Latest Update May 2000
Any type of risk can cause a disruption at a firm and since risk arises in the course of ordinary activities, it can never be completely eliminated. But the risk that a disruption (at a firm, in a transfer system) causes widespread difficulties at other firms, or in other market segments; i.e. the risk of contagion, must be contained and possible eliminated. Why? Because such a failure could cause, at the extreme, a complete breakdown in a financial system due to the extensive linkages of today's markets. The risk of contagion arising from a disruption at a firm or in one market is known as systemic risk.
Systemic safety is the flip side of systemic risk. There is widespread acceptance that regulators and central banks have an important role to play in promoting systemic safety and protecting against systemic risk. Their conundrum is to weigh the merits of measures promoting systemic safety against the foregone benefits of the activities that would be curtailed or eliminated by such measures.
That systemic safety can be threatened by the failure of one small institution was vividly demonstrated in September 1998 when the US Federal Reserve Bank organised a rescue of a hedge fund, Long-Term Capital Management, because it feared the fund's collapse would spark off havoc in the financial markets. LTCM had market exposures of over $200 billion while its capital base was about $4.8 billion.
In its report on the LTCM debacle, the US President’s Working Group on Financial Markets notes, "the events in global financial markets in the summer and fall of 1998 demonstrated that excessive leverage can greatly magnify the negative effects of any event or series of events on the financial system as a whole." The group continues, "The principal issue arising out of the events…is how to constrain excessive leverage. By increasing the chance that problems at one financial institution could be transmitted to other institutions, excessive leverage can increase the likelihood of a general breakdown in the functioning of financial markets."
The report, titled President’s Working Group on Financial Markets on "Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management" (1999) recommends a number of measures to constrain such excessive leverage. These measures are:
- More frequent and meaningful information on hedge funds should be made public.
- Public companies, including financial institutions, should publicly disclose additional information about their material financial exposures to significantly leveraged institutions, including hedge funds.
- Financial institutions should enhance their practices for counterparty risk management.
- Regulators should encourage improvements in the risk-management systems of regulated entities.
- Regulators should promote the development of more risk-sensitive but prudent approaches to capital adequacy.
- Regulators need expanded risk assessment authority for the unregulated affiliates of broker-dealers and futures commission merchants.
- The US Congress should enact provisions proposed by the President’s Working Group to support financial contract netting.
- Regulators should consider stronger incentives to encourage offshore financial centres to comply with international standards.
The thought that a mere hedge fund, albeit one that was highly-leveraged, could have caused financial melt-down prompted the Basle Committee on Banking Supervision to evaluate the risks that could result from the activities of highly-leveraged institutions (HLI), with particular regard to their interactions with banks. "Banks' Interactions with Highly Leveraged Institutions (1999)" and "Sound Practices for Banks' Interactions with Highly Leveraged Institutions (1999)" were the reports that resulted from the Basle Committee's working group investigations. The Committee emphasised that many of the systemic risks associated with the activities of HLIs could be addressed through better risk management at the counterparty level. Prudent internal risk management could limit or reduce the leverage of HLIs, and thus limit the riskiness of their portfolios, As such, it might also reduce the potential for systemic disruptions resulting from a rapid deleveraging or liquidation of positions, and could contribute to greater stability in the financial system as a whole.
In addition to promoting sound internal risk management practices, the report suggests that banking regulators could review existing regulatory standards to ensure that these did not provide banks with distorted incentives in dealing with HLIs. The Committee also noted that in some cases, supervisors could impose more stringent capital requirements than those of the Basle Accord, or rely on a differentiated supervisory treatment of individual banks, depending on the riskiness of their particular lines of business. To encourage increased transparency on the part of HLIs, the Committee suggested a credit register for bank loans to HLIs.
The pace of change in financial markets, which has become increasingly international, complex and inter-linked, has compounded the delicate task of ensuring systemic safety. A major financial institution which operates in only one jurisdiction or sells only one type of product may soon be a thing of the past. The future financial institution will be a global creature which has many implications for systemic risk, and thus systemic safety. Their international operations are so large and complex that they have outgrown the national accounting, legal and supervisory systems on which the safety and soundness of individual institutions and the financial systems currently rely.
The major challenge facing guardians of systemic safety is how to adapt national supervisory tools to cope with these financial giants. One of the main regulatory responses so far has been the increased co-operation among regulators and central bankers, resulting in a number of important agreements. The Windsor Declaration (May 1995) is one of the best examples of this new regulatory spirit. The Declaration called upon supervisors to co-operate when responding to market disruptions, and to share information regarding large exposures in individual markets. The Windsor Declaration was followed by the Declaration on Co-operation and Supervision of International Futures Exchanges and Clearing Organisations and an accompanying Memorandum of Understanding among 15 supervisors. The Declaration outlined the type of events which would trigger information requests and sharing: a large decrease in a member's capital position, large proprietary trading positions, and a concentration of positions in any futures or options contract. (See regulatory co-operation for more details on these Declarations and other relevant documents on this aspect of systemic safety.)
Systemic safety issues have also occupied centre-stage at recent G-7 meetings at Halifax, Canada; Lyon, France and Denver, USA. Communiqués from each of these meetings have called for measures to strengthen banking regulation and supervision, in particular deeper co-operation among supervisors of global firms to "promote the development of globally-integrated safeguards, standards, transparency and systems necessary to monitor and contain risks" and improved supervision in the emerging market economies. The Basle Committee on Banking Supervision's paper entitled, "Core Principles for Effective Banking Supervision" (1997) is the first of the banking regulators' response.
The paper sets out 25 basic principles that are required for an effective supervisory system. They are:
- Principle 1 - Preconditions for effective banking supervision
- Principles 2 to 5 - Licensing and structure
- Principles 6 to 15 - Prudential regulations and requirements
- Principles 16 to 20 - Methods of ongoing banking supervision
- Principle 21 - Information requirements
- Principle 22 - Formal powers of supervisors
- Principles 23 to 25 - Cross-border banking
A group including G-10 bank supervisors and representatives from Chile, China, the Czech Republic, HongKong, Mexico, Russia and Thailand prepared the document. Argentina, Brazil, Hungary, India, Indonesia, Korea, Malaysia, Poland and Singapore were also closely associated with the work.
The Basle Committee stresses that these principles are minimum requirements and need to be supplemented by specific measures to address particular conditions and risks of individual countries. Supervisory and other public authorities in all countries and internationally are expected to use these core principles when reviewing their existing supervisory arrangements and to initiate programmes to address any deficiencies as quickly as is practical within their legal authority. The consultative paper also contains explanations of the various methods which supervisors can use when implementing these principles. The Principles have been designed to be verifiable by supervisors, regional supervisory groups and the market at large. The Basle Committee will monitor the progress made by individual countries in implementing the Principles. It is suggested that the International Monetary Fund and the World Bank use the Principles to help individual countries strengthen their supervisory arrangements in connection with work aimed at promoting macroeconomic and financial stability. Implementation of the Principles and the effectiveness of bank supervisory regimes was reviewed at the International Conference of Banking Supervisors in October 1998 and biennially thereafter. At the October meeting, the Basle Committtee decided to have a document prepared for use in compliance assessments. "Core Principles Methodology" (1999) is the result.
The document is divided into three chapters. Chapter 1 outlines the background to the Core Principles and explains the need for their timely and effective implementation. It also describes under what conditions assessments should be made, as well as the preconditions for effective banking supervision that should be taken into account when forming an assessment. Chapter 2 looks at the considerations regarding the conduct of an assessment and how the results should be compiled and presented. The chapter emphasises that the assessment must consider a chain of related requirements, which may encompass laws, prudential regulation, supervisory guidelines, on-site examinations and off-site analysis, supervisory reporting and public disclosures, and evidence of enforcement or non-enforcement.
Chapter 3 lists the 25 core principles. All significant criteria which are relevant for compliance are enumerated. Two categories of criteria are used: 'essential criteria' which are those elements that should be present in individual countries in ordered for supervision to be considered effective and 'additional criteria' which are elements that further strengthen supervision and which all countries should strive to implement.
Both reports build on an earlier report by the Basle Committee and the Offshore Group of Banking Supervisors, entitled "The Supervision of Cross-Border Banking" (1996). The working group that wrote this report was set up to consider some of the problems which arose from the implementation of the 1992 minimum standards for cross-border supervision. The Basle Committee's 1992 minimum standards established four main principles:
- All international banks should be supervised by a home country that capably performs consolidated supervision.
- The creation of a cross-border banking establishment should receive the prior consent of both the host country and the home country authority.
- Home country authorities should possess the right to gather information from their cross-border banking establishments.
- If the host country determines that any of these three standards is not being met, it could impose restrictive measures or prohibit the establishment of banking offices.
The 1996 report dealt with two main problems. The first relates to information access; i.e. home supervisors having difficulty obtaining all the information they require for effective consolidated supervision. The second relates to host and home supervisors having no common standards to judge each other's supervisory work and gaps in supervision posed by 'shell branches' and 'sister institutions'. The document sets out the conditions attached to greater information -sharing between home and host supervisors. For example, it states that home supervisors do not routinely need to know the identity of individual depositors and that all information exchanged is subject to strict confidentiality. To ensure that all cross-border banking operations are subject to effective home and host supervision, the report sets out a set of principles, in Annex B, which can be used by host supervisors as a checklist to determine whether home supervisors are meeting the 1992 Minimum Standards. The checklist gives pointers on how to check whether the home country supervisor has the power to exercise global oversight and the abilities to perform consolidated supervision. A fuller explanation of the 1992 standards are contained in "Minimum Standards for the Supervision of International Banking Groups and their Cross-Border Establishments (1992)."
The G-30, a private think tank, believes that one of the best ways of reducing systemic risk is to develop a global framework of comprehensive and effective management controls which global institutions should use to manage risk. This framework should be developed by major financial institutions in cooperation with supervisors. In its report on systemic risk, "Global Institutions, National Supervision and Systemic Risk" (1997), the G-30 argues that such a framework must start from the premise that "the fundamental responsibility of ensuring financial stability of financial institutions, and thereby limiting systemic risk, rests with the Board and management of global institutions themselves…It also implies that supervisors will be readier to rely on institutions that they supervise, and that the institutions themselves will accept the responsibility to improve the structure of, and discipline imposed by, their internal control functions." Such an approach also presumes a two-tier supervisory structure because smaller, less geographically diversified institutions will have a less elaborate regime imposed upon them.
Other recommendations contained in the G-30 report, which examines the potential for systemic risk arising from the gap between the global operations of financial institutions and markets and nationally-based systems of accounting, reporting, law and supervision are:
- Global institutions should subject their worldwide operations to expanded review by a single, independent, external audit firm or firm group, and should agree upon more consistent and meaningful disclosure of financial and risk information on a global, consolidated basis;
- Assessment of legal risk in international transactions should take into account the enforceability of contract provisions, including netting, and the effectiveness of insolvency procedures. To reduce such risk, countries should be encouraged to strengthen legal standards;
- National and functional supervisors should agree upon a lead coordinator for global firms, apply a global review framework to all parts of a financial group and agree upon consistent reporting requirements for global firms;
- Supervisors should formulate guidelines for risk management in organized markets and at institutions that are part of the market infrastructure.
The emergence of financial conglomerates has also prompted supervisors to co-operate across sectors. The Tripartite Group, an informal group of banking, securities and insurance supervisors from the G-10 countries issued in 1995 a document titled "The Supervision of Financial Conglomerates. Discussion Documents". The paper sets out the principles by which financial conglomerates should be supervised, recognising that many financial conglomerates include entities, which are not regulated. Among its recommendations is a call for group-based risk assessment of firms which are supervised on a solo basis. This assessment could be both quantitative, i.e. capital requirements on a consolidated basis (for more details see Section III entitled 'financial conglomerates' in the overview on capital adequacy) or qualitative, i.e collecting relevant information about other group companies. This assessment could be both quantitative (capital requirements on a consolidated basis) or qualitative (collecting relevant information about other group companies.) The Group puts forward the idea of having one regulator with primary responsibility for group-based risk assessment. This regulator is likely to emerge as the lead regulator when serious concerns arise about a financial conglomerate but still has no authority to take over or interfere with the regulator in charge of the solo entity operating within the latter's jurisdiction. The lead regulator's main role is to ensure that relevant regulatory information about the conglomerate is shared promptly among other concerned regulators.
The Tripartite Group also recommends that supervisors monitor intra-group exposures, and impose limits if necessary on such exposures within the regulated entity. Regulators must also understand the corporate and managerial structure of the financial conglomerates and be prepared to acquire powers to prevent the manipulation of group structures, which make effective regulation difficult.
The safety and soundness of a financial system requires the imposition of minimum capital requirements to cover the various risks taken on by financial institutions. The 1988 Capital Accord was the first attempt to standardise capital requirements for banks. The 8% minimum promulgated in "International Convergence Capital Measurement and Capital Standards" addressed credit risk. Eight years later, the Basle Committee agreed on minimum capital charges for market risk. The "Amendment to the Capital Accord to Incorporate Market Risks" (1996) is a watershed in the way capital requirements are set because it allows banks to use their internal models to calculate capital charges for market risk. This is the first time banking regulators have moved from simple percentages to sophisticated in-house models to determine regulatory capital. (See capital adequacy for more details on the relevant documents.)
The failure of a major institution has always been considered one of the main sources of systemic risk. The February 1995 collapse of Barings, the oldest merchant bank in the United Kingdom, qualified as one of the triggers capable of producing a major systemic shock. It did not, partly because the relevant regulatory bodies worked together to contain the shock tremors resulting from Barings' collapse. The root cause of Barings' ruin lay in its complete lack of internal controls. The Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings (1995), thus shows indirectly how important robust risk management systems are to promoting systemic safety. (see also 'Not Just One Man.') But even before the collapse of Barings, banking regulators and practitioners knew that sound internal risk control was essential for the prudent operation of a financial institution, and thus to promoting systemic safety. Many risk control guidelines have been issued, but the report which has shaped current best practices in risk control is "Risk Management Guidelines for Derivatives" (1994). This seminal work was written by the Basle Committee on Banking Supervision and the International Organisation of Securities Commissions.
There is no doubt that a serious hiccup in settlement procedures, or a failure in a settlement system, could be a major source of systemic risk. This is because the amounts at stake are so huge. The Bank for International Settlements estimates that the average daily turnover of global currencies in spot, outright forward and foreign exchange swap contracts is US$1 1/4 trillion; the resulting large exposures raise significant concerns for individual banks and the international finance system as a whole. In March 1996, the Committee on Payment and Settlement Systems of the central banks of the G-10 countries, issued a report "Settlement Risk in Foreign Exchange Transactions" which detailed practical steps for dealing with currency settlement risk. It also called upon individual banks and industry groups to improve current practices, and design mechanisms to lessen settlement risk, or face further regulatory action on risk management in the foreign exchange area. (for more details see settlement risk)
In May 1997, the same Committee issued a report to clarify the role of robust clearing and settlement arrangements in promoting systemic safety. "Clearing Arrangements for Exchange-Traded Derivatives" discusses the sources and types of risks to clearing houses. It singled out potential vulnerabilities in several areas: inadequate financial resources to withstand member defaults or extreme price movements; lack of mechanisms to monitor and control intra-day risks; and weaknesses in money settlement arrangements, including the risk of unwinding provisional funds transfers late in the day. (for more details see market integrity)
A report to enhance central banks' understanding of the economic and monetary policy roles of the repurchase agreement (repo) markets discusses the systemic risk implications of repos. In " Implications of repo markets for central banks " (1999), the Committee on the Global Financial System notes that repo markets tend to reduce the systemic risk associated with shocks transmitted from uncollateralised interbank and money markets in two ways. The first arises from the fact that repos are collateralised. Secondly, repos help maintain institutions' access to liquidity when market shocks occur precisely because they are collateralised (and so reduce counterparty risk worries.) But the report also says that repo markets may contribute to systemic risk in three ways. The use of collateral in repos withdraws securities from the pool of assets that would be available to unsecured creditors in the event of a bankruptcy. Another concern is that the close linkage of repo markets to securities markets means that they may help transmit shocks originating from this source. Finally, repos allow institutions to use leverage to take larger positions in financial markets, which could add to systemic risk if the institutions concerned have inadequate risk control systems.
See also settlement risk, regulatory co-operation, capital adequacy, risk control, and market integrity
- International Convergence Capital Measurement and Capital Standards (1988)
- Groups and their Cross-Border Establishments (1992)
- Minimum Standards for the Supervision of International Banking Groups and their Cross-Border Establishments (1992)
- Risk Management Guidelines for Derivatives" (1994)
- The Supervision of Financial Conglomerates. Discussion Documents (1995)
- Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings (1995)
- Amendment to the Capital Accord to Incorporate Market Risks (1996)
- The Supervision of Cross-Border Banking (1996)
- Settlement Risk in Foreign Exchange Transactions (1996)
- Clearing Arrangements for Exchange-Traded Derivatives (1997)
- Core Principles for Effective Banking Supervision" (1997)
- Banks Interactions with Highly Leveraged Institutions (1999)
- Sound Practices for Banks' Interactions with Highly Leveraged Institutions (1999)
- Implications of Repo Markets for Central Banks (1999)
- Not Just One Man (Lillian Chew)
Latest Update May 2000