Interconnectedness: A Source of Systemic Risk or Resilience in Financial Markets?
After the 2008 financial crisis, the global economic paradigm shifted from “too big to fail” to “too interconnected to fail.” But does interconnectedness really add a layer of resilience to the financial system or is it the source of systemic risk? The question was at the heart of most of the finance panels at the Milken Institute Global Conference.
Opinions among conference panelists were mixed. Some argued that interconnectedness enables market players to quickly pick up the business of a crisis-stricken financial institution, for instance by purchasing its assets or attracting its customers. This substitutability effect, they say, leads to a higher level of market stability and prevents a risk from becoming systemic. Others argue that interconnectedness creates a link of knotted chains that intimately connects different segments of the economy such as the money, capital and commodity markets. Performance of each segment thus becomes crucially dependent on other parts. Yet historical evidence suggests that, in fact, their activities are not necessarily substitutable.
Let us start by referring to a not very distant time in history, September 2007. Just before the 2008 financial crisis, capital markets faced great turbulence. This was as a result of what happened in structured investment vehicles (SIVs): often huge, mainly bank-run, programs designed to profit from the difference between short-term borrowing rates and longer-term returns from structured product investments. A structured product takes a traditional security and replaces its usual payment features with non-traditional payoffs derived from the performance of the underlying assets, exposing investors to credit and liquidity risks. These programs usually invested in credit market instruments, such as U.S. subprime mortgage-backed bonds and collateralized debt obligations. In the case of a blip in the market, these instruments were supported by liquidity facilities from highly rated, mainstream banks. Commercial banks, therefore, backstopped the market for SIVs. Here we observe the hierarchical design embedded in the structure of the financial system.
At the very same period, the European Central Bank and the U.S. Federal Reserve, which are at the top of this hierarchy, were forced to intervene in the money market through their emergency liquidity-boosting operations to rescue banks, which did not have enough cash to meet requests and were unable to liquidate enough assets to plug the gap. The problem intensified when the problems in “asset- backed commercial paper” — or ABCP — became so serious that some European banks were preparing for additional calls on credit lines to SIVs. But the banks were also grappling with a backlog of unsold leveraged loans, placing additional pressure on their balance sheets. Interestingly, this specific incident created even more serious problems for their U.S. counterparties as most of the European banks had borrowed in U.S. dollars and used U.S. financial institutions to fund these instruments. We all know the end result of the turmoil experienced in these markets in 2007: the most severe financial crisis since the Great Depression, which led to extensive use of unconventional monetary policy packages and bailouts.
Some regulators, when looking for systemic risk, indeed search for a kind of volatility in the system that forces a government agency to intervene using taxpayers’ money to backstop the market. By this account, our very recent history shows that interconnectedness creates systemic risk. The underlying reasons are credit, maturity and liquidity transformation that leads to credit, maturity and liquidity mismatches. All of these happen as a result of the activities that this level of interconnectedness between different parts of the economy enables us to do.
History provides more evidence for the conclusion that interconnectedness adds to systemic risk than that it provides a safety net. Globalization, however, is a dynamic and unstoppable force. Given that the world is becoming a more complex and interconnected place, the future might provide different lessons. The point to emphasize here is that whether or not interconnectedness creates “substitutability” is a key factor in tackling the question of whether interconnectedness is stabilizing or de-stabilizing. In either case, it seems that interconnectedness is here to stay and will be part of our future. The right starting point is to understand the underlying mechanisms and characteristics of this phenomenon. When we have done that, we will have a sound analytical foundation to debate whether interconnectedness is an issue to be resolved or a phenomenon to be embraced.