Basic Summaries on Systemic Risk

Systemic Risk I: Non-Conventional Monetary Policy

A Practical Overview

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The operational frameworks of central banks have changed fundamentally in the wake of the great financial crisis. Non-conventional monetary policies have become the new normal in all large developed economies. Their main forms have been balance sheet expansion and risk premium compression through asset purchases and targeted lending, forward guidance in respect to future monetary policy, and changes to collateral rules. Future non-conventional policies could team up with fiscal expansion to create versions of “helicopter money”. Non-conventional policies have created new systemic risks, arising from [i] prolonged sedation of financial markets through containment of asset price volatility, [ii] exhaustion of scope for further monetary stimulus in future crises and [iii] addiction of economies to cheap funding. Read more

Federal Reserve

Federal Reserve Building, Washington DC, USA

The Federal Reserve relied heavily on non-conventional monetary policy after the great financial crisis, purchasing treasuries and mortgage-backed securities in excess of a quarter of concurrent GDP. In conjunction with various forms of forward guidance it compressed both term and credit risk premiums by unprecedented margins. The Federal Reserve has also been the first large central bank to begin reversing ultra-easy monetary policy. The initial focus is on a normalization of interest rates, while any reduction of the Fed’s huge balance sheet is more uncertain and a matter for the further future. The prime focus remains on downside or deflationary risks for the economy, while considering the inconvenient side effects for the global economy. The latter include growing addiction to cheap funding and challenges to the business model of financial institutions. Read more

European Central Bank

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The European Central Bank runs one of the most complex monetary policy regimes in the world. Since the euro area sovereign crisis its operating framework has extended well beyond regular liquidity supply and now includes [i] long-term full-allotment and targeted lending operations, [ii] large-scale asset purchases, [iii] active and comprehensive collateral policies, [iv] flexible forward guidance on policy operations and [v] a contingent facility to intervene in government bond markets in case of sovereign debt crises. Read more.

Bank of Japan

The Bank of Japan has walked furthest on the path of non-conventional policies. It introduced quantitative easing as early as 2001 for the purpose of expanding its monetary base. After a first attempt of exiting non-conventional policies, the Bank had to revert to broader and larger asset purchases in the “Comprehensive Monetary Easing” from 2010. In 2013 it took a big step up through its “Quantitative and Qualitative Monetary Easing”, a massive expansion of the monetary base and compression of risk premia, mainly through purchases of government securities and maturity extension. The program has picked up pace since then and is being supported by novel features, such as “yield curve control” and “inflation overshooting commitment”. Read more.

Systemic Risk II: Government Finances

Public Debt and Financial Repression

The National Debt Clock, a billboard-size digital display showing the increasing US debt, on Sixth Avenue August 1, 2011 in New York.  US Vice President Joe Biden said Monday he was confident that Congress would approve a major austerity plan to avoid a debt default as he met with skeptical members of his Democratic Party. AFP PHOTO/Stan HONDA (Photo credit should read STAN HONDA/AFP/Getty Images)

Public debt ratios in the developed world have reached record highs. This has reduced governments’ capacity to stabilize financial and economic cycles in the future. It has also increased the dependence of sovereign debt sustainability on low real interest rates. Avoidance of excessively tight fiscal conditions and protection of sovereign solvency in developed economies partly relies on “financial repression”: a set of macroeconomic and regulatory policies that channels cheap funding to public budgets for a prolonged period of time. Read more.

Systemic Risk III: Financial System

Regulated Banking System

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The great financial crisis revealed vulnerabilities of the regulated banking system’s capital structure, liquidity reserves and resolution regimes. This has given rise to an unprecedented expansion and tightening of regulatory rules that include a massive increase in minimum capital ratios, mandatory minimum leverage ratios, new compulsory liquidity ratios and new resolution regimes. The new rules may have unintended consequences, however, including tighter bank lending conditions and more regulatory arbitrage. Read more.

Shadow Banking System

Aerial view of Westferry Circus and Canary Wharf at night, London

Shadow banking means financial intermediation outside the reach of standard regulation. Shadow banks engage in term, credit and liquidity transformation similar to regulated banks and function principally to channel institutional cash pools to the funding of asset holdings. This makes them an essential part of financial markets. Often this intermediation takes place in a complex multi-institutional setting.  The special vulnerability of the shadow banking system arises from its dependence on collateral (asset) value and the absence of a safety net in form of central bank backstops. Read more.

Institutional Asset Management

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Institutional asset management seems to be in structural ascent, due mainly to demographic developments. The importance of asset managers for global financial conditions is now comparable in importance to the regulated banking system. Asset managers bear much less leverage than banks, but the sheer size of their asset holdings and their vital role for market liquidity and leverage in the shadow banking system has created substantial vulnerabilities. There is evidence that institutional asset managers and their clients can be the source of self-reinforcing market momentum. Read more.

Emerging Markets/ China

Emerging markets have greatly increased in importance since the 1990s. In particular, local-currency bonds and foreign-currency corporate debt have expanded rapidly. Emerging economies and political systems are now highly dependent on global financial conditions and their feedback onto developed markets is powerful. A particular concern is China, due to its size and aggressive use of financial repression to sustain high levels of leverage and investment. The expected decline in China’s medium-term growth will put the sustainability of private debt, corporate earnings and property prices to a test. Read more.