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….

The Urgent Agenda for Financial Reform

Thanks to unprecedented interventions by central banks and fiscal authorities, the pandemic-induced financial strains of March-April 2020 are now well behind us. Unfortunately, as a consequence of the official actions necessary to stabilize the financial system, market participants now count on government backstops to insure them against the fallout from future disturbances.

Naturally, central banks should be prepared to combat extreme shocks that threaten financial stability. However, to limit excessive reliance on central banks, we need to ensure that financial institutions can continue to operate smoothly on their own even in bad times. This means redesigning parts of the financial architecture. While market participants have a major role to play, it is authorities who need to address externalities—spillover effects—and to improve incentives for the private sector to maintain the liquidity of markets and access to short-term funding in times of moderate stress.

With the pandemic-induced disruptions still fresh in memory, this is the perfect time to identify deficiencies and implement reforms aimed at improving the resilience of the financial system. Fortunately, the June 2021 Report of the Hutchins Center-Chicago Booth Ta sk Force on Financial Stability (H-B) addresses all the key challenges, laying out a broad agenda for U.S. financial reform. In addition, we have the July 2021 G-3 0 R e port that provides detailed proposals for reforming the U.S. Treasury market.

In this post, we discuss these reform proposals, highlighting areas where we strongly agree and believe that implementation is urgent. In particular, we emphasize the benefits that would come from changes in the Treasury market (cash and repo), in the central counterparties (CCPs) that have become the most critical links in the global financial system, and in open-end mutual funds holding illiquid assets. We also highlight the governance proposals in the H-B Report. In our view, full implementation of the agendas set out in the these reports would make the U.S. financial system far safer than it is today….

Cyber Risk, Financial Stability and the Payments System

Cyber risk remains at the top of the list of risks to the financial system, and the financial system is well known as the primary target for hackers (see here, here and here). In response, financial institutions expend huge resources on protecting their information systems—by one estimate, well over $100 billion. Yet, private sector actions to prevent cyber losses fall short due to a glaring externality: since the damage is likely to spill over to other financial firms and to markets, individual firms cannot reap the full benefits of preventing cyber attacks.

To get a sense of the financial stability risks associated with cyber fragility, we need to understand the financial system in some detail. Unfortunately, financial networks are highly complex and vary significantly across markets and functions. They also evolve meaningfully over time. On top of these enormous challenges, assessing network vulnerabilities frequently requires institution- or transactions-level information that is normally not publicly available.

This brings us to the important recent work of Eisenbach, Kovner and Lee (EKL), who study the vulnerability of the U.S. large-value interbank payments system, Fedwire, to a cyber attack on one of the principal nodes of the payments network—namely, one of the top five banks. In this post, we highlight EKL’s analysis as a model for the assessment of cyber-driven network risks. We suggest how central bankers should react to a cyber attack on the payments system, and speculate about what is needed to prevent, as well as mitigate, cyber risks….

Stress tests lack COVID-scale stress

In recent months, the Federal Reserve acted aggressively to support nearly all parts of the U.S. economy. Unprecedented monetary policy actions, both in size and scope, served to maintain market function and the flow of credit. And, while we have misgivings about the Fed’s CARES Act-driven moves to support the nonfinancial sector, we applaud Chair Powell and his colleagues for their quick and decisive actions (see our previous posts here, here and here). This, together with fiscal policy support for individual households and small firms, has kept an awful situation from becoming far worse—at least for now.

But, the Fed’s responsibility extends beyond monetary policy to the regulatory and supervisory arenas: it is obliged to maintain the safety and soundness of the banking system (and, to some extent, of the broader financial system). On this score, and in stark contrast to its actions in 2009, the Board of Governors has come up significantly short. Without full disclosure of the latest stress test results, suspicions will linger about the ability of the largest banks to provide credit to healthy borrowers if the COVID recovery falters. (See our earlier post for details.)

In this post, we examine the results from the Fed’s 2020 assessment of bank capital adequacy published on June 25. Based on the COVID-related sensitivity analysis—for which individual results are unavailable—one-quarter of the 33 banks tested fall below the regulatory minimum in the worst of the three cases. The fact that we can only guess which banks those might be creates suspicion regarding many banks….

An Open Letter to Randal K. Quarles, Federal Reserve Vice Chair for Supervision

Dear Vice Chair Quarles,

Nearly three years ago, we wrote an open letter congratulating you on your nomination as the first Vice Chair for Supervision on the Board of Governors of the Federal Reserve System. In that letter, we highlight the central mission of ensuring the resilience and promoting the dynamism of the U.S. financial system.

Today we write to express our profound disappointment regarding the plans (expressed in your June 19 speech on “The Adaptability of Stress Testing“) to limit the disclosure of this year’s large-bank stress tests. In our view, failure to publish the individual bank results from the special COVID-19 related “sensitivity analysis” weakens the credibility and effectiveness of the Fed’s stress testing regime.

Consequently, we urge you to reverse course and to announce this week the individual bank sensitivity results, along with the aggregates. To put it bluntly, the point of a supervisory stress test is disclosure. Anything short of full transparency leaves potentially destabilizing questions unanswered.

COVID-19 Stress Test

The COVID-19 shock is almost surely leading to a larger economic downturn than the Great Financial Crisis of 2007-09. However valuable, neither stress tests nor financial supervision in general has prepared us for a shock of this magnitude.

These developments leave us profoundly concerned that the global financial system lacks the resilience needed to weather what will clearly be a very violent storm. In our view, the most up-to-date information regarding the impact on the financial system of COVID-19 comes from NYU Stern Volatility Lab’s SRISK. By utilizing timely weekly market equity data, rather than less accurate and substantially delayed book-value information, SRISK enables us to gauge the aggregate shortfall of capital in the financial system during a crisis (defined as a 40 percent drop of the global equity market over the next six months). Analogous to a severe stress test, the idea behind SRISK is that an intermediary contributes to fragility to the extent that it is short of capital at the same time that there is a system-wide shortfall (see, for example, here). Just as a forest is more vulnerable to fire during a drought, so the financial system is more vulnerable to a large shock when there is a large aggregate capital shortfall.

In the remainder of this post, we highlight some recent SRISK developments and compare them to those during the 2007-09 crisis. We view these developments as a clear warning to regulators and supervisors that the COVID-19 shock meaningfully threatens financial stability across major jurisdictions….

The Costs of Inefficient Regulation: The Volcker Rule

By creating a new regime to limit threats to the U.S. financial system—including heightened scrutiny for systemic intermediaries and a new resolution framework—the Dodd-Frank Act (DFA, passed in July 2010) has made the U.S. financial system notably safer. However, DFA also included burdensome regulations that, in our view, reduce efficiency while doing little to improve resilience. The leading example of such a provision is DFA section 619, known as the Volcker Rule. As Duffie noted before regulators began to implement the Rule (see the citation above), it is not “cost effective.”

Ultimately, the need to focus on this overly complex and relatively ineffective regulation distracts both the government authorities and private sector risk managers from tasks that really would make the system safer. Not only that, but cumbersome rules almost surely increase pressure to ease regulation more broadly. This leads policymakers to scale back on things like capital requirements and resolution plans that we truly need to ensure financial system resilience.

In this post, we briefly describe the Volcker Rule, highlighting its complexity, its tenuous links to risk management, and its apparent negative impact on the financial system….

Improving resilience: banks and non-bank intermediaries

Debt causes fragility. When banks lack equity funding, even a small adverse shock can put the financial system at risk. Fire sales can undermine the supply of credit to healthy firms, precipitating a decline in economic activity. The failure of key institutions can threaten the payments system. Authorities naturally respond by increasing required levels of equity finance, ensuring that intermediaries can weather severe conditions without damaging others.

Readers of this blog know that we are strong supporters of higher capital requirements: if forced to pick a number, we might choose a leverage ratio requirement in the range of 15% of total exposure (see here), roughly twice recent levels for the largest U.S. banks. But as socially desirable as high levels of equity finance might be, the fact is that they are privately costly. As a result, rather than limit threats to the financial system, higher capital requirements for banks have the potential to shift risky activities beyond the regulatory perimeter into non-bank intermediaries (see, for example here).

Has the increase of capital requirements since the financial crisis pushed risk-taking beyond the regulated banking system? So far, the answer is no. However, in some jurisdictions, especially the United States, the framework for containing systemic risk arising from non-bank financial institutions remains inadequate….

Commentary

Money, Banking, and Financial Markets