One of the key components of a prosperous financial system in our world is the existence of a solid banking sector that provides a range of services to ensure the smooth flow of money in the economy. This position is closely tied to the interrelationships among banks, which can be pivotal in either promoting economic growth or presenting systemic risks.
Here are some aspects of interconnections among banks that could be accompanied by systemic risk, where the whole economy could collapse due to the failure of financial institutions:
1. Common Asset Holdings:
Refers to the situation where financial institutions invest in the same assets within their portfolios. These assets include mortgage-backed securities, bonds, CDOs. Hence, if the value of any of these assets declines, several banks could experience high losses, leading to systemic risk.
2. SIFIs (Systemically Important Financial Institutions):
Represent a large variety of financial institutions present on a global scale. The failure of any of them can trigger the possibility of having an unstable financial sector. For instance, Lehman Brothers, considered a SIFI, declared bankruptcy in September 2008. Therefore, the entire financial system was impacted due to its interconnectedness with other financial institutions through several financial instruments and transactions. The market experienced a significant drop in asset prices, people losing confidence in the financial market, and a credit market freeze.
3. Counterparty Relationships:
Play a crucial role in terms of the interconnections among banks and financial institutions. These relationships involve a set of financial transactions done between banks, including derivatives, swaps, and other financial instruments. Throughout the lifecycle of such transactions, counterparty risk arises, referring to the possibility of a counterparty failing to fulfill contractual obligations before settlement and thus impacting the stability of the financial system. For instance, a significant financial crisis occurred in Russia in 1998, posing a threat to Long Term Capital Management (LCTM), one of the most successful hedge funds incorporated by financial experts, especially in the Russian market. Hence, the position of LCTM deteriorated, raising its counterparties’ fear of the ability of LCTM to meet its obligations.
On the other hand, interconnection among banks is considered an approach towards a better-functioning financial system that directly impacts the stability and efficiency of the economy. Hence, it is required to apply a series of mitigation measures and practices to preserve the financial system and avoid systemic risk through:
1. Diversification of Asset Portfolio:
Banks could look towards diversifying their asset portfolio rather than limiting themselves to investing in common assets. This would clearly reduce the risk of systemic risk in the event of a drop in one of the asset values, as that could impact some banks rather than the whole financial system. Besides, it encourages competition among banks towards finding the best investments.
2. Regulation for SIFIs:
Forcing SIFIs to abide by certain regulations as they are the foundations of the financial system. This includes mandating SIFIs to have higher levels of capital compared to regular financial institutions; therefore, this can ensure their resiliency in cases of financial distress. Furthermore, SIFIs must maintain certain high liquidity standards to cover any short-term obligations.
3. Reducing Counterparty Risk:
Reducing counterparty risk is essential to be taken into consideration by banks before committing to any deal. Hence, banks should precisely investigate the factors contributing to credit risk, represented by evaluating the counterparty’s credit history and reputation in the market, the capacity to repay by evaluating the counterparty’s income and expenses, and forcing the integration of collateral agreements as a guarantee for financial transactions in case the counterparty defaults on payments.
In conclusion, while interconnections between banks are essential for a robust financial system, their effectiveness hinges on the implementation of measures. The investigation highlights that these measures are crucial to prevent systemic risks and ensure stability, emphasizing that interconnections alone may lead to stress without adequate safeguards against system failure.