EU Central Banker Details Key Elements for Successful Systemic Risk Regulation

With the US moving towards the creation of a systemic risk regulator, be it the Fed or a Council of Regulators, and the EU creating a Systemic Risk Board, a member of the executive board of the European Central Bank detailed the elements of successful systemic risk regulation. In remarks at the European Banking Center, Lorenzo Bini Smaghi said that the four components of a successful systemic risk regulator are: 1) creating a clear legislative framework to underpin the Board’s work; 2) preparing risk assessments and potential risk warnings based on pervasive analysis; 3) backing up risk warnings with granular information about hedge funds and other non-regulated entities; 4) translating risk warnings and related policy recommendations made by the systemic risk regulator into concrete action by regulators.

He analogized the European Systemic Risk Board to a doctor who examines a patient, makes a diagnosis and recommends medicine. It is up to the patient to abide by the doctor’s recommendation. The doctor is not in a position to take direct action. The treatment will only be as good as the patient’s willingness to take the medicine prescribed.

The senior official also outlined a workable definition of systemic risk as the risk that an event will trigger a loss of economic value or confidence in a substantial portion of the financial system that is serious enough to have significant adverse effects on the real economy. See 2001 G-10 Report on Consolidation in the Financial Sector.

Risk detection conducted by the Board involves monitoring risk to identify sources of risks from within the financial system, stemming from financial institutions, or market infrastructure. Risk monitoring involves processing large and often disparate amounts of information. In addition, continuous market intelligence efforts are essential for effective risk monitoring and the early detection of new financial instruments, practices or business strategies which could create risks in financial markets.

In the case of the Systemic Risk Board, market intelligence will be complemented by institutional and policy intelligence available to central banks and regulators represented on the Board. The official said that risk monitoring should be facilitated by tools, including contemporaneous financial stability indicators and forward-looking early warning indicators and models. These tools need to be regularly updated in order to capture innovation in financial markets, fueled by new products and new business models.

He noted that macro-prudential indicators comprise a vast set of indicators, including asset valuations, risk appetite, market liquidity, funding liquidity, and credit risk. Some of these indicators may contain information relevant to early warnings as they may draw attention to rapidly increasing exposures to specific asset classes and broad-based increases in financial leverage.

Risk assessment relates to the evaluation of the relevance and potential severity of each risk identified as material in the surveillance phase. It should therefore include a quantitative evaluation of the likelihood that the potential risk scenarios will materialize. It should also include cost estimates in terms of the failure of institutions, costs deriving from the malfunctioning of financial markets or impairment of the real economy.

The product of these factors forms the basis for the ranking of risks, he said. Quantitative methods and analytical tools such as stress testing models should support, together with expert judgment, the prioritizing or ranking of risks.

Stress testing models have become the workhorse of macro-prudential stability analysis in the last decade, he observed, including quantitative impact studies for specific scenarios. Their main purpose is to assess the resilience of the financial systems against extreme but still plausible events.

The risk assessment task is currently much less developed than the risk detection one. This is not only because it involves considerable analytical sophistication, he said, but also because there are significant gaps in the information on hedge funds and other financial intermediaries and their linkages with other parts of the financial system.

In his view, systemic risk analysis needs to be supported by a suite of state-of-the-art analytical models and tools, and a conceptual framework for using them. The complex and intertwined financial linkages call for a constant cross-checking of several indicators or measures. In addition, the pace of innovation requires that the set of tools for systemic risk detection and assessment be constantly revised.

While the risk assessment exercise should become increasingly quantitative, he said, it must never become mechanistic or fully model-based. Expert judgment and qualitative assessments will always be crucial to understand the messages coming from various analytical tools.

A comprehensive information base is also key in the risk detection phase that precedes the actual risk assessment. This is because the establishment of a wide radar screen supporting rigorous monitoring is only possible if the critical information is available.

The current crisis demonstrated that a significant part of credit intermediation was channeled outside the regulated financial sector and off the radar screen into hedge funds and other entities comprising the non-regulated shadow banking system. Moreover, little was known about the exposures between this shadow system and the regulated one, which turned out to be substantial.

Information on non-banking institutions, potentially of systemic importance, such as hedge funds, was scattered, not quality-checked and provided on a voluntary basis. A tendency to create a bias towards the best performers was the result.

In addition to risk detection and assessment, the systemic risk regulator will also issue risk warnings and policy recommendations. This is new, said the central banker, and will differ substantially from other types of analysis. The Systemic Risk Board must translate systemic risk assessments into proposals for concrete policy actions.

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