Banking on Thin Ice !

Gaining back trust and confidence amongst its investors is one of the most difficult part the central banks across the world are facing.Ripple effects caused by defaults,liquidity crisis in money markets and loss of confidence cause a bank run.This systemic risk allows an entire financial system to collapse. Due to the interlinkages of financial system this collapse spreads quickly across the globe. Traditionally, the banks across were less interconnected.However, in recent times they are well connected through common policies, common basel requirements necessary for every central bank of member country and products like currency derivatives that allows cross currency swaps. These international swaps allow exchange rate fluctuations and indirectly influence many factors that affect the economy of the countries involved.Besides all this, analyzing systemic risks in international banking continues to be an activity with high rewards and helps the banks to review where they went wrong.

Traditionally, banks focussed on controlling inflation and targeting growth. This was a common objective of most of the central banks in the world. They kept the supply and demand of currency under-control, focussed on the budget deficit(if any) and kept inflation under the wings.But the inflation targeting somehow failed to get financial stability back  before and after the crisis in 2007-2013.The longest duration of global meltdown saw US collapse and the Euro Sovereign Debt Crisis(commonly called the Euro-zone crisis).

Paul Krugman wrote in 2009 that the run on the shadow banking system as the “core of what happened” to cause the crisis. “As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible – and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank.” He referred to this lack of controls as “malign neglect.” The actions of one country have triggered many changes in another country’s economy.Some experts have said that regulated banking organizations are the largest shadow banks.

Many “shadow bank”-like institutions and vehicles have emerged in American and European markets, between the years 2000 and 2008, and have come to play an important role in providing credit across the global financial system.Shadow banks can also cause a buildup of systemic risk indirectly because they are interrelated with the traditional banking system via credit intermediation chains, meaning that problems in this unregulated system can easily spread to the traditional banking system.

Regulated or unregulated, one thing should be understood and clearly that is if an individual bank faces a problem then the whole banking system is not too far from facing serious issues too.In a recent IMF working paper by Stijn Claessens and M. Ayhan Kose(January 2013) four reasons that caused the recent descent of the banking system are:

(1) the widespread use of complex and opaque financial instruments;

(2) the increased interconnectedness among financial markets, nationally and internationally, with the U.S. at the core;

(3) the high degree of leverage of financial institutions; and

(4) the central role of the household sector.

These factors, in combination with the ones common to other crises, and fueled at times by poor government interventions during different stages, led to the worst financial crisis since the Great Depression.

Central banks are fragile and late intervention by governments just make matters worse. However, prediction of banking failures are hard to point out and since banks are all globally connected any action by one central bank of a country can lead to failures of the world banking system so careful intervention is important. Presence of shadow banks is a different question altogether and presence of them sometimes can worsen situations for traditional banks since they are give way to unregulated activities in a regulated market.Subsequent to the subprime meltdown in 2008, the activities of the shadow banking system came under increasing scrutiny and regulations.But shadow banking existed for purely one reason and that was that there was a demand for it or else it could never have existed.

© 2013 Deena Zaidi. All rights reserved.