First published in One Issue Two Voices (Woodrow Wilson International Centre) - https://www.wilsoncenter.org/publication/one-issue-two-voices-systemic-financial-risk
By: Anita Anand
Since the 2008 financial crisis, regulators have been preoccupied with the notion of systemic risk in financial markets, believing that such risk could cause the markets they oversee to implode. At the same time, they have demonstrated an inability to develop and implement a comprehensive policy to address systemic risk. This inability is likely due not only to the ambiguity inherent in the term, “systemic risk,” but also to existing institutional structures which, because of their mandates, ultimately make it difficult to regulate risk across an entire economic system. These two considerations —defining systemic risk and developing appropriate institutional structures— are central to any discussion of systemic risk.
The term systemic risk inspires ambiguity, despite the volumes of academic writing in this area.While many agree that systemic risk refers to the interconnectedness of financial institutions in such a way that the failure of one may lead to the failure of others, they
disagree about specifics, including the extent to which the risk should be specified and whether the contemplated collapse relates to financial institutions only or to the entire economic system.
This essay analyzes the term systemic risk, ultimately arguing that it has grown to refer not simply to the failure of financial institutions but also to events that cause volatility in capital
markets more generally.
The essay is divided into three main sections, followed by a brief conclusion. The first section, “What Is Systemic Risk?” focuses on issues relating to definition. It also examines the concept of “macroprudential regulation,” which, broadly speaking, is policy that seeks to mitigate systemic risk. The second, “Systemic Risk and the Canadian Financial System,” examines the asset-backed commercial paper (ABCP) crisis and, in so doing, points to aspects of the Canadian economy that can give rise to systemic risk. The third section, “Regulating Systemic Risk,” discusses the possible policy responses to these issues, culminating in a discussion of the Canadian federal government’s new proposal for a cooperative regulatory authority.
WHAT IS SYSTEMIC RISK?
Most commentators agree that there is no universally accepted definition of systemic risk. It comes as no surprise, then, that a primary criticism lodged against proponents of regulating systemic risk is that the term defies precise definition: “If we cannot define it, how can we regulate it?” An examination of the academic literature, as well as writings and speeches of policy makers during and following the financial market crisis, suggests that the term systemic risk has itself evolved over time. While originally conceived as the failure of one financial institution that in turn causes the domino-style failure of others, systemic risk now
generally describes a possibility of financial meltdown that affects an entire economic system.
Traditionally, the literature has focused on the concept of systemic risk in the financial sector alone, referring to a triggering event that causes a chain of negative economic consequences.Crockett explains this domino-style effect as follows:
For banks, this effect may occur if Bank A, for whatever reason, defaults on a loan, deposit, or other payment to Bank B, thereby producing a loss greater than B’s capital and forcing it to default on payment to Bank C, thereby producing a loss greater than C’s capital, and so on down the chain.
Thus, the traditional definition of systemic risk relates specifically to financial institution failure
brought on by defaults in contractual relationships between and among institutions. The risk of a domino effect is central to this conception of systemic risk, as is the risk of some triggering event that occasions the fall of the first domino.
To give one example, these features are apparent in the definition of systemic risk
adopted by the Supreme Court of Canada: [R]isks that occasion a ‘ domino effect’
whereby the risk of default by one market participant will affect the ability of others to fulfill their legal obligations, setting off a chain of negative economic consequences that
pervade an entire financial system.
Unfortunately, this traditional definition has several problematic ambiguities. For example, at what point must the “risk” crystallize in order to be referred to as “systemic”? Is evaluation of the risk possible only after the financial institution has failed (for example, by declaring bankruptcy)? If only one financial institution fails, and others survive because of government
intervention, does systemic risk arise? What type of triggering event can cause systemic risk—only the failure of financial institutions to meet their contractual obligations? The traditional definition leaves all of these questions, and others, unanswered.
These ambiguities have led John Taylor, a professor of economics at Stanford University, to develop a more structured definition. He highlights three components of any definition of systemic risk: the risk of a large triggering event; the risk of financial propagation of such an event through the financial sector; and macroeconomic risk that the entire economy will
The triggering event can arise from the failure of a financial institution, as described above; however, as Taylor explains, it may also arise from an exogenous shock—such as a terrorist attack (9/11) or a natural disaster—and the contracting of liquidity in the public sector.
While Taylor’s three-part definition of systemic risk leaves room for questions (for example, what is “financial propagation”?), at the very least it suggests that the term can (and should) be interpreted more broadly to include risks that not only occasion the failure of financial institutions but also destabilize an entire economy.
Along these lines, Kaufman and Scott explain that the term “refers to the risk or probability of breakdowns in an entire system, as opposed to breakdowns in individual parts or components, and is evidenced by co-movements (correlation) among most or all of the parts.”
Similarly, Dijkman asserts that “systemic risk usually refers to financial shocks that are likely to be serious enough to damage the real economy.” Thus, a link is drawn between the financial markets and the “real economy,” that is, the economy concerned with producing and consuming goods and services as opposed to buying and selling financial products.
Policy makers, it appears, have also adopted a more general understanding of systemic risk than merely the domino-style failure of financial institutions. For example, Bank of England governor Mark Carney refers to the “probability that the financial system is unable to support economic activity.” Similarly, former Federal Reserve chairman Ben Bernanke writes that the concept of systemic risk should be broadly defined to include “developments that threaten the stability of the financial system as a whole and consequently the broader economy, not just that of one or two institutions.”
Even with a broad understanding of “systemic risk” the question arises as to whether the existence of systemic risk is discoverable ex ante (before the risk arises) or only ex post
(after a breakdown in the financial system has made the risk evident). The development
of policy relating to the mitigation of systemic risk depends on the ability to make predictions and determine whether those predictions are valid. There were moments before the crisis in the United States when regulators could have responded to systemic risk. For example, the former chair of the Commodity Futures and Trade Commission (CFTC), Brooksley Born, is
widely acknowledged to have predicted the crisis in over-the-counter (OTC) derivatives before the 2007 financial market crash. Yet the U.S. Congress moved to enact legislation that prevented the CFTC from taking any pre-emptive regulatory action.
If we agree that systemic risk may in fact require regulation, then we move into the sphere of “macroprudential regulation,” a term that refers to a definite intention by regulators to respond to systemic risk (above and beyond merely identifying it). The Group of Thirty has declared that “macroprudential policy is concerned not only with systemic risk but also
with developing the appropriate responses to those risks in order to strengthen the financial system and avoid similar crises in the future.”
The focus is on “the interconnectedness of financial institutions and markets, common exposures to economic variables, and procyclical behaviors [that] can create risk.” The
reforms contemplated below modify this concept by seeking to ensure that any regulatory response to crises takes account of common institutions and markets.
SYSTEMIC RISK AND THE CANADIAN FINANCIAL SYSTEM
Some commentators may have difficulty discussing systemic risk in the Canadian context—and not only because of the definitional issues associated with the concept. Canadian capital markets fared relatively well during the recent financial crisis, and it could be argued that systemic risk has not been an issue for Canadian regulators, especially given that, historically, the Bank of Canada has regulated at least the clearing and settlement process.
However, there are aspects of the Canadian economy that can give rise to systemic instability—as, for example, with the asset-backed commercial paper (ABCP) crisis (discussed below). Many commentators rightly point to the efficacy of Canada’s regulatory framework in safeguarding against financial contagion.
Nevertheless, a consensus seems to be emerging regarding certain sources of systemic
risk, perhaps applicable in any jurisdiction, which augmented the scale of the financial crisis.
These sources include regulatory capital requirements, credit ratings,derivatives trading, registration exemptions, clearing and settlement systems, lending standards, and securitization. Conflicts of interest or other moral hazard problems are also endemic in Canada —particularly those associated with creditors (bank and non-bank), rating agencies, monoline (specialized) insurance policy providers, and distribution agents (dealers and investment advisors) — which may contribute to systemic risk.
The importance of these factors became evident during Canada’s ABCP crisis.The collapse of the ABCP market involved “conduits”—trusts holding pools of assets that issue notes or commercial paper—established and managed by sponsors (corporations, banks, or other third parties that provided standby liquidity to the conduits), while ratings agencies rated
the ABCP, and investment dealers marketed and sold it to investors. Experts agree that the U.S. subprime mortgage crisis was the catalyst for the near collapse of Canada’s ABCP market, which was averted through restructuring pursuant to the Companies’ Creditors
Arrangement Act under the guidance of Purdy Crawford.Had the $32 billion ABCP market collapsed, the default would have propagated throughout our financial system. Thus we must ask, what aspects of the ABCP crisis gave rise to a near systemic collapse?
Responding to this question may shed light on the value of regulating systemic risk after the crisis, an issue discussed in more detail in “Regulating Systemic Risk” below.
ABCP was distributed almost exclusively in the exempt market, with little oversight relative to that exercised over issuers of securities (and their disclosure) in the public markets.That said, ABCP could be issued without prospectus-level disclosure, although some information did accompany the distribution of these securities: the distributing entities provided an information memorandum, a legal opinion, and a report by the associated rating agency, which in all cases was the Dominion Bond Rating Service (DBRS).
What factors gave rise to the ABCP crisis? First, ABCP issuers were exempt from securities law prospectus requirements, which would have mandated a certain level of disclosure with respect to the notes or commercial paper being issued. Second, non-bank sponsors of ABCP issuers, for example Coventree Inc., were not subject to regulatory supervision in
t hat capacity. Third, domestic and foreign banks, as well as non-bank financial institutions, also acted as liquidity providers to the ABCP conduits, providing them with standby lines of credit. Many such liquidity providers were not subject to capital requirements and were otherwise minimally regulated (if the provider was not a financial institution). Fourth, the conduct of rating agencies that approved the securities (in this case DBRS) was unregulated.
Fifth, the risks borne by ABCP were passed on to the public by investment dealers and salespeople, who, while subject to “know your client” and “suitability” rules administered by
the Investment Industry Regulatory Organization of Canada (IIROC), were not subject to any explicit fiduciary duties.
More broadly, the ABCP crisis demonstrates that various aspects of Canada’s financial system were poorly regulated. Regulatory authorities failed to act in a coordinated manner, which in turn allowed the ABCP crisis to evolve more quickly and to reach greater proportions than if regulators had worked together to forestall it. Thus, the diffusion of regulatory oversight (different bodies overseeing different aspects of the same market) reduced the ability of these bodies to appreciate the size and scope of the crisis and to act
effectively ex ante to contain its effects.
In hindsight, the failure of regulators to oversee the ABCP market suggests that there were gaps in financial market regulation. Hindsight tells us that crises in markets outside Canadian borders can have vast effects on similar markets inside Canadian borders: the ABCP market and its relation to the U.S. subprime crisis is a key example. It also tells us that coordination among regulatory bodies on an ongoing basis is likely to be beneficial.
REGULATING SYSTEMIC RISK
The traditional focus of prudential regulation has been to supervise financial institutions and, in particular, the soundness of their financial condition. By contrast, securities regulation has been concerned with investor protection and market efficiency. Managing systemic
risk has not traditionally fallen squarely within the mandates of either of these regulators, though central banks have undertaken this task to some degree. In particular, the Bank of Canada has held statutory responsibility since 1996 for overseeing and controlling
systemic risk in the context of clearing and settlement systems.
A common thread running through the legal mandates of all of these bodies—securities regulators, monitors of financial institutions, and central banks—is that the same consumer base is ultimately served under each regime. In all likelihood, however, central banks and prudential regulators would not view their mandate as one about consumer protection. Central banks seek to reduce risk in the financial system. Prudential regulators seek to supervise financial institutions, limit their risk-taking, and ensure that they meet capital requirements. But the effect of both central banking and prudential regulation is to ensure
that consumers in our society are protected and, in the case of prudential regulators, that their funds are safely maintained. This understanding of the ultimate beneficiaries of central banking and prudential regulation is fundamental to my argument here. But even once we accept this point—and in particular that the stability of the financial system and its institutions ultimately serves consumers —the question of who should have comprehensive oversight of systemic risk in financial markets remains open.
A first option is to retain the status quo. Under the passport system, established in 2003 by the Canadian Securities Administrators (CSA), if an issuer or investment dealer complies with the rules of one jurisdiction, it is deemed also to be in compliance with those of the other participating jurisdictions. The main problem with relying on the CSA to manage systemic risk is that, because of its non-mandatory nature, no true and timely national response can take place under its purview; at any point, provinces can refuse to participate in an initiative. This gap may be why even those who object to a national securities regulator argue that the
current system requires reform and that a pan-Canadian body is preferable.
A second policy option, one ultimately chosen by the federal government, is to pass federal legislation rather than relying on the CSA. This option engages constitutional considerations particular to Canadian federalism that are mostly beyond the scope of this essay. In brief,
however, securities law in Canada has historically been exclusively under provincial jurisdiction. The Supreme Court of Canada has recently rejected draft federal legislation designed to create a single pan-Canadian securities regulator that would address broader issues of systemic risk as well as more day-to-day matters of securities regulation. Nevertheless, the Court also held that managing systemic risk and national data collection are areas within the federal government’s constitutional jurisdiction.The Court suggested a
“cooperative approach” that “recognizes the essentially provincial nature of securities regulation while allowing [the federal government] to deal with genuinely national concerns.”
In response to the Securities Reference, the federal government and participating provinces have introduced two pieces of draft legislation. The first is the provincial and territorial
Capital Markets Act (CMA) and the second is the federal Capital Markets Stability
Act (CMSA). These Acts would form the Capital Markets Regulatory Authority (CMR A) – a separate body with a specific mandate to focus on systemic risk and to ensure information sharing among existing regulators.This body would have legislative authority to oversee securities markets, especially in times of financial crisis. As a joint federal-provincial
regulator, it would comprise provincial representatives (likely from current securities commissions), and would seek counsel from the relevant institutions: the federal Department of Finance, the Office of the Superintendent of Financial Institutions (OSFI), the Canada Deposit Insurance Corporation, the Financial Consumer Agency of Canada (FCAC), and the Bank of Canada. The CMRA would be charged with assessing systemic risks on a regular basis and discussing measures to mitigate those risks. In this context, systemic risk is defined as “a threat to the stability of Canada’s financial system that originates in, is transmitted through or impairs capital markets and that has the potential to have a material adverse effect on the Canadian economy.”
The powers in the proposed federal statute, including the definition of “systemic risk,” are broad and the parameters of legitimate action by the regulatory body are undefined, at least to some extent. This ambiguity is perhaps necessary given the amorphous nature of the concept. However, from a pragmatic standpoint, questions arise: What constitutes a “threat”
that “impairs capital markets” or that has “a material adverse effect on the Canadian economy”? Market participants will be struck by the lack of certainty and predictability inherent in the statute. The ambiguity was exacerbated by the proposed regulation of “systemically important entities” (SIEs), including market infrastructure entities, credit rating organizations, and capital markets intermediaries. While this concept has been removed in the most recent iteration of the draft legislation, the concept of systemic risk is to be newly
regulated in Canadian law, and the consequences of the proposed legislation are, without question, significant.
While the term systemic risk contains ambiguities and has, in the past, been narrowly construed as pertaining solely to the successive failures of financial institutions in a domino-like fashion, the concept should be broadly interpreted to refer to the possibility of financial meltdown of an entire economic system. Developing a systemic risk policy requires research,
institutional coordination, and legal input. As the world is certain to experience another financial crisis, it is imperative that such coordination among regulators occurs, both within and across countries.