occurs and the market prices of assets begin to collapse. Bankruptcies of leveraged individuals and institutions follow. Banks and other financial institutions fail in these circumstances because they are inherently leveraged. The resulting failure of the payments mechanism and the inability to create credit bring on an economic collapse (Feldstein, 1991, pp. 1–2).

This article addresses the question of how financial institutions, contracting forms, and government financial policies affect the degree of macroeconomic volatility. Models that posit such relationships are sometimes referred to as models of “financial fragility.” These models explore ways in which the financial system can add to the volatility of economic activity by defining sources of financial “shocks” and financial “propagators” of other shocks. Financial shocks are defined as disturbances to the real economy that originate in financial markets. Financial propagation refers to the ways in which financial contracts, markets, and intermediaries can serve to aggravate shocks that originate elsewhere. Economists have not always been receptive to the idea that financial arrangements matter for business cycles. From the standpoint of traditional neoclassical general equilibrium theory, financial arrangements (which include financial contracting, the actions of financial intermediaries, and government policies toward the financial sector) typically are viewed as epiphenomenal—simply as a set of mechanisms for executing ArrowDebreu contingent claims to allocate resources optimally. Mainstream macroeconomists and finance specialists of the 1960s seemed to agree.¹ Corporation financial decisions were neutral according to Modigliani and Miller (1958), with the addition of minor caveats to take account of physical bankruptcy costs and tax incentives; and firms all faced identical costs of funds adjusted for systematic risk factors according to the capital asset pricing model. Thus, there was no call to object to the standard IS-LM macroeconomic framework’s assumption that all firms effectively faced the same cost of funds (summarized by “the” interest rate) and that this cost equaled the marginal product of capital.

Huge losses suffered by users of off-exchange (or OTC) derivatives have created widespread concern that derivatives may be undermining the stability of financial markets. During the last 12 months alone companies have reported losing more than $10 billion on derivatives investments. A prime example is Metallgesellschaft A.G. (MG), Germany’s 14th largest industrial firm corporation, which reported losses of almost $1.5 billion as a result of a hedging strategy gone sour.¹ Only a massive $1.9 billion rescue operation by 150 German and international banks kept MG from going into bankruptcy. While MG did not default on its futures or swap obligations, had it done so the ramifications for some major international banks and for OTC derivatives markets in general may have been far-reaching. Substantial losses also have been reported by other large firms and investment funds: Orange County California ($1.5 billion), Showa Shell Sekiyu ($1.5 billion), Kash-ima Oil ($1.4 billion), Pacific Horizon Funds of Bank of America ($167.9 million), Procter & Gamble ($157 million), Air Products and Chemicals ($113 million), and Gibson Greetings ($19.7 million), to name just a few.² These incidents have left the clear impression that even sophisticated firms may not appreciate the potential risks associated with using derivatives, and that derivatives-related losses can be large enough to impair the solvency of even sizeable firms.

The articles by Minsky and Calomiris in this volume deal with the mechanisms through which financial factors contribute to business cycles, emphasizing the sources of the increased macroeconomic fragility and what public policies should be adopted in response.

The following comments are directed at two articles: “Is The Banking and Payments System Fragile?” by George J. Benston and George G. Kaufman (hereafter B-K), and “Systemic Risk in OTC Derivatives Markets: Much Ado About Not Too Much” by Franklin R. Edwards. The discussion of B-K is more extensive and comes first.

Market discipline “means that markets provide signals that lead borrowers to behave in a manner consistent with their solvency” (Lane, 1993, p. 55). It is a crucial element in “private sector solutions” to the problem of financial fragility. A different category of solutions are “regulatory solutions.” But the two categories are deeply connected, and market discipline towards financial safety cannot be separated from regulation. It is true that, to some extent, market discipline can replace government supervision and regulation. But, in the authors’ view, the main influence of market forces is to complement the efforts of supervisors and regulators (Gilbert, 1990, p. 3; Lane, 1993, p. 63). An adequate regulatory setting is needed for market disciplining mechanisms to be effective.

The 1974 failure of Herstatt Bank and the disruptions which hit financial markets ushered in an era of heightened concern about the potential vulnerability of payments systems, especially the wholesale large-value systems, to systemic risk and other problems. Systemic risk—the likelihood that a problem in one institution will cause the insolvency of healthy institutions—through runs, the creation of liquidity problems, or other forces, has been a major policy focus.¹

Financial institutions and markets occupy a pivotal position in the economy through their role in allocating funds and as the core of the payment systems. Moreover, financial intermediaries are in a unique position of trust in managing funds belonging to the general public. These considerations have led governments to legislate a plethora of regulations that are designed to enhance or maintain public confidence in financial markets. To a large degree, this regulatory emphasis reflects the worry that failure of financial intermediaries and chaotic episodes in securities markets can impair public confidence in t he financial system, which may lead to a massive withdrawal of funds from financial intermediaries. Obviously, such a crisis would cause a serious breakdown of the financial system in which not only investors would lose, but the entire economy would suffer. However, government regulation of the securities markets also reflects the concern for the protection of investors whose savings are invested either directly in the securities markets or entrusted to profesionally managed financial intermediaries.

We do not, in any real sense, have an integrated, truly global financial system. There are many financial institutions in the industrial countries, such as the majority of S&Ls in the United States, whose involvement with the global economy is minimal and indirect. There are countries, many in the developing world, for example, which have no indigenous international institutions of any global systemic significance, even though some of their local institutions are very large in terms of deposits or assets or some other measure. What is true, however, is that the dividing line between global and national (or regional) financial institutions has grown more vague and there are many more institutions that have some kind of international presence, or involvement, than in the past.

The purpose of this article is to evaluate the role of government regulation dealing with the risk that fragility of the financial structure may lead to a collapse of the system. Other papers presented at this conference deal with the possible sources of such a collapse—the payments system, international connections, or derivative securities—and with the likelihood that the system is fragile, and the extent to which private solutions maybe adequate to deal with the problem.

Payment system risks were the “major minor” banking policy issue of the 1980s. They were minor issues in that they were of interest mainly to the Federal Reserve System and to bank operations officers; they were major issues in that they supposedly involved significant risks and that they were a source of constant regulatory pressure on banks.

The increasing globalization of banking and finance means that autarky (self-sufficiency at the national level) is no longer a feasible strategy in financial regulation: there is the potential for regulation determined at the national level to be undermined by developments in other regulatory jurisdictions, and regulatory requirements in one country have impacts in others. This creates a standard case for international regulatory cooperation, as, given the externalities involved, cooperative strategies have the potential to increase the effectiveness of regulation, and limit the scope for regulatory arbitrage.

The optimization model built by F. Bruni and F. Paterno underlines, in the definition of the objective function and the constraints, some costs and benefits associated with the policy choice of bailout versus no-bailout. It would be of interest to introduce some other real costs, i.e., costs for the real economy. For example, the bailout policy could lead to systemic distortions (the “moral hazard” arguments) and to crowding-out effects generated by increased public expenditures. Conversely, the no-bailout policy could induce a cumulative loss of confidence, systemic repercussions, and short-run and long-run implications on investment, growth, employment, etc. In both cases, the policy has an impact on the real growth path. The channels and the intensity of this impact need to be analyzed more carefully by referring to dynamic models with a sufficient degree of integration of real and financial variables.

To quote from the latest BIS Annual Report,¹ which devotes a whole chapter to the subject:

Payment and settlement systems are to economic activity what roads are to traffic: necessary but typically taken for granted unless they cause an accident or bottlenecks develop (p. 172).

Since Maastricht has become even more famous than it was beforehand, as the site of the eponymous Treaty a few years ago, it is a perfect place to consider issues of international political economy. Then British concern at the prospective embrace of European federalism led to our opt-out from monetary union. On the subject of banking and financial regulation, however, the British have been in the forefront of those seeking international cooperation, both at the European (Brussels) and international (Basle) levels.

One of the reasons for this Conference on Financial Fragility is Hy Minsky’s continued attention over 40 years to the economic instability hypothesis: that the financial system in a market economy is inherently unstable. Hy more than any other economist in the last several generations has stressed the dependence of the real economy on the stability of somewhat fragile financial institutions.

The financial press in the United States is having a great time telling readers about the risks associated with financial derivatives. The casual reader might think that some new risks have been invented or, at a minimum, that our financial system is riskier now than a few years ago. Neither conjecture is true. New risks have not been discovered, and the financial market is not a riskier place.

Financial fragility means that the ability of the financial system to withstand economic shocks is weak. The basic reasion that the system is held to be fragile by proponents of a financial-fragility interpretation is that the financial services industry is supposedly inherently unstable. On this view, a loss of confidence in the institutions in that industry is an imminent possibility, with disruptive consequences for the real economy. The situation, however, is even more dire, according to the proponents, because financial fragility is not limited to the domestic system. It is easily transmitted internationally.

For most of you it is the first day, but for me it is the third. Since Wednesday I have been confined in a roomful of academics discussing financial fragility. That might sound dull, and indeed it started quietly, but by the end the mood was getting quite heated and indeed tempers were occasionally getting fragile.

It is a pleasure to attend a conference which brings together so many well-known names in financial and monetary economics, particularly in a city whose name is so closely associated with European monetary and financial integration. At the same time, the intellectual standards of my fellow participants makes it an obligation and a challenge to try to provide some new insight or vantage point from which to view the subject of financial fragility.

We are experiencing several general processes of change in the banking world:

Before I discuss the relationship between financial fragility and supervision, I would like to explain that there are different layers to be distinguished with regard to supervision.¹

To try to summarize the issues of “financial fragility” in ten minutes is a tall order, and I think you asked us all really to comment on the presentations of the speakers this morning and this afternoon. I hope you will forgive me, therefore, if I am selective in the issues I deal with.