Financial System Resilience: The Climate Change Edition

Supervisors around the world wish to ensure that the financial system is resilient to climate change. To that end, current best practice is to formulate detailed long-run climate scenarios and then ask whether financial institutions, especially banks, can withstand the losses associated with them. These scenarios typically map the path of surface temperature, sea level, and the resulting economic damage over the next 30 or 40 or 50 years.

However, financial-system stress arises from sudden, widespread changes in the value and perceived quality of leveraged intermediaries’ assets, while climate change is likely to remain gradual over decades. As a result, skeptics reasonably doubt that climate change poses systemic financial risk sufficient to merit the use of scarce supervisory resources and a costly testing apparatus. To quote John Cochrane: “[B]anks did not fail in 2008 because they bet on radios not TV in the 1920s. Banks failed over mortgage investments they made in 2006.”

Fortunately, we now have low-cost, high frequency, forward-looking tools for monitoring climate-related sources of financial instability. In this post, we use one such tool to identify episodes in which the potential influence of climate change on systemic resilience may be worthy of attention. We also look at how an aggregate measure of financial system vulnerability evolves over time….

Stress Testing Financial Networks: The Case of CCPs

Following the crisis of 2007-09, in which AIG’s bilateral derivatives trades played a notable role, the G20 leaders called for central clearing of standardized derivatives. The resulting shift has been dramatic: central counterparties (CCPs) now clear about three-fourths of interest rate contracts, up from less than one-fourth a decade earlier (see Faruqui, Huang and Takáts).

By substituting a CCP as the buyer to every seller and the seller to every buyer, central clearing mutualizes and can—with appropriate margining, trade compression, position liquidation procedures, and reporting—reduce counterparty risk (see Tuckman). CCPs also contribute to financial resilience by promoting uniform margin standards, reducing collateral and liquidity needs, and making risk concentrations (like that of AIG in the run-up to the crisis) more transparent.

At the same time, the shift to central clearing has concentrated risk in the CCPs themselves. Reflecting economies of scale and scope, as well as network externalities, a few CCPs serving global clearing needs have grown enormous. For example, as of the last report at end-September 2018, open interest at LCH Clearnet exceeded $250 trillion. Moreover, the clearing activity of some CCPs lacks any short-run substitute. As a result, to avoid disrupting large swathes of the global financial system, any recovery or resolution plan for these CCPs must ensure continuity of service (see CCP Resolution Working Group presentation to the OFR Financial Research Advisory Committee). Finally, CCPs are the most interconnected intermediaries on the planet, making them channels for transmission and amplification of financial distress within and across jurisdictions. As then-Governor Powell clearly states in the opening quote, the safety of CCPs is central to the resilience of the global financial system.

We and Richard Berner have been studying how regulators use stress tests (see our earlier posts here and here) to assess the resilience of financial networks, including banks and nonbanks. In our joint work, we focus on CCPs due to their centrality, their extreme interconnectedness and their lack of substitutability. This post is based on our research….

What Risk Professionals Want

As memories of the 2007-09 financial crisis fade, we worry that complacency is setting in. Recent news is not good. In the name of reducing the regulatory burden on small and some medium-sized firms, the Congress and the President enacted legislation that eased the requirements on some of the largest firms. Under the current Administration, several Treasury reports travel the same road, proposing ways to ease regulatory scrutiny of large entities without changing the law (see here, here and here). And, recently, the Federal Reserve Board altered its stress test in ways that make it more likely that poorly managed firms will pass. It also voted not to raise capital requirements on systemically risky banks over the next 12 months.

A few weeks ago, one of us (Steve) had the privilege to speak at the 20th Risk Convention of the Global Association of Risk Professionals (GARP). Founded in 1996, GARP engages in the education and certification of risk professionals and has several hundred thousand members worldwide. (Disclosure: Brandeis International Business School and NYU Stern are GARP Academic Partners.) The organizers allowed us to solicit the views of the 100-plus attendees on two issues that are central to financial resilience: Are bank capital requirements high enough? And, do central counterparties (CCPs) have sufficient loss-absorbing buffers? They answered both questions with a resounding “NO” ….

Size is Overrated

This month, in the guise of supporting community banks, the U.S. Senate passed a bill (S.2155) that eases regulation of large banks. We share the critics’ views that this wide-ranging dilution of existing regulation will reduce the resilience of the U.S. financial system.

In its best known and most publicized feature, the Senate bill raises the asset size threshold that Dodd-Frank established for subjecting a bank to strict scrutiny (such as the imposition of stress tests, liquidity requirements, and resolution plans) from $50 billion to $250 billion. In this post, we examine the role of asset size in determining the systemic importance of a financial intermediary. It turns out that (aside from the very largest institutions, where it does in fact dominate) balance sheet size is not a terribly useful indicator of the vulnerability a bank creates. We conclude that Congress should ease the strict oversight burden on institutions that pose little threat to the financial system without raising the Dodd-Frank threshold dramatically.

Judge makes an elegant proposal for accomplishing this. For institutions with assets between $100 billion and $250 billion, Congress should just flip the default. Rather than obliging the Fed to prove a mid-sized bank’s riskiness, give the bank the opportunity to prove it is safe. This approach gives institutions the incentive to limit the systemic risk they create in ways that they can verify. It also sharply reduces the risk of litigation by banks that the Fed deems risky...

Basel's Refined Capital Requirements

After nearly a decade of negotiations, last month, the Basel Committee on Banking Supervision completed the Basel III post-crisis reforms to capital regulation. The final standards include refinements to: credit risk measurement and the computation of risk-weighted assets; the calculation of off-balance-sheet exposures and of the requirements to address operational risk; and the leverage ratio requirement for global systemically important banks (G-SIBs).

In this post, we focus on revisions to the way in which banks compute risk-weighted assets. To foreshadow our conclusion: the new approach adds unnecessarily to regulatory complexity. If the concern is that current risk-based requirements result in insufficient capital, it would be better simply to raise the requirements.

Operational Risk and Financial Stability

Recent disasters—both natural and man-made—prompt us to reflect on the relationship between operational risk and financial stability. Severe weather in sensitive locations, such as Hurricane Irma in Florida, raises questions about the resilience of the financial infrastructure. The extraordinary breach at Equifax highlights the public goods aspect of data protection, with potential implications for the availability of household credit.

At this stage, it’s important to pose the right questions about these operational shocks and, over time, to draw the right lessons. We expect that systemic financial intermediaries’ risk managers, members of their boards, their regulators, and their ultimate legislative overseers are currently in the midst of an intensive review of exposures (and that of the financial system as a whole) to these risks.

So, what is operational risk (OR)? The Basel Committee for Banking Supervision (BCBS) defines OR as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events”....

Commentary

Money, Banking, and Financial Markets