ECON 7114 Money Banking and Financial Markets : Explaining Systemic In

Definitions and meaning:

The system which efficiently uses its resources, assess and manages monetary risks, maintains the employment rate close to country’s natural economic level and eradicates the relative price movements of assets of real or financial nature which may affects the financial stability or employment rates is known as a stable financial system.  It’s a state in which the financial market and institutions is less or unaffected to economic downturns and functions smoothly is a stable system. Whereas, the system in which there is no balance between supply and demand is known as unstable.  In stable state, the system absorbs the unwelcomed events or outcomes through self-adjusting processes and prevents from adverse and disruptive effects on the economic or financial systems while in un stable state, banks are hesitant to support the profitable ventures, asset prices fall unnaturally from their actual values and delay in payments. In adverse condition, it can lead to bankruptcy, hyperinflation or collapsing of stock markets (Breuer, 2004)

Explaining systemic instability

The systemic instability is considered as one of the most dreadful and alarming events in banking system. It is ambiguous and is an event which effects the entire banking, economy and financial system rather a single or limited institution (Bartholomew & Whalen, 1995). It not only affects the individual, business entity by a monetary difficulty spreading to other institutions and may lead to collapse of entire system. Its impact can be seen not only at regional or national level but at global level too. According to Kaufman, “the systemic risk is the risk of chain reactions that can lead to breakdown or collapsing of interconnected institutions”.

There are some measures by which the systemic risk can be assessed (Dragan,2013) :

• The macroeconomic or monetary data sheet being the aggregate indicators of inequalities which are used to show the strength of a risk in financial or economy as a whole.
• Buying capacity and risk-taking nature of individuals or entities can be considered as the indicators of financial markets.
• Risk concentration can be considered as an indicator in the financial system. This became into notice as it raised the query the thing which was missing in the analysis of economic stability before the crises of 2007 also known as contagion. The spreading of risk depends upon the inter connections between the financial systems, institutions, financial markets and economy of a nation.
• The implementation of risk maps or a band of compound indicators in an integrated monitoring system.
• The macroeconomic stress test can be considered as the fifth model for systemic risk assessment.

Causes of systemic instability

Systemic banking instability in were rare in past but the recent global crises and other events have made it relatively more common especially in the developing countries. Though are numerous that can lead to this instability some of them are (Dragan, 2013):

Credit risk mismanagement:

This can be defined as the probability of calculating the losses that may arise from the borrower’s inability to make the payment or debt taken. It is also known as directional credit. This situation arises when banks as an instrument is used in meeting the fiscal and economic policies or when there is a need of increasing the savings, high interest rate is used as a measure which results in moulding of rates to meet the requirements of borrower’s.

Currency Crises:

This can be one of the reasons of banking instability as in this case the banks which have borrowed money in foreign currencies or through other contracts incur huge capital losses due to the devaluation of the currency which results in reducing bank portfolio credit value.

Macroeconomic shocks:

The imbalance in the economic due to external or internal factors can be defined as macroeconomic shocks. When the funding cost of a bank rises sharply arising from the fixed rates on borrowing, banks try to mitigate the losses by investing heavily in short term maturities. This is long can lead to undercapitalization of banks.

Liberalizations in banking:

The liberalization without prudential supervision can lead to banking instability. This is similar to oligopoly, where national banks are protected from foreign banks which do not have any access to the financial market and non-banking financial institutions operating within the economy. This forces the newly formed banking bodies to provide their services at lower rate arising from lower capital cost. This makes the balances of the bank decline and hence will become undercapitalised. This will further lead to losing their loyal customers and increase the cost of funding.

Contagion:

This situation arises when two or more banks involved in derivative transactions may fail at the same time due to counterparty risk. For instance, if an institution A fails to achieve certain position with counter institution B, then both A and B will fail. Similarly, if B cannot establish its positions, then other associated parties will fail. Hence, a phenomenon like this should be analysed wisely from different perspectives so that there can be counter measures as it affects majority of institutions. The two types of externalities that poses risk to contagion are Pro cyclicality and common exposure. Pro cyclicality is value of goods or services moving in the same direction to that of the economy meaning its grows with the economy and vice versa. While the other being common exposure which increases the risk of instability as it is directly related to currency volatility. The decline in currency in one country can affects the revenue of a company having subsidiaries in other countries (Dobler, et al. 2016)

Effects of systemic risk

As we briefly studied the causes of systemic instability in banking sector, now we will analyse the various effects of systemic crisis over the economy. It not affects the debtors, creditors, depositors, managers, shareholders but even the supervisory committee.

The disintermediation in the banking system:

When banks become insolvent, this creates negative environment for the investors resulting in decrease in confidence of the shareholders, depositors, etc which further leads to massive withdrawals of cash. When the most of the customers default in the repayment of loan, then the bank have to write down the loans by giving them new value or even zero value. When it becomes evident that loan won’t be repaid then it removes it from the balance sheet. As a result, the bank’s asset value becomes less than it liabilities declaring the bank insolvent.

Similarly, when most of the depositors tries to withdrawals their cash then there comes a situation when the bank has no cash left to pay to its customers then this situation is known as illiquid.

The inefficient use of resources:

When banks try to revise their loan policy by restricting the funds to large borrowers who are facing problems in repayment of their loans which further leads to less investment due to negative environment. This effect is also known as crowding out effect.

Increase in interest rates:

The instability in the banking sector leads to increase in interest rates which further leads to decrease in investments and inflation. This leads to imbalance in the economy.

Ineffective monetary policy:

The monetary policy of any country plays a major role in maintaining the economic stability.

When banks are on the verge of insolvency, its monetary policy becomes ineffective.

Possible Cures of instability

Deleveraging:

It is one of the step which companies or institutions uses in time of economic crises to regain the trust of investors and shareholders. It tries to lower down the lower down the debt amount by generating cash from its operations or selling of its assets such as bonds, shares, divisions, real estate or sub diaries. It is adopted as a measure to reduce risk and avoid bankruptcy.

Interference of central bank (Lender of last resort):

 In time of crises, the central should come and bails out the companies or intuitions which are on the verge of bankruptcy. However, this practice should be promoted as banks then start taking more risk thinking they have central banks to rescue them in the time economic down town (Herr, Rudiger and Wu ,2016).

Macroprudential regulation

The macroprudential regulation should be adopted instead of micro as the macroprudential is only concerned with the safeguard of individual bank while the macroprudential is concerned with the complete stability of financial system. Micro-prudential is only concerned with the exogenous risks of individual bank and neglects the endogenous risk. In addition, it also neglects the systemic importance of individual institutions on the basis of size, limit of leverage, complexity and interrelations with the financial system (Brunner Meier et al, 2009).

This is why one of the main objective of macro regulation is to acts as a countervailing force to the uncalculated risk taken during the surge and increasing credit growth and proper risk assessment during the economic downtown (Ekpu, 2016).

Conclusion:

It is apparent that in banking sector the contagion has much wider effects and spreads relatively faster than other financial sectors. The attain the financial stability and to mitigate systemic risk and contagion, macroprudential regulation approach should be implemented. The monetary policy should be reviewed according to changing in market scenarios. The central should monitor the banks over their lending policies. Lastly, to gain the trust of the investors and shareholders the bank can also use concept of deleveraging.

References:

Ekpu, V. (2016). Micro-prudential Vs Macro-Prudential Approaches to Financial Regulation and Supervision.

Breuer, J. (2004). Banking instability, Conflict of Interest and Institutions. CIBER working paper, B-03-05.

Dragan, O. (2013) Systemic Risk in Banking Sector. The USV Annals of Economic and Public Administration.

Herr, H., Rudiger, s. and Wu, J (2016). The Federal Reserve as Lender of Last Resort During the Subprime Crises- Successful Stabilisation Without Structural Changes. Journal of Economic and Political Science.

Dobler, M. et al. 2016. The Lender of Last Resort Function after the Global Financial Crises. International Monetary Fund.