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Global Networks and Financial Instability

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By Joseph Joyce Global Networks and Financial Instability The ten-year anniversary of the global financial crisis has brought a range of analyses of the current stability of the financial system (see, for example, here). Most agree that the banking sector is more robust now due to increased capital, less leverage, more prudent balance sheets and better regulation. But systemic risk is an inherent feature of finance, and a disturbance in one area can quickly spread to others through global networks. The growth of financial markets and institutions during the 1990s and 2000s benefitted many, including those in emerging market economies that became integrated with world markets during this period. But the large-scale extension of credit to the housing sector

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by Joseph Joyce

Global Networks and Financial Instability

The ten-year anniversary of the global financial crisis has brought a range of analyses of the current stability of the financial system (see, for example, here). Most agree that the banking sector is more robust now due to increased capital, less leverage, more prudent balance sheets and better regulation. But systemic risk is an inherent feature of finance, and a disturbance in one area can quickly spread to others through global networks.

The growth of financial markets and institutions during the 1990s and 2000s benefitted many, including those in emerging market economies that became integrated with world markets during this period. But the large-scale extension of credit to the housing sector led to property bubbles in the U.S., as well as in Ireland and Spain. The development of financial instruments such as mortgage backed securities (MBS), collateralized debt obligations (CDOs), and credit default swaps (CDS) were supposed to spread the risk of lenders in order to mitigate the impact of a negative price shock. However, these instruments and the extension of credit to subprime borrowers increased the vulnerability of financial institutions to reversals in the housing markets. Risk increased in a non-linear fashion as balance sheets became highly leveraged, and national regulators simply did not understand the nature and scale of these risks.

The holdings of assets across borders amplified the impact of the disruption of the U.S. financial markets once housing prices fell. European banks that had borrowed dollars in order to participate in the U.S. MBS markets found themselves exposed when dollar funding was no longer available. The gross flows of money between the U.S. and Europe increased the ties between their institutions and increased the fragility of their financial markets. It took the the establishment of swap networks between the Federal Reserve and European central banks to provide the necessary dollar funding.

John Kay has written about the inability to recognize and minimize systemic risk in financial systems in Other People’s Money: The Real Business of Finance. He draws from engineers the lesson that “…stability and resilience requires conscious and systematic simplification, modularity, which enables failures to be contained, and redundancy, which allows failed elements to be by-passed. None of these features—simplification, modularity, redundancy—characterized the financial system as is had developed in 2008.”

Similarly, Ian Goldin of Oxford University and Chris Kutarna examined the impact of rising financial complexity on the stability of financial systems in the period leading up to the crisis: “Cumulative connective and developmental forces produced a global financial system that was suddenly far bigger and more complex than just a decade before. This made the new hazards harder to see and simultaneously spread the dangers more widely—to workers, pensioners, and companies worldwide.”

Goldin and Mike Marithasan of KU Leuven also looked at the impact of increasing complexity on financial systems in The Butterfly Defect: How Globalization Creates Systemic Risks, and What to Do About It. They use Iceland as an example of how complex financial relationships were constructed with virtually no understanding of the consequences if they unraveled. They draw several lessons for dealing with a more complex financial networks. These include global oversight by regulators using systemic analysis, and the use of simple rules such as leverage ratios rather than complex regulations.

The Basel III regulatory regime follows this advice in a number of areas. But the basic vulnerability of financial networks remains. Yevgeniya Korniyenko, Manasa Patnam, Rita Maria del Rio-Chanon and Mason A. Porter have analyzed the interconnectedness of the global financial system in an IMF working paper, “Evolution of the Global Financial Network and Contagion: A New Approach.” They use a multilayer network framework with data on foreign direct investment, portfolio equity and debt and bank loans over the period 2008-15 to analyze the global financial network.

The authors compare the networks for the years 2009 and 2015, and report which countries are systematically important in the networks. They find that the U.S. and the U.K. appear at the top of these rankings in both of the selected years, although the cross-border holdings of U.S. financial institutions has increased over time while those of the U.K.’s institutions fell. China has moved up in the rankings, as have other Asian countries such as Singapore and South Korea. The authors conclude that “The global financial network remains most susceptible to shocks coming from large central countries…and countries with large financial systems (namely, the USA and the UK)…”

A decade after the global crisis, the possibility of the rapid propagation of a financial shock remains. There is more resiliency in those parts of the financial system that failed in 2008, but the current most vulnerable areas may not be identified until there is a new crisis. Policymakers who ignore this reality will be tripped up when the next shock occurs, and they will learn that  “The past is not dead. It’s not even past.”

Dan Crawford
aka Rdan owns, designs, moderates, and manages Angry Bear since 2007. Dan is the fourth ‘owner’.

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