6.      FINANCIAL RISK AND INSTABILITY

 

 

While financial markets can generate substantial earnings and returns, they can also be subject to instability and collapse. Financial institutions must manage the direct financial risks that their activities create while the authorities must monitor the build-up of exposures within the financial system more generally and across the economy as a whole. Different assumptions have historically been made as to whether markets are inherently stable of unstable with other sets of theories arising with regard to the proper justification for financial regulation and official intervention in market processes.

 

(1)       Financial Risk

 

Recent substantial increases in the quality of risk management capability and market liquidity have to be considered against the nature of the underlying risks concerned and other aggravating risk factors. The principal financial risks that arise can be identified in terms of:

 

1. Credit or counterparty default risk (involving the non-payment of interest during term and/or non-repayment of principal on maturity);

2. Market or position risk with fluctuations in the value of debt or equity stock quoted on formal markets or sold secondarily;

3. Foreign exchange or currency risk (including settlement or ‘Herstatt Risk’ with the non-completion of one side of a currency transaction);

4. Interest rate risk (which may affect debt instruments specifically as well as create unfavourable conditions across markets more generally);

5. More complex financial derivatives and commodity related risks (especially on options including ro, beta, delta, gamma and theta).

 

The two other principal forms of risk are operational and legal risks. Operational risk is principally concerned with the failure of internal systems and controls including human processes or through human error, fraud or theft. Legal risk is concerned with the validity and enforceability of transactions and contractual documentation and includes legal capacity, documentation validity and enforceability. Other business and management risks as well as external environmental risks have also to be considered.

 

Other market factors are also relevant in considering the current condition of national and global systems. These are monitored by national central banks and such international bodies as the International Monetary Fund (IMF) and Financial Stability Board (FSB). Relevant factors include:

 

1. High levels of sovereign debt which have soared in many countries as a result of earlier ineffective management policies or fiscal stimulus or bank support costs incurred during one following the financial crisis;

2. Continuing high levels of household debt (UK liabilities increased from 108% to 159% of GDP between 1994 and 2005 and with over £1tn still outstanding and with comparable increases from 92% to 135% in the US and in Europe);

3. Significant global payment imbalances especially with the continuing US trade deficit and perceived high value of the Chinese Renminbi;

4. Difficulties in recycling available funds as banks restructure their balance sheets and corporate and household borrowers limit commitments;

5. Further potential liquidity pressures and contagious effects in the event of any sovereign debt difficulties such as in the Euro area and the pressure of this on larger international or national banks.

 

Other more specific continuing concerns within the financial sector include:

 

1. Possible foreign exchange instability especially with the continuing low dollar and high Renminbi;

2. Value of commodity prices as investors and speculators switched funds to perceived high return areas;

 

 

     

1. )Susceptibility to hedge funds and other investment vehicles to further downturns in markets;

2. The ability of equity finance vehicles to continue in operation without favourable credit terms and the overall value and effectiveness of such a highly leveraged models despite some notable recent successes;

3. The sustainability of the ‘carry trade’ market (especially with the borrowing of funds in Japan and re-lending them elsewhere) with credit tightening and with the continued value of the international remittances market (with overseas residents transferring substantially large amounts of money back to their home countries for family or investment purposes).

 

A number of more general trends can then be identified. These include the emergence and dominance of new complex products. Markets have also generally moved from being loan to debt (producer to trader) based with a collapse in a traditional relations and personal banking. Finance and capital markets have assumed a new autonomy especially with the separation of the new global economy from the underlying trade or mercantile markets. Global finance has also become increasingly ‘Anglo-US’ based with the emergence of London and New York as the principal financial centres and, in particular, with the more recent pre-eminence of London following a number of reports on US markets.

 

(2)       Financial Instability

 

The recent financial crises have forced a reconsideration as to whether financial markets are inherently efficiency and stable or inefficient and unstable. Approaches maintaining that markets are stable are based on such ideas as ‘efficient markets theory’ and ‘rational expectations theory’. These assumes that markets are informationally efficient, and that asset prices are traded on all available information, with prices only varying from fundamental values where there has been some error. Other economic writers, such as Hyman Minsky and Charles Kindleberger, argued that markets are inherently cyclic and unstable and prone to collapse without correction.

 

(3)       Financial Theories or Objectives

 

The traditional objectives of financial regulation have been to protect individual depositors and market or financial stability. The failure of an individual contract or transaction on the collapse of a particular financial institution may result in immediate loss to the relevant consumers (depositors, investors or policyholders) involved. Larger crisis may also threaten the stability of the specific market. The particular danger that arises in the banking area is that concerns with the stability of a particular bank may result in a withdrawal of funds from that bank (a run) which may threaten its stability. The closure of one bank may then threaten the stability of other institutions either through direct credit exposures or though parallel runs. Where a number of banks are involved, this process of contagion (or domino) may be sufficient to threaten the stability of banking market, which could result in a larger systems or systemic crisis or collapse.

 

Early writings on the need for financial regulation were based on more general public interest ideas such as in the US. The Supreme Court had to develop a number of specific and then general exceptions under the5th and 14th Amendment of the Constitution to allow the state and federal authorities to impose specific regulatory constraints. A substantial body of federal regulation was introduced in the US following the stock market collapse in 1929 and the Great Depression in the early 1930s.  This included the Banking Act 1933, Securities Act 1933 and Securities and Exchange Act 1934 which created the basis for modern US financial regulation.  The Banking Act specifically included the Glass Steagall provisions on the separation of commercial of investment banking.  An enormous amount of regulation was imposed until the 1970s with writers then challenging the extent to which all of this acted against rather than in the public interest under more recent ‘public choice’ and ‘regulatory capture’ theory.

 

More theories justifying financial regulation tend to be based on ideas of specific market failure or default. The most commonly referred to arguments in terms of market failure are systemic collapse and externalities, natural monopolies and information asymmetries with consumer protection replacing any public interest.  Officials have also focused on uncertainty and network effects, especially following the recent crises in the markets.

 

            (4)       Financial Market Contagion and Stability

 

Financial sectors can be affected by the build-up of risk in different ways with different potential levels of contagion or spread of crisis arising.

(a)       Banking Markets

 

This problem of contagion and systemic collapse is more prone in the banking market due to the underlying maturity mismatch or transformation problem referred to earlier with banks funding themselves through short deposit or wholesale borrowing and then lending this medium to long-term. In the event of a large withdrawal of funds, the bank will not be able to realise funds quickly as these will have been committed to medium to longer terms loans. As personal debt obligations, these cannot be transferred or sold easily. They can be assigned although an assignee may want some reduction in value due to their inability to carry out the same initial credit checks on the borrower. If a loan or funding book has to be sold quickly, this may result in a substantial reduction or ‘fire sale’.

 

 

 

 

 

 

 

 

 

 

 

 

 

(b)       Securities Markets

 

Securities markets have traditionally not been subject to the same danger of contagion and systemic collapse. This is due to the absence of the same underlying maturity mismatch or transformation as securities firms hold transferable security instruments. These can generally be easily sold on a formal or over-the-counter (OTC) market. As securities firms will also not have the same direct lending exposure to each other as with banks, the same risk of deposit withdrawals (runs) and contagion does not arise. Increased concerns have nevertheless arisen in recent years with the large volume of securities transactions taking place on the main exchanges and with operational or settlement (‘plumbing’) problems. The operation of major markets was threatened, for example, on Black Wednesday in 1987 and following the terrorist attacks in 9.11.2001. Difficulties also arose on the London Stock Exchange on 9.11.2008 with trading having to be suspended for a period.

 

(c)       Insurance Markets

 

Insurance markets are also not subject to the same dangers of contagion and systemic collapse. Difficulties may nevertheless arise where firms fail to invest appropriately to ensure that they have sufficient income to cover their ongoing fixed (life cover) or contingent (fire and other risk insurance) contingent liabilities. Insurance firms operate by investing the premia received from clients in portfolios of assets to generate an adequate return to cover their liabilities.

 

(d)       Complex Groups and Financial Conglomerates

 

The most recent significant concern that has arisen has been with regard to the emergence of large complex groups of financial conglomerates made up of banking, securities and insurance firms. The difficulty that arises in this case is that losses suffered in any market and including specifically the more volatile securities, currency or derivatives markets can spread to the banking component of the group and possibly trigger a bank run, contagion and a systemic threat. This risk of ‘inter-group’ or ‘cross-sector loss transfer’ has to be managed carefully.

 

(e)       Complex Objectives

 

More modern regulator systems have nevertheless tended to adopt more complex objectives. The new regulatory system set up in the UK under the FSMA, for example, imposes four specific statutory objectives on the Financial Services Authority (FSA). These consist of maintaining market confidence, promoting consumer protection and consumer education and reducing financial crime. The FSA has explained that it interprets maintaining market confidence to include ensuring market stability more generally. A number of additional more general but less formal ‘supervisory principles’ are also imposed under s2(2) FSMA based on proportionality, management responsibility, efficiency and competition. The core four statutory objectives were later revised under the Banking Act 2009 and, in particular, after the Northern Rock crisis, to include an express financial stability objective with consumer education been removed and transfer to another body.

 

The effect of this is that in practice, the FSA in the UK considers a large number of ly conflicting objectives in designing and implementing regulatory policy. The objectives of modern financial regulation have accordingly become considerably more complex. This may be considered to include each of the following which have to be effectively balanced and prioritised in practice:

 

1. Financial confidence;

2. Financial responsibility;

3. Proportionality

4. Financial awareness, education or capability;

5. Financial damage;

6. Financial efficiency;

7. Financial competition;

8. Financial innovation;

9. Reduced financial crime;

10. Financial conduct;

11. Promotion of good standards and financial ethics more generally;

12. Increased financial contribution and welfare more generally.

 

(5)       Financial Stability

 

The overall objective must be to maintain financial stability more generally.  Difficulties exist in defining financial stability specifically with many economic texts tending to use quantitative or numeric measures of all this removes judgment and discretion. Financial stability may be most clearly understood in terms of maintaining proper market function with financial instability arising where markets or the financial system as a whole are not able to carry out their proper functions.

 

Regulatory authorities across the world have tended to focus following the recent crises on the need to oversee the stability of the financial system and economy as a whole.  This has been considered in terms of the development of new Macro-prudential regimes although again a number of difficulties arise in defining the precise functions involved and identifying and allocating the most appropriate tools.  This work has been taken forward with the establishment in the UK of the Financial Policy Committee (FPC) with in the Bank of England, which replaces the earlier external tripartite Council for Financial Stability (CFS).

 

A European Systemic Risk Board (ESRB) has also been set up within the EU with a separate system of European System of Financial Supervisors (ESFS) and sector specific European Banking Authority (EBA), European Securities and Markets Authority (EMSA) and European Insurance and Occupational Pensions Authority (EIOPA). A similar Financial Stability Oversight Council (FSOC) has also been set up in the US Dodd Frank Wall Street Reform and Consumer Protection Act 2010. It remains to be seen how of this will be developed over time.