Systemic Risk

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Overview

Systemic risk refers to the risk of a breakdown of an entire system rather than simply the failure of individual parts. In a financial context, if denotes the risk of a cascading failure in the financial sector, caused by linkages within the financial system, resulting in a severe economic downturn. A key question for policymakers is how to limit the build-up of systemic risk and contain crises events when they do happen.

Reducing the likelihood and severity of future financial crises can be ensured by a coordinated global effort to monitor market trends and bubbles, and to end government bailouts for failing financial institutions.

The US Securities and Exchange Commission (SEC), the Office of Financial Research, (OFR, an independent bureau within the United States Department of the Treasury that was established Dodd–Frank), the Financial Stability Oversight Council (FSOC, a Federal agency established by Dodd-Frank) and the Financial Stability Board have all issued reports or proposals focused on the supposed risks of the asset management industry. The gist of these reports and consultations is a recognition that the asset management industry —particularly because of its size—pose systemic risk implications that require additional regulating.

Regulation

In the U.S., the Dodd-Frank Wall Street Reform and Consumer Protection Act created an Office of Financial Research to monitor global market developments that might lead to systemic failure. The OFR is part of the U.S. Treasury Department and supports the Financial Services Oversight Committee of federal financial regulators. The FSOC directs the OFR and requests data and analyses to support its members’ work. FSOC also retains authority to deem nonbank institutions as significant important financial institutions (SIFIs).

Despite warnings in the Dodd-Frank Act that federal bailouts were a thing of the past, Dodd-Frank specifically authorizes the FDIC to guarantee the assets and liabilities of failing financial firms. It also calls on the Fed to create a list of systemically significant firms for special oversight. The FDIC is an independent federal agency created by the US Congress in 1933 in response to the thousands of bank failures that occurred in the 1920s and early 1930s. Its role is to maintain stability and public confidence in the nation's financial system by insuring commercial bank deposits; examining and supervising financial institutions for safety and soundness and consumer protection; making large and complex financial institutions resolvable; and managing receiverships.

A number of European and global entities have undertaken efforts to address systemic risk. For example, the G-20 nations agreed to reduce bank leverage by increasing the Basel III capital requirements for financial institutions. The European Union has worked to create a European Financial Stability Facility (EFSF) to provide temporary help to member states regarding fiscal debt burdens and fiscal deficits. The EFSF is a significant part of the €750B European Stabilization Mechanism to help member states.

The FSB

The Financial Stability Board (FSB) is an international body that monitors and makes recommendations about the global financial system. It was established in April 2009 by G20 heads of state as a successor to the Financial Stability Forum (FSF).

The FSB promotes international financial stability by coordinating national financial authorities and international standard-setting bodies as they work toward developing strong regulatory, supervisory and other financial sector policies. It fosters a level playing field by encouraging coherent implementation of these policies across sectors and jurisdictions.

The FSB, working through its members, seeks to strengthen financial systems and increase the stability of international financial markets. The policies developed in the pursuit of this agenda are implemented by jurisdictions and national authorities.

More specifically, the FSB was established to:

  • Assess vulnerabilities affecting the global financial system as well as to identify and review the regulatory, supervisory and related actions needed to address these vulnerabilities;
  • Promote coordination and information exchange among authorities responsible for financial stability;
  • Monitor and advise on market developments and their implications for regulatory policy;
  • Monitor and advise with regard to best practice in meeting regulatory standards;
  • Undertake joint strategic reviews of the international standard setting bodies and coordinate their respective policy development work to ensure this work is timely, coordinated, focused on priorities and addresses gaps;
  • Set guidelines for establishing and supporting supervisory colleges;
  • Support contingency planning for cross-border crisis management, particularly with regard to systemically important firms;
  • Collaborate with the International Monetary Fund (IMF) to conduct Early Warning Exercises;
  • Promote member jurisdictions’ implementation of agreed commitments, standards and policy recommendations, through monitoring of implementation, peer review and disclosure.

CFA Institute Outlook

CFA Institute believes the systemic risk concerns specific to the asset management industry are misplaced and may reflect a lack of understanding regarding the ways that this industry differs from other financial services industries, such as the banking industry. The asset management business is fundamentally different from bank and insurance institutions in that asset managers typically do not own the assets they manage, and assets managed are typically marketable and highly liquid securities.

CFA Institute supports meaningful measures to reduce systemic risk in the financial industry. We believe, however, that it is important to balance the actual need for additional regulation with the industry. This industry is already highly regulated, and showed little systemic implications stemming from the 2007-08 financial crisis; in fact, it has shown resiliency during tumultuous times.

We are unsure that a systemic risk issue exists in regard to the vast majority of open-end funds. The regulatory requirements already in place under the Investment Company Act of 1940 provide a robust barrier against that kind of contagion. It is important that policy makers base their regulatory framework on a thorough understanding of the industry it seeks to regulate.

We question the utility and appropriateness of regulatory actions to mandate “risk contagion” efforts across the fund industry, particularly where there are substantial questions about their effectiveness. Instead, we recognize that some degree of risk is inherent in, and vital to, our capital markets.

CFA Institute sponsors the Systemic Risk Council, which is composed of US and European market leaders, academics and former policy makers. As sponsor of the SRC, CFA Institute actively monitors and encourages regulatory reform of systemic risk detection and mitigation in U.S. capital markets, particularly in the areas of bank capital requirements, money market reform, and funding for financial regulators.

CFA Institute has also participated in a G–20 task force charged with making recommendations to harmonize financial regulatory standards worldwide.

Regarding the view of CFA Institute on systemic risk:

  • We have called for monitoring of systemic factors on a global basis, and for regulators globally to work together to enable this monitoring.
  • We called for the OFR in the United States to be independent of the member regulators of the FSOC.
  • We are concerned that conflicts of interest inherent in the OFR’s structure — answering to the regulators who may have created policies that are leading to systemic risks — will bias its analyses and that its findings will provide false comfort and cover for FSOC members.
  • We believe that provisions giving the FDIC authority to guarantee the liabilities of failing institutions send a dangerous message to market participants. Specifically, we are concerned that it conveys to potential creditors that systemically significant firms continue to be too big to fail, and that their liabilities will ultimately receive federal bailouts to prevent systemic failures.
  • We believe this creates moral hazard within the financial markets and should be replaced by mechanisms that deal with the failure of large financial institutions through a bankruptcy mechanism.
  • While we support higher capital requirements for financial institutions including, in particular, large commercial banks, we urge caution in promoting a single global approach to financial market regulation. Such approaches have the potential to encourage coordinated decisions and activities that might exacerbate, rather than diminish, risk on a global basis.
  • We are concerned that the Basel risk-weighting system is based on a static system that ignores the magnitude of the accumulated risks. In particular, the risk weightings continue to apply regardless of whether the exposure amounts to $10 million or $10 billion.

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