Central Bank Chief Lists Elements for Early Detection of Systemic Risk for European Systemic Risk Board
As an EU-wide systemic risk regulator is readied, the President of the European Central Bank said that the early detection of systemic risks in the financial markets will be the main task of the new European Systemic Risk Board. In remarks at Cambridge University, Jean-Claude Trichet detailed stress testing and the collection of information from financial intermediaries, such as banks and hedge funds, as key elements in the early detection of systemic risk.
The ECB head defined systemic risk as the threat that developments in the financial system can cause a seizing-up or breakdown of the system and trigger massive damages to the real economy from the failure of large and interconnected institutions. The financial system is particularly prone to systemic risk because it is composed of intermediaries that are connected with each other through direct transactions, as in interbank markets, or through similar investment and financing decisions with third parties such as other intermediaries or end investors.
Financial markets, in turn, are connected with each other through the trading activities of financial intermediaries and through end investors active in more than one market. Systemic risk within the financial system relates to the risk that these inter-connections spread financial instability throughout the system. Financial instability spreads through contagion, which is the failure of one financial intermediary triggering the failures of other financial intermediaries.
The old approach focused too much on individual risks and too little on interconnections across intermediaries and markets, noted the central banker. It also generated a lot of information about some types of intermediaries but much less about others, particularly the shadow banking system composed of hedge funds and other private funds. This relatively narrow focus made it difficult to fully understand the pro-cyclical behavior of the system in the aggregate.
The new European Systemic Risk Board will be the macro prudential regulator on the front lines of preventing a systemic disruption or failure of the financial system. In the view of the ECB chief, there are three components to detecting systemic risk early. First, the systemic risk regulator needs to have a full understanding of the on and off balance sheet exposures of large and complex financial intermediaries, such as banks and hedge funds.
Second, the extent and diversity of investment practices across all segments of the financial system requires particular attention. For example, fast-growing credit to similar sectors or regions could be a sign of vulnerabilities building up. The imbalances might become unsustainable later and unravel in a disorderly fashion. This risk requires looking at early warning signals in current market data.
Third, detecting systemic risks early also requires stress-testing the system against extreme events and shocks that would surprise markets. Such macro-stress tests help to make an assessment of the resilience of financial systems against shocks that have a low probability but a highly destabilizing power.
A broader challenge for the Board will be collecting all the information that is necessary to identify systemic risks early. This task requires combining some micro-level data with aggregate data from components of the financial system, which in turn means covering major types of intermediaries, in particular large and complex ones. To contain systemic risk, the Board needs to have a good understanding of all parts of the financial system that are relevant for the risks of contagion.
Some of this data will be more difficult to compile and bring together than other pieces. There are some financial sectors about which considerably less is known than about others. For example, while individual hedge funds do not seem to be a source of significant systemic risk, it is very important that the relevance of this industry for the overall cyclicality of the financial system be assessed. A particularly complicated topic is measuring the interconnectedness among the systemically most important hedge funds and other intermediaries.
A crucial element of collecting all information needed to identify and contain systemic risk is an effective exchange of information between the systemic risk regulator and the securities and other micro-prudential regulators. It follows that there will be strong demands on micro and macro-prudential regulators to ensure the smooth exchange of information under the post-crisis regulatory regime now being created.