Financial Advisors

Systemic Risk Council: Addressing Remaining Fault Lines in the Global Financial System

The CFA Institute sponsored an online discussion on October 14, on behalf the Systemic Risk Council, to discuss whether a second phase of reforms were needed to ensure the resilience of the financial system, not least in light of the market dislocations prompted by the Covid-19 pandemic. The discussion took as its point of departure a statement by the Systemic Risk Council (SRC) identifying possible reforms under two headings: banking and resolution, and levered markets and shadow banking. Speakers included policymakers Andrea Enria (EU) and Randall Quarles (US, and G20 Financial Stability Board chair), a range of SRC members, and other commentators. 

Sir Paul Tucker, SRC chair, Sheila Bair (founding chair) and former ECB president Jean-Claude Trichet set the scene, highlighting the SRC’s March recommendations on what the authorities should do to maintain stability during the pandemic, and the agenda for reform. In terms later echoed by nearly all participants, they noted the difficulty in gauging the true level of current systemic vulnerability given the masking effects of a gigantic government safety net. Some vulnerabilities had been apparent before order was restored by the major central banks’ massive asset purchases during the spring, but none in ways that made reform an urgent issue for the general public.

Several other issues stood out during subsequent sessions (what follows does not purport to represent the comments or views of the two participating office holders)

Assessing Resiliency. Panels described the authorities’ past achievements as well as current concerns about global banking resiliency in various ways, but the conclusion was consistent across nearly all speakers: more equity capital would be needed, underlying the importance of restrictions on distributions now. Some felt the level of credit-market stimulus made it nearly impossible to accurately assess capital ratios, the level of capital buffers, and the relevance of the stress tests of banking institutions.

Resolution as a Crisis Management Tool. Nearly all speakers agreed that the “too big to fail” problem was not yet fixed. The resolution of failing institutions was described as a last-resort mechanism that most thought would work well only in one-off situations for individual firms. The SRC statement urges top officials to make stronger commitments in this area, and identifies a possible reform for dealing with multiple, simultaneous failures.

Shadow Banking and Growing Leverage. There was a robust discussion on risks to stability from non-bank finance. As had been expected, the re-regulation of banking had incentivized the movement of some banking-like activity into open-ended or levered funds and vehicles. As one member of the audience suggested in a question, the term “shadow banking” can be controversial, some say pejorative, suggesting as it does that private markets for credit are somehow unstable or unchecked. Yet, bank-like non-banks have become increasingly important in lending and investment markets. Debate participants underlined the importance of private credit markets for capital formation, particularly in emerging market economies. But there was concern that in the U.S. the Financial Stability Oversight Council (FSOC) and other regulators have somewhat forgotten about shadow banking vulnerabilities. Serious disruptions in private credit markets most certainly could cause systemic contagion and stress.

OTC Derivatives Trading. Another issue on the systemic-risk radar concerns the transfer of the enormous OTC derivatives market onto a new clearing structure known as Central Clearing Counterparties (CCPs). This was part of the G20’s response to the Great Financial Crisis, implemented via Dodd-Frank in the US, and the SRC has repeatedly stressed that more needs to be done to ensure crisis is averted if ever one of them fails. The panels were clear that CCP resolution needs to be a top priority in the United States, the EU and internationally through the Financial Stability Board. As the SRC statement stressed, tackling these central clearing issues will necessitate much greater focus from national market and securities regulators.

Closing Thoughts. Many of us listening to the comments of these highly regarded regulators, former regulators, and academic luminaries, felt a palpable sense of unease and urgency around looming economic risks. While the government and central bank safety net rolled out in core markets against the Covid-19 pandemic has been both enormous and unprecedented, it was clear to all presenters that much more will still be needed to counteract escalating risks. This will be particularly true in parts of the world that are less able to deficit-finance programs to deal with economic disruption of this nature. The key takeaways from the debate are eye-opening. Serious systemic vulnerabilities remain despite the massive government and central bank stimulus. Challenges to bank resiliency are increasing, and dangerous pockets of non-bank systemic risk are being ignored. Finally, far more worldwide cooperation is essential at a time when cooperation is becoming a scarce resource. In the closing words of SCR Chair Sir Paul Tucker, “We are waiting for someone to take the hard steps and come forward to address the risks that plainly confront us. Who will it be?”

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Kurt Schacht

Kurt N. Schacht, JD, CFA is Managing Director for CFA Institute’s advocacy group. He has overseen CFA Institute policy research, standards and government relations area, and has been responsible for the CFA Institute Code of Ethics and Standards of Professional Conduct, the Global Investment Performance Standards (GIPS®), and the CFA Institute Asset Manager Code and one of its flagship publications, the Financial Analysts Journal. Prior to joining CFA Institute, he served as chief operating officer for a mutual fund complex, general counsel and COO for a Manhattan based hedge fund, and as deputy director/chief legal officer for the State of Wisconsin Investment Board (SWIB). He is an industry practice expert on investment management, corporate governance and financial service industry regulation, including Investment Company Act and Investment Advisers Act rules and practice.

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