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Unit 4

Ahmed Mouneimneh

SMC University

5 October 2015

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Table of Contents
Abstract ......................................................................................................................................................... 3
Introduction ................................................................................................................................................ 3
Discussion .................................................................................................................................................... 4
Analysis ......................................................................................................................................................... 6
Conclusion ................................................................................................................................................. 10
References ................................................................................................................................................ 10

‘There are known knowns. These are the things we know that we know. There are known

unknowns. That is to say, there are things that we know we don’t know. But there are also

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unknown unknowns. These are the things we don’t know we don’t know.’

Donald Rumsfeld

Abstract
This paper shows that financial risk has too many dimensions linked to uncertainty. It finds that

the largest risk events are random, but part of the macro-economic cycles. They cannot be

confined to few countries, but they spread across the international banking network. They

generate financial crises, as a result of asset bubbles, hyper speculation in stock markets, and

excessive credit creation.

Introduction
Many countries have witnessed systemic banking crises over the years that required restructuring

their financial systems, which is an undertaking of fiscal cost, with budget outlay of more than half

of entire GDP. This prompted a debate on policies needed to restore financial stability, and

mitigate future financial crises. Managing and resolving a financial crisis is a complex process, that

raises important questions about government’s role (Klingebiel & Laeven, 2002).

The bulk of the literature on international bank risk has mostly been prepared by the big

credit rating agencies, and it is unfortunate to say that this literature is more marketing driven,

and its shortcomings in the ratings process, which failed to anticipate bank failure. Such a process

did not enable the investors, or creditors community to understand how to analyze international

bank risk (Fight, 2004). In addition, history has shown ample discussion, debate, and frequently

argument about financial market instability and central bank policy. Yet, with some of the financial

markets’ finest analysts caught in a seemingly endless procession of asset price bubbles, followed

by devastating credit crunches (Cooper, 2010). The latest banking crisis of 2008 is broadly viewed

as among the most severe since the Great Depression, as it has given banking regulators

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reinforcement to work on developing frameworks to address financial stability threats more

effectively (Borio & Drehmann, 2009). The surprising aspect of the 2008 financial crisis was how

quickly and extensively the relatively small, the sub-prime mortgages of United States (US) spread,

where only two years later governments worldwide had to provide massive support to their

banking systems; knowing international banks played a key role in transmitting contagion through

their claims on each other (Garratt, Mahadeva & Svirydzenka, 2011).

While full-blown financial crises have fortunately struck only a few of the main countries all

have experienced strains from time to time. However, there are strong differences in traditions.

The US, for example, has a long history of banking regulation. Many continental European

countries also have quite long-standing traditions of regulation and official supervision of financial

institutions. New Zealand is one of few countries that has reacted differently, and argued that the

solution to improving the prudential behavior of banks lies not in regulating, and supervising them

evermore closely, but making sure that the stakeholders in banks are aware of and are exposed to

the risks they are running (Mayes & Wood, 2007).

The view that banking crises often result from the growing fragility of private sector

balance sheets during favorable economic conditions, which subsequently referred to as financial

imbalances. Such financial imbalances, associated with aggressive risk-taking, are driven by, but

also feed, an unsustainable economic expansion. However, at some point, however, the

unwinding of these conditions, potentially causing widespread financial strains. The precise timing

of the unwinding is impossible to predict, but the longer the imbalance persists, the higher the

likelihood of the reversal (Borio & Drehmann, 2009).

Discussion
There are two major periods of history of financial supervision in the views of Central Bank (CB)
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economists. The first relates to the period before 1914, working primarily on US banking history,

and UK banking history; both primarily relating to the period 1895–1914, before the evolution of

central banking in developed countries (Goodhart, 2004). CBs have evolved historically over the

course of time; at first, they were set up by special government charter, and established to enable

the government to raise money. The initial capital, raised from the private sector, was invested in

government debt, and the CB usually became a financial operator. Naturally the CB also became

banker to the government, with tax receipts and public sector expenditures passing through its

books. In return for this support for government finance, the government usually provided the CB

with certain competitive advantages in its role as an ordinary commercial bank (Mayes & Wood,

2007).

There was relatively little statutory legislation of financial regulation in the previous two

centuries for most of the time in England; however, there was a strong desire to avoid responding

to banking crises. That contrasts with the US where there was a lot of regulation, and where bank

crises, and the role of interest groups dominate the explanation. Banking regulation is set of rules

by government, which is an inevitable feature of an economy. It seeks to identify market failures

that prevent an industry from functioning competitively, and to correct for such failures. On this

view it is a way of reducing market failure. The alternative view sees regulation as in fact

producing market failure of producing monopoly profits (Capie, 2007).

Firstly, financial regulation is not a clear-cut concept, for there are other aspects in addition

to financial regulation that explains the degree of financial stability in a country. Countries

introduce banking regulation for different reasons, but their aim is to avert financial crises. As

such, Britain is thus a clear case of the influence of the governing economic thought of the time,

while bureaucracies and crises are a consequence of financial regulation. In the US, on the other

hand, vested interests were key in shaping regulation, and regulation was a source of crises. In

France, centralization, and intervention were the most important determinants of financial

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regulation. In Germany, the emphasis was more on vested interests, and a major banking crisis as

a consequence of the Great Depression, in shaping financial regulation. Sanctions can also vary

widely. No strict bilateral relation should be inferred between the existence of regulation, or

absence thereof, and the occurrence of financial crises (Garcia-Herrero, 2007).

Analysis
The list of banking collapses and losses seems to be endless. It is that the most heavily regulated of

industries seems to provide us with a steady stream of moral stories in which record amounts of

monies are lost, and bankruptcies. Meanwhile, it is that economists, academia, business,

accountants, bankers, consultants, regulated by governments, and transnational entities seem to

get it wrong. However, the fact is, that individually, all experts and parties agree on the risks and

pitfalls which characterize the liberal economic model resides on ineffective structures attempting

to regulate the twin pillars of human nature, and greed (Fight, 2004).

Adam Smith warned in 1776 of the dangers of limited liability, asserting company directors

were the managers of other people’s money; are not expected to watch over it the same that

partners would apply to their own cash. Negligence, and profusion must always prevail, he

concluded. Further, Louis Brandeis, the distinguished US Supreme Court Justice, borrowed Smith’s

“other people’s money” as the title of his excoriation of American finance sector at the beginning

of the 20th century. Brandeis’s concern was the intermingling of industry and finance that had

allowed JP Morgan and Andrew Carnegie, Henry Clay Frick and John D Rockefeller to create a self-

reinforcing cycle of economic and political power. That power, Brandeis stressed, was acquired

with the savings of the American public (Kay, 2015).

Nowadays, the interconnectivity of the international banking system impacts the threat of

systemic risk; where cross-sectional systemic risk is the potential for shocks that hit one part of the

system to be transmitted to the rest of the system. This possibility can be analyzed in a variety of
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ways. However, all approaches look at connections between different entities that are reflected in

their balance sheets. A straightforward approach is to simulate shocks to bank balance sheets, and

examine the repercussions. However, this involves making many assumptions about the type and

size of shock, how widespread it is, and how banks adjust to its occurrence and its contagiousness

of the banking network (Garratt, Mahadeva, & Svirydzenka, 2011). Systemic risk refers to the

spread of a party’s economic distress to other linked to that party through financial transactions.

Systemic risk is a serious concern in finance, where trade credit links producers through a chain of

obligations, as in the insurance industry through the reinsurance. The anxiety about systemic risk

is perhaps strongest among bank executives and regulators. As such, mutual claims, which, by

abuse of interbank loans, or interbank transactions, have grown substantially in recent years.

These include intraday debits on payment systems, overnight, and term interbank lending in the

Fed Funds market, or its equivalents, as well as contingent claims such as interest rate and

exchange rate derivatives in OTC markets. To the extent that interbank loans are neither

collateralized, nor insured against a bank’s failure may trigger a chain of subsequent failures, and

therefore force the central bank to intervene to remove such a contagion process (Rochet, 2009).

Taleb (2010) asserts that the fragility of some systems with large concentration, and

illusions of stability leading to the crisis of 2008 had left him, and other financial experts convinced

that the banking system was the mother of all accidents waiting to happen. They were convinced

that the banking system was going to collapse under the weight of hidden risks. Their views were

that conventional metrics using volatility is not an indicator of stability, but rather a greater risk of

big jumps. This has duped the chairman of the Federal Reserve Bank, and the entire banking

system (Taleb, 2010).

Banks incur losses as a result of poor credit policies, bad debt, operational losses,

speculation, inefficiencies, and fraud. Such losses adversely impact the bank’s asset quality,

funding profile, equity base, and operations. When such losses exceed the bank’s total capital and

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reserves, bank insolvency occurs. While losses can often be controlled or minimized with quality

management, some variables such as taxes and exchange rate or interest rate controls are outside

a bank’s control (Fight, 2004).

It is possible to build a risk model with indicators that assess the build-up of risks of future

banking distress in an economy. Such model calculates the weighted average of the riskiness of

the foreign exposures, incorporates property prices, and an estimate of the riskiness of the

domestic portfolio, with its size approximated by the private sector domestic credit aggregate in

the overall portfolio. These indicators are based on the coexistence of unusually strong, and

protracted increases in credit and asset prices. They perform reasonably well, in out of sample

too, showed their ability to point to potential banking distress ahead of the current crisis.

However, without including property prices, such a model failed to predict crises in the previous

analysis. This partly helps to explain the financial strains incurred in the banking system (Sorge,

2011).

Risk occurs through financial and non-financial decisions, as well as operational, and loan

portfolio development strategies. The key risks relating to investment banks are different than

commercial banks. Investment banks are transaction-driven firms while commercial banks are

loan-driven entities. The key risk for investment banks is that they only generate their income

from fees. In addition, they have Proprietary trading risks, which is inherently high-risk

speculation, such as the losses suffered by several institutions in 1994 were caused by an

unexpected rise in dollar interest rates, and a collapse in bond prices. Significant risks can exist

where there are in trading settlement, or delivery open positions, or when the margin calls on an

exchange are insufficient to cover a collapse of the market (Fight, 2004).

If financial stress can be contained within a few countries, it can be more easily dealt with;

but when the banking network is so interconnected that stress crisscrosses many national borders,

it becomes truly systemic. In these circumstances, resolution is more complicated, the

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probabilities of default are higher and the losses given default are larger. Stress flows around the

network in a way that is proportional to the estimates of international claims and liabilities. Such

clustering captures well-known changes in the international banking landscape that have occurred

over the past quarter century using the major financial centers as a benchmark. As a result, the

international banking network became more prone to systemic risk after 1989 and peaked at the

time of the Lehman Brothers’ collapse. Furthermore, it appears that the capacity of the

international banking network to transmit contagion was not much less a year after the failure of

Lehman Brothers. The reason for this is that contagion analysis only concerns the cross-sectional

component of systemic risk and offers no insights as to changes in the average quality of banks’

balance sheets over time (Garratt, Mahadeva & Svirydzenka, 2011).

Financial crises risk model develop by Hyman Minsky helps explain the market economies.

He highlighted that the changes in the supply of credit were pro-cyclical, and increased when the

economy was booming, and decreased during slowdowns. During the expansions investors

became more optimistic; they revised upward their estimate of the profitability of a wide range of

investments, and became more eager to borrow. At the same time, both the lenders’ assessments

of the risks of individual investments, and their risk averseness declined, as they became more

willing to make loans, including some for investments that previously had seemed too risky. When

the economy slowed, investors became less optimistic and more cautious; the lenders also

became more cautious as their loan losses increased, especially if the losses led to declines in their

capital. Minsky believed that increases in the supply of credit in good economic times and the

subsequent decline in the supply led to fragility in financial arrangements, and increased the

likelihood of a crisis. He focused on the variability in the supply of credit, and attached great

importance to the behavior of heavily indebted borrowers, particularly those that increased their

indebtedness to buy real estate, or stocks, or commodities in search for short-term capital gains.

Their motive was the profits from the increases in the prices of these assets, which they

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anticipated would greatly exceed the interest payments on the borrowed money. When the

economy slowed, many of these borrowers would become distressed sellers, for the prices of

these assets would be falling (Kindleberger & Aliber, 2011).

Conclusion
There seem to be several types of risk, rather than a single one facing international banking, which

this paper can point out as a result of the research findings. The international banking network is

an integral part of the market economies; hence its risk and fortune are directly linked to the

macro-economic cycles. Financial crises arise from asset bubbles, such as real estate, securities, or

commodities prices, cross border exposures, speculation, and the supply of credit are some of the

major risks facing international banking; especially, when such risks can not be confined to only

one country, but becomes contagious, and hence systemic.

References

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Borio, C. E., & Drehmann, M. (2009). Assessing the risk of banking crises–revisited. BIS Quarterly

Review, March.

http://millenniumindicators.un.org/unsd/nationalaccount/workshops/2010/moscow/AC223

-S38Bk1.PDF

Capie, F. (2007). 3 Some historical perspective on financial regulation1. The structure of financial

regulation, 69.

Cooper, G. (2010). The origin of financial crises: central banks, credit bubbles and the efficient

market fallacy. Harriman House Limited

Fight, A. (2004). Understanding international bank risk. John Wiley & Sons.

Garcia-Herrero, A. (2007). 3 Some historical perspective on financial regulation. The structure of

financial regulation, 69.

Garratt, R., Mahadeva, L., & Svirydzenka, K. (2011). Mapping systemic risk in the international

banking network. http://core.ac.uk/download/pdf/6398361.pdf

Goodhart, C. A. (2004). Financial supervision from an historical perspective: Was the development

of such supervision designed, or largely accidental. In Conference on the Structure of

Financial Regulation, bank of Finland, mimeo.

Kay,J.<http://www.ft.com/intl/cms/s/0/16daa19c-556c-11e5-9846-

de406ccb37f2.html#axzz3nUeV7HVH>

Kindleberger, C. P., & Aliber, R. Z. (2011). Manias, panics and crashes: a history of financial crises.

Palgrave Macmillan.

Klingebiel, D., & Laeven, L. (Eds.). (2002). Managing the real and fiscal effects of banking crises

(Vol. 428). World Bank Publications.

Mayes, D., & Wood, G. E. (Eds.). (2007). The structure of financial regulation. Rutledge.

Rochet, J. C. (2009). Why are there so many banking crises?: the politics and policy of bank

regulation. Princeton University Press.

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Taleb, N. N. (2010). The black swan: The impact of the highly improbable fragility (Vol. 2). Random

House.

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