Resilience Of Financial System Research Articles

The Value of Bank Capital Buffers in Maintaining Financial System Resilience

There is a current controversy concerning the appropriate size of capital requirements for banks to mitigate systemic losses. We are the first in kind to quantify the size of capital buffers required to reduce systemic losses using loan loss provisions data for Australian banks from 2002 to 2014 and annual public accounts from 1978 to 2014. We find that first, during the stable times, banks’ multi-year loan loss rates are positively related to past loss rates and lagged loan growth and are inversely related to the deposit ratio, bank size and the GDP growth rate. Taking economic downturns into consideration, loss rates are negatively related to liquidity, but are positively related to deposit funding and size. Second, we simulate the distributions of bank losses and financial system losses in Australia for future periods. In doing so, we quantify the size of capital buffers required to significantly reduce systemic losses. Our results lend support moderate capital buffer increases.

Non-Traditional Risk Sources and Financial System Resilience

This paper identifies 20 non-traditional risk sources that may test the resilience of the financial system in the longer term.Non-traditional risk sources refer to societal, technological, geopolitical and environmental factors that may undermine the resilience of the global financial system. In essence, financial system resilience can be defined as the capacity to continuously perform the primary functions, in particular supporting the real economy and enhancing societal well-being.Examples of these non-traditional risk sources include:- Societal factors, e.g. rapid ageing of populations may undermine the financial sustainability of retirement provisioning schemes which will challenge societal well-being. Pension schemes are key sources of capital within the global financial system.- Technological factors, e.g. data security issues and the risk of identity theft may undermine the trust of in the – largely electronic – financial system.- Environmental factors, e.g. severe carbon constraints may lead to stranded assets for oil companies and other industries that are highly dependent on fossil fuels. This will negatively affect the assets of institutional investors with large exposures in those sectors.- Geopolitical factors, e.g. major political and military conflicts, or lack of supranational regulation, may also challenge the resilience of the financial system.Many of these factors can be considered as “non-traditional risk sources” as most financial institutions and financial supervisors take these factors less into account in their conventional risk management processes. Admittedly, what is non-traditional for some sectors may be quite common for others. For example, analysing the risks of floods (climate change) or the outbreak of a virus may be relatively new for banks, but is standard practice in the casualty insurance industry.This report aims to broaden the perspective of risk managers, investors, supervisors and regulators of financial markets on where “the next financial crisis” may come from. Clearly, additional research is needed. For example, prioritising these risk sources (e.g. likelihood, impact, complexity) and defining risk mitigation mechanisms at organisational and system-wide level.The publication has been developed in close collaboration with the Executive Fellow community at Duisenberg school of finance (DSF). Executive Fellows are leading financial services executives, professionals and policymakers who are actively involved in DSF research and dialogue activities.

The Regulation of Financial Derivatives: An Agent-Based Model Approach.

In 2007-08, the world experienced the greatest financial crisis since 1929, which turned – in the following years – in one of the deepest and most prolonged periods of economic stagnation of modern history. While there were multiple conditions that originated the so-called Great Financial Crisis, a general consensus emerged that financial derivatives played an important role in the outbreak of the crisis and in posing a credible threat that the entire global financial system could melt down. As a reaction, several countries in the world and international organizations agreed on a policy response to reformulate the global architecture for the regulation of the financial system, including the financial derivatives industry. Yet, the fundamental question of whether the contemporary system of derivatives regulation can effectively shield the financial system from sources of systemic risk is still undecided, for reasons that especially relate to the complexity of the networked structure of the financial derivatives industry. As a way to contribute to tackle this issue, this work aims to investigate whether an important component part of the present system of financial derivatives regulation – namely, Central Counterparts (CCPs) Clearing Houses – provide a more resilient financial system. The research question is addressed through a simulation approach based on an agent-based modeling of the financial derivatives industry. The results of the simulation show that the introduction of a CCP improves the resilience of the simulated financial derivatives industry, although it does not completely shield the financial system from disruptions that may especially depend from the degree of interconnectedness of financial operators and the magnitude of defaults. In sum, this work offers some methodological guidance for enriching the repertoire of tools at disposal of financial regulatory authorities in anticipating the consequences of interventions in the financial industry.

Macroprudential regulation under repo funding

The use of collateral has become one of the most widespread risk mitigation techniques. While it brings stabilizing effects to the individual cash lender, it may exacerbate systemic risk by accelerating bank deleveraging under funding stress. We show how a liquidity shock to the cash lender may propagate as a solvency shock via liquidity hoarding even if the cash lender remains solvent in all states of nature. Albeit a privately optimal response of the cash lender to a liquidity shock, bank deleveraging may lead to excessive bankruptcy among its borrowing counterparties while, at the same time, triggering contagion across asset classes. To buttress financial system resilience, we lay out a menu of macroprudential policies that deactivate this channel of financial contagion.

Shadows and Mirrors: The Role of Debt in the Developing Resolution Strategies in the U.S., U.K., and European Union

In response to the 2008-10 financial crisis, international standard setters and national authorities have sought to create a more resilient financial system while fashioning statutory frameworks and strategies to make the resolution of so-called systemically important financial institutions (“SIFIs”) possible. The effort to create more resilient SIFIs has included significantly higher capital and liquidity requirements as well as restrictions in some countries on the activities in which banks can engage. The initiatives designed to make SIFIs resolvable have focused on adopting common resolution tools - such as the authority to place companies into insolvency proceedings, impose losses on equity and debt-holders, restructure their operations, and maintain critical functions - and on identifying viable strategies to resolve globally active SIFIs. Those strategies have begun to coalesce around approaches that focus on restructuring and recapitalizing the failing SIFI through the bail-in or conversion of debt into a new capital base. This approach places a particularly emphasis on the role of debt as a source for new, bailinable equity to recapitalize the SIFI. This paper examines some of the differences in the approaches taken in the US, UK, and European Union and the possible implications for the industry and the financial system.

Rethinking financial stability: Challenges arising from financial networks’ modular scale-free architecture

We examine the connective architecture of the main Colombian payment and settlement systems in order to update what we know about local financial networks, and to elaborate on the main consequences for financial stability. Evidence suggests that local financial networks display a modular (i.e. clustered) scale-free (i.e. inhomogeneous) architecture. Results concur with other real-world networks, and propose new insights and challenges for authorities contributing to financial stability. For instance, (i) traditional reductionist assumptions for modeling financial systems (e.g. homogeneity) may be particularly misleading; (ii) the observed modular scale-free architecture favors robustness and resilience; (iii) the generating process of such architecture overlaps with literature on trading relationships; (iv) carelessly reducing inhomogeneity in financial systems may backfire in the form of a less robust and less resilient financial system; and (v) financial authorities should understand and take advantage of the existing architecture by means of designing and implementing macro-prudential regulation and system-calibrated requirements.

Aspects of Regional Financial Stability: A Policy Approach

The soverign debt crisis in Europe and the withdrawal of funds from the Asian markets (similar to capital outflows from Asia after the collapse of the Lehman Brothers) have highlighted the importance of more resilient regional and national financial systems in Asia. Regional architectures such as ASEAN, ASEAN plus six and the East Asia Summit are part of the process that may contribute to the emergence of a more resilient financial system in Asia. This paper analyses some of the financial issues that could contribute to the develoment of a more resilient global financial system and contribute to regional financial stability.

New Requirements of the Basel Committeee on Banking Supervision to Capital as a Measure to Ensure the Stability of the Banking Sector

In this paper is devoted to problems of the introduction of new capital and liquidity standards proposed by Basel III. In particular, the authors critically analyze the lack of rigidity of the new requirements especially with respect to systemically important financial institutions. They also emphasize the necessity of macroprudential regulation to build more resilient financial system. DOI: 10.5901/mjss.2014.v5n24p294

How Could Macroprudential Policy Affect Financial System Resilience and Credit? Lessons from the Literature

The first, the allocation channel, operates through the constraints and incentives of financial institutions. By employing regulatory tools that affect the cost-benefit trade-offs of financial decisions, the authority would incentivise financial institutions to reallocate their resources across alternative investments. During credit booms, for example, raising the countercyclical capital buffer would help enhance resilience and could dampen excessive balance sheet expansion. Conversely, lowering this buffer during a downturn would discourage banks from excessive deleveraging, provided that the remaining capital buffer is judged to be adequate to absorb future losses with a sufficiently high probability. In a post-crisis environment, however, some banks’ pre-crisis capitalisation may prove to be insufficient to absorb losses and confidence in the sector could, as a result, be low. Low capital levels may hamper banks’ access to funding markets and, ultimately, impair bank lending. Requiring undercapitalised banks to raise their capital levels could, in such circumstances, help underpin a sustained recovery of credit growth.

A network model of financial system resilience

We examine the role of macroeconomic fluctuations, asset market liquidity, and network structure in determining contagion and aggregate losses in a stylized financial system. Systemic instability is explored in a financial network comprising three distinct, but interconnected, sets of agents – domestic banks, overseas banks, and firms. Calibrating the model to advanced country banking sector data, this preliminarily model generates broadly sensible aggregate loss distributions which are bimodal in nature. We demonstrate how systemic crises may occur and analyse how our results are influenced by firesale externalities and the feedback effects from curtailed lending in the macroeconomy. We also illustrate the resilience of our model financial system to stress scenarios with sharply rising corporate default rates and falling asset prices.

Macroprudential Banking Regulation: Does One Size Fit All?

The macroprudential regulatory framework of Basel III imposes the same capital and liquidity requirements on all banks around the world to ensure global competitiveness of banks. Using an agent-based model of the financial system, we find that this is not a robust framework to achieve (inter)national financial stability, because efficient regulation has to embrace the economic structure and behavior of financial market participants, which differ from country to country. Market-based financial systems do not profit from capital and liquidity regulations, but from a ban on proprietary trading (Volcker rule). In homogeneous or bank-based financial systems, the most effective regulatory policy to ensure financial stability depends on the stability measure used. Irrespective of financial system architecture, direct restrictions of banks’ investment portfolios are more effective than indirect restrictions through capital, leverage and liquidity regulations. Applying the model to the Swiss financial system, we find that excessively increasing regulatory complexity has destabilizing effects. These results highlight for the first time a necessary change in regulatory paradigm to ensure effectiveness and efficiency of financial regulations with regards to fostering financial system resilience.

A Network Model of Financial System Resilience

We examine the role of macroeconomic fluctuations, asset market liquidity, and network structure in determining contagion and aggregate losses in a financial system. Systemic instability is explored in a financial network comprising three distinct, but interconnected, sets of agents – domestic banks, international financial institutions, and firms. Calibrating the model to advanced country banking sector data, we obtain sensible aggregate loss distributions which are bimodal in nature. We demonstrate how systemic crises may occur and analyze how our results are influenced by firesale externalities and the feedback effects from curtailed lending in the macroeconomy. We also illustrate the resilience of our model financial system to stress scenarios with sharply rising corporate default rates and falling asset prices.

A Network Model of Financial System Resilience

We examine the role of macroeconomic fluctuations, asset market liquidity, and network structure in determining contagion and aggregate losses in a stylised financial system. Systemic instability is explored in a financial network comprising three distinct, but interconnected, sets of agents - domestic banks, overseas banks, and firms. Calibrating the model to advanced country banking sector data, this preliminary model generates broadly sensible aggregate loss distributions which are bimodal in nature. We demonstrate how systemic crises may occur and analyse how our results are influenced by fire-sale externalities and the feedback effects from curtailed lending in the macroeconomy. We also illustrate the resilience of our model financial system to stress scenarios with sharply rising corporate default rates and falling asset prices.

Developing Asia and the global financial regulatory agenda

The objective of global regulatory reform is to build a resilient global financial system that can withstand shocks and dampen, rather than amplify, their effects on the real economy. Lessons drawn from the recent global financial crisis have led to specific reform proposals with concrete implementation plans at the international level. Yet, these proposals have raised concerns of relevance to Asia's developing economies and hence require further attention at the regional level. We argue that global financial reform should allow for the enormous development challenges faced by developing countries – while ensuring that domestic financial regulatory systems keep abreast of global standards. This implies global reforms should be complemented and augmented by national and regional reforms, taking into account the very different characteristics of emerging economies’ financial systems from advanced economies. Key areas of development focus should be (i) balancing regulation and innovation, (ii) establishing national and cross-border crisis management and resolution mechanisms, (iii) preparing a comprehensive framework and contingency plan for financial institution failure, including consumer protection measures such as deposit insurance, (iv) supporting growth and development with particular attention to the region's financial needs for infrastructure and for SMEs, and (v) reforming the international and regional financial architecture.

Stress Tests for Defined Benefit Pension Plans: A Primer

Stress testing is a useful and increasingly popular, yet sometimes misunderstood, method of analyzing the resilience of financial systems to adverse events. This paper aims to help demystify stress tests and illustrate their strengths and weaknesses. Using an Excel-based template with institution-specific data, readers are walked through the basics of liability valuation and stress testing of assets and liabilities of a typical defined benefit plan.

Stress Tests for Defined Benefit Pension Plans - A Primer

Stress testing is a useful and increasingly popular, yet sometimes misunderstood, method of analyzing the resilience of financial systems to adverse events. This paper aims to help demystify stress tests and illustrate their strengths and weaknesses. Using an Excel-based template with institution-specific data, readers are walked through the basics of liability valuation and stress testing of assets and liabilities of a typical defined benefit plan.

Regulating credit rating agencies: The issue of conflicts of interest in the rating of structured finance products

As a result of the financial crisis, the work of the credit rating agencies (CRAs) has been questioned. It is said that they underestimated the risk in structured finance products and allowed conflicts of interest (for example, the issuer-pays model) to affect their ratings. Consequently, the regulatory frameworks have been reviewed. This article reflects upon the ongoing debate and suggests that the issue of conflicts of interest should be approached in a complete and coherent manner; in addition to regulating CRAs, other contributing factors need to be addressed. As a result, three different proposals are put forward. First, it is argued that regulation of CRAs is necessary, but with more global convergence and less detailed provisions than under current regimes. Accordingly, the introduction of a global, principles-based rulebook is advocated. Second, it is suggested that CRAs should be held civilly liable for malfeasance to the same standards of negligence as those applying to other institutions, which is not the case today because of a ‘privileged’ regulatory treatment. Finally, a case is made for less reliance on ratings since that would increase market heterogeneity, thereby contributing to a more resilient financial system that is less susceptible to the potential effects of conflicts of interest in CRAs.

Financial crisis enforcing global banking reforms

Purpose – The purpose for writing the paper is to emphasize the need for global banking reforms so as to prevent future economics crisis.Design/methodology/approach – The methodology followed is based on literature review and secondary data.Findings – This was found that banking crisis can be prevented in future by the following methods such as regulating systemic risk; separating proprietary trade; information transparency; creating a robust and resilient financial system etc.Practical implications – The creation of a new systemic risk regulator, either at the national or international level would be helpful if it could warn about the major existing systemic risks, including the exploding debt, central banks' balance sheet, and the bailout mentality. The groups such as the Financial Stability Board, working along with the IMF and G20, are better suited to that role.Originality/value – In the wake of the crisis, policymakers around the world are looking for ways to fix the international financial system. ...

Policy framework for effective and efficient financial regulation

The structure and operation of the financial system have undergone marked changes in the past couple of decades, driven by dramatic improvements in technology, rapid product innovation, integration of financial systems, competition in financial services, and policy, regulatory, and trade reforms. These developments have led to a dynamic, sophisticated, and global financial services arena which fostered economic growth. Yet, the financial and economic crisis has brought to the fore many inappropriate or ill-adapted elements of our approach to financial regulation. The crisis has forced us to think hard about the financial system: how it works, the objectives it should fulfil, and the tools and policies to help shape it. The Policy Framework for Effective and Efficient Financial Regulation, supported by General Guidance and a High-Level Checklist, is a tool that can support ongoing efforts by policymakers, regulators, and supervisors to achieve a stronger, more resilient financial system. It is not meant to substitute for the more focused, micro-prudential principles and guidelines of international standard-setting bodies. But it can guide our strategic thinking and promote governmental leadership and action so that the financial system can play its vital role in the functioning of the economy, both domestically as well as globally. The Policy Framework, including the General Guidance and High-Level Checklist, is the product of work by the Committee on Financial Markets and the Insurance and Private Pensions Committee, and was the subject of a broad public consultation. The Policy Framework challenges policy makers to think about the fundamentals of financial regulation in a globalised financial system. It also invites them to improve their understanding of the financial system and work in close cooperation with other countries to develop proper tools and instruments so that public policy objectives are met. I hope that policymakers will use the Policy Framework in setting national policy and in working with international partners.

Impact of Regulatory Reforms on Large and Complex Financial Institutions

Financial sector reforms are being considered to address the risks posed by large and complex financial institutions (LCFIs). The vast majority of global finance is intermediated by a handful of these institutions with growing interconnections within and across borders. Common trends that contributed to the recent global crisis included sharp increases in leverage, significant reliance on short-term wholesale funding, growth of off-balance-sheet activities, maturity mismatches, and increased share of revenues from complex products and trading activities. The key objective of the financial sector reforms is to promote a less leveraged, less risky (or better cushioned), and thus a more resilient financial system that supports strong and sustainable economic growth. The recent proposals of the Basel Committee on Banking Supervision (BCBS) on capital standards represent a substantial improvement in the quantity and quality of capital in comparison with the pre-crisis situation. The analysis of this paper suggests that, subject to usual caveats associated with limited data disclosures and availability, phase-in arrangements will allow most banks to move to these higher standards through earnings retention, assuming a modest economic and earnings outlook. It also suggests that should banks generate strong earnings in the coming years, and distribute lower dividends, they could rebuild common equity capital ratios faster than required under the current phase-in periods. The analysis of the paper also suggests that the new capital standards will have a significant impact on investment-banking-type activities, including through tighter requirements for trading book exposures. Investment banking activities will also be affected by a host of other regulatory initiatives, including the new accounting rules and higher standards for securitization, derivatives, and trading businesses, as well as measures to restrain certain activities. Yet, LCFIs with an investment banking focus have flexible business models and can adjust their strategies easily to mitigate the effects of the regulatory reforms, notwithstanding a multitude of regulations affecting their activities. The ultimate effect of the reforms on business models remains to be seen until the regulations take their final shape.