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The evolution of systemic risk

09 April 2010 Gareth Stokes
Gareth Stokes, FAnews Online Editor

Gareth Stokes, FAnews Online Editor

Tectonic shift is used to describe the ‘evolution’ of Earth’s land masses. Scientists believe the seven continents we have today were once part of a single land mass, which separated over millions of years. A similar tectonic shift is taking place in the

A tectonic shift

Before we tackle the future, we have to understand where we come from. To do this, Terblanché described the changing dynamics of human interaction. When early man formed hunter-gatherer societies productivity increased 50-fold, our move to farming communities with labour specialisation resulted in a further 90-fold improvement, but it was the industrial revolution that supercharged development. The revolution resulted in a 175-fold increase in wealth for approximately one third of the global population.

Today’s global economy has put paid to constraints such as time zones and distance. “We have built a world that can (and does) communicate and transact across borders,” said Terblanché. A quiet revolution is taking place – one that will result in a 10 000-fold positive impact on 80% of the world’s citizens. Over the past twenty years the number of countries participating freely in world trade has increased from 17 to 77. As a result economists struggle to model cross-border interaction, and find it extremely difficult to recognise downside risk. The modern economy is beset by changes in volatility, unpredictability and complexity.

Network theory could be the answer

A study of the interaction between countries two decades ago reveals 136 trading pairs, today there are approximately 3 000. “This has grave implications for the management of risk, because we don’t think of our world in terms of a networking structure,” said Terblanché. He opined that if one or two countries crashed out of a 136-pair network the rest of the world would survive relatively unscathed. An example would be the 1980s Asian banking crisis. But if we remove one or two critical hubs from the modern world, the entire network comes crashing down. As a result of this interconnectedness, economists now use network models to study inter-country risk.

If you take a snapshot of global interconnectivity every ten years you can see critical nodes developing. In 2010 the US and UK remain dominant, with solid links to countries like China, Australia, Canada and Brazil. The importance of single nodes in the network demonstrates the tectonic shift in risk that’s taken place over the past four decades. A networking model of the US banking system illustrates this shift. Studies show that 75% of all US inter-bank transactions are handled by just 66 of 8 000 American banks. If an ‘outlier’ fails the rest of the system will continue without hiccups, but if one of the key banks fails – game over!

“This systemic risk is what has to be monitored in the new risk world,” said Terblanché. He believes there are two ways to deal with the change. The first is to untangle the interconnectivity through a stronger focus on globalisation, the second to square up to the problem and figure a way through.

Tools to deal with systemic risk

The pre-1970 global economy was easier to understand. Goods and services were supplied in return for cash, which was deposited at banks and underpinned by physical gold. In other words, the symbol economy in the financial services realm was nicely linked to the real economy. This simple relationship ended when US President Nixon abandoned the gold standard in August of 1971. His action broke the causal link between goods and services and the banks, and banks started generating – rather than housing – assets.

In the years immediately following Nixon’s decision we experienced massive spikes in banking system volatility, a 10-fold increase in the value of banking assets and a coincident decline in liquidity. But bank shareholders were over the moon. Banks’ average return on equity (ROE) in the early 1970s stood at 7% per annum (with a volatility of 2). Today the ROE is closer to 20% with a “tectonic shift” in volatility! “To save the system we need to have regulation, policies and frameworks,” said Terblanché. Regulation is the only anchoring point between the symbol and real economies.

Unfortunately regulation is a double-edged sword. One example is the so-called ‘Greenspan put’ when the previous Federal Reserve chairman decide to depart from the tried and tested Taylor rule for setting interest rates. The result was a bubble in the US property market. When this was combined with US legislation to force banks to extend sub-prime financing the results were catastrophic. “Tampering with policies facilitates a bubble and magnifies your risk!” Money is like water, following the path of least resistance. US regulatory changes are to blame for the $800m (in 2001) to $26trn (five years later) surge in the CDS market. The market was soon eight times the value of the underlying bonds. And derivatives grew by 30% per annum over a period when global GDP growth was pegged at 4%. The $200trn derivatives market soon exceed world GDP by five times! Terblanché observed: “If you change legislation you change the relationship between the service economy and the real economy.”

Time for a new economic theory

The private sector cannot shoulder all the blame for the global financial system meltdown. Many of the questionable practices that led to the sub-prime crisis were legislated. Instead we must consider the tools used to assess systemic risk. We’re transacting in a world where traditional methods of risk assessment cannot be relied upon in isolation. This realisation prompted an “Economic theory doesn’t serve us!” headline in the respected Economist magazine recently. Traditional tools for measuring economic risk have failed us 18-times since 1971, and instead of introducing corrective measures we’ve rebuilt shattered economies using the same flawed blueprint.

We grew up in an age of Western dominance. Asian economies (particularly China) are today emerging as the new dominant economic force, but in a world where interconnectivity is on the rise, the greatest resilience and fragility we have lies in this interconnectedness. The good news for South Africa: “We are in the unique position where advanced economies dream of having the stability emerging economies have!”

Editor’s thoughts: Financial services companies tread a fine line between regulatory compliance and profit. Each new regulation forces a change in business practice to maximise profit – which is why regulators must carefully consider the unintended consequences of their actions. Is more regulation the answer – or should we be concentrating on smarter regulation? Add your comments below, or send them to gareth@fanews.co.za

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