by Nancy Jacklin, former US Executive Director, International Monetary Fund; Partner, Clifford Chance; Independent Director, AB Mutual Funds

What is international systemic risk?

The international financial system performs the essential functions of financing the global economy and providing the means by which payments are made and settled. If its operation is significantly disrupted, there can be profound negative effects for both financial market participants and the real economy. In today’s highly interconnected financial markets and economies, a major disruption of a national financial market in an advanced economy will likely have contagion effects on the system more broadly.

How do risks arise?

Systemic risk typically starts with a significant unexpected loss in a major financial institution or market. This shock to market participants may result in a financial panic with each participant rushing to reduce its own exposures to those or similar risks. This becomes a flight to less risky assets and a hoarding of cash and other highly liquid financial instruments. These actions reduce credit availability and thus the liquidity of the system, thereby interrupting its effectiveness. The shock that triggers the panic may also arise outside the financial system such as a pandemic or geopolitical event and will have similar effects.

What are some examples of risk emerging and spreading?

Sovereign Debt Risk

In 1982, the Mexican Government shocked the world by stating it would be unable to meet its foreign debts on time and requested a restructuring from its international bank lenders. Once the affected banks looked at their other sovereign lending, it was clear that Mexico was not the only debtor in potential debt distress. The aggregate borrowings of all the debtor countries in this circumstance, if not repaid when due, would have put many large financial institutions at risk. The specter of a major global financial crisis was at hand. This crisis was managed through collaboration of the debtor countries, the governments of the countries of the lending banks, the IMF, and the lenders themselves to obtain an orderly resolution of the debt crisis without any fundamental financial institution failure or financial panic. The banking saying at the time was that “sovereigns can’t go bankrupt.” They could, in fact, lack the currency reserves to meet their foreign debts.

The US Housing Market

In 2008, a major shock to the US financial system occurred when mortgage defaults substantially increased on loans to so-called sub-prime borrowers. This caused large losses on securities which had been created by bundling portfolios of these mortgage loans. These packaged securities were sold not only to US financial institutions and other institutional investors but to many eager foreign investors, as well. Large scale defaults on the sub-prime mortgages occurred. Several large US investment banks had unsustainable levels of exposure to these securities. The resulting panic from the defaults and these institutional failures included depositor runs on commercial banks heavily engaged in the lending. High levels of international exposure meant that this turned into a global financial crisis known as the Great Financial Crisis. The response required major actions: by central banks to maintain liquidity in frozen financial markets, by governments to restore depositor faith in the banking system and deal with economic dislocations, by financial market participants, and by the IMF to help address the international spillover effects.

The Covid Pandemic

In 2020, the severity of the Covid Pandemic, the absence of any predictable path for its evolution or containment, and the expected severe adverse impact on the global economy, led to a flight to low risk assets, a hoarding of cash, and a freezing of the credit system. Central banks responded with creative solutions to provide liquidity to the financial markets impacted by investor flight and governments responded by providing budgetary support to ward off further contagion and a global economic depression.

How might systemic risk emerge in the current environment?

Where might fundamental shocks arise that cause financial market participants to panic and how could they become a crisis?

Several potential risks have recently been cited in government and private sector reports and commentaries:

1. The risk of surprise is highest in the least transparent markets where inherent risks in the activities may not have been properly assessed and where the potential loss bearers are not identified. The risk is especially great in markets where there is a high degree of leverage (that is, a high level of debt financing of a market participant’s positions). Several potential sources of such risk are the activities of unregulated financial institutions such as hedge funds, and creators of and investors in private credit. Another recently highlighted risk involves the increased volume of international bond market investing by unregulated non-bank financial institutions and their use of increasing volumes of foreign currency swaps to hedge their cross-border exposures. This foreign exchange market expansion creates a fast track for international contagion of any financial crisis.
2. The risk that a major financial institution or financial sector utility (such as a payments system or clearing house or financial exchange) may be subject to a major cyber-attack from which it cannot quickly recover. 
3. The possibility that credit risk has not been adequately assessed in vulnerable sectors such as commercial real estate or private credit, with the result that a serious economic downturn or unexpected increase in interest rates creates large, unexpected losses.
4. Geopolitical shocks in the current international environment could emerge.
5. Unexpected/unknown risks from the current disruption of the established global economic order could lead to financial market instability or outright panics. Given the level of uncertainty in the evolution of the global economy and international economic relations, any attempt to credibly forecast or predict outcomes of the current choices being made is highly problematic.

How do we keep risk from becoming a crisis?

Reducing Risk

1. The first line of defense is risk management by the banks and other financial institutions that comprise the international financial system. Each has improved managing sovereign, credit, market, and operational risks based on lived experience and enhanced regulation.
2. The second line of defense is effective financial institution supervision and regulation. Global coordination of those policies assures there are no gaps in the international system and that there is a level playing field for the regulated institutions. This standard-setting and oversight are carried out by regulators such as the Basel Committee for Banking Supervision, which helps to create internationally accepted capital standards for banks, and others such as IOSCO (International Organization of Securities Commissions) which sets global standards for securities markets and the IAIS (International Association of Insurance Supervisors) which sets standards for insurance regulation. The IMF and World Bank have roles in helping assess whether countries are adopting adequate systems of financial supervision.
3. The third line of defense is for the official sector to assess the risk environment for financial markets vulnerabilities. The Financial Stability Board issues regular reports on market resilience, areas of vulnerability, and recommendations for needed corrective actions by the international community. National governments and central banks also have processes for assessing such risks and vulnerabilities. In the U.S., the Financial Stability Oversight Council, chaired by the Secretary of the Treasury, has this function and the Federal Reserve Board independently conducts its own periodic review with reporting. The IMF also assesses these vulnerabilities, with a particular view of global interconnectedness, through its multilateral surveillance functions.

Containing Risk

• Central banks are the lenders of last resort to provide liquidity to essential financial markets and financial institutions to prevent or contain systemic risk.
• If a banking institution is suffering losses in a systemic crisis that threaten its solvency, then, in the U.S., the FDIC will protect federally insured depositors to the extent allowed by law and seek to liquidate or sell the failed institution as quickly as possible to try to limit contagion effects.

If the crisis involves debt distress of sovereign countries or has other international dimensions, a broader set of institutions will need to step in. Responses to international crises are laid out in another BWC Backgrounder, Tools to Combat Global Financial Crises. In a globally connected financial system, financial risk will turn into global crises with increasing frequency. Understanding how these risks emerge, reducing them and their chance of contagion are crucial parts of crisis mitigation.

Featured author: 

Nancy Jacklin, former U.S. Executive Director, International Monetary Fund; Partner, Clifford Chance; Independent Director, AB Mutual Funds