Last day, last General Session, last session...
General Session V: "Interconnectedness and Contagion in Global Markets: Missed Opportunity"
Panelists: Kimo (sp?), Jim Allison of ConocoPhillips, Allan Mendelowitz of the Federal Housing Finance Board, Adam Litke of Bloomberg, Stuart Wason of OSFI Canada, + one more (PC Guy)
Kimo: The literal interconnectedness of assets, now that the topology is actually known by regulators, isn't significant to explain the amount of contagion seen during the financial crisis. [KR: They've literally mapped this over time, which is pretty cool.]
Jim: Path-dependence relates to contagion. Some exogenous cause is not contagion. Contagion is how an exogenous cause affects entities 1-(i-1) and then that affects entity i.
Allan: Remember that all of this is happening in a fractional-reserve system. Institutions are brought down by liquidity and collateral shortages. One aspect of contagion is Jim's type. The other type is related to the lack of information, where everyone tends to assume the worst, which leads to fire sales. So the perception of a problem is as important as actual problems.
Adam: Over an even longer timeframe, the connections become even more unlikely and unexpected.
Stuart: Insurance doesn't do as much work on interdependencies, but it's applicable to us as well. Contagion risk is less of an issue, although there are examples.
Some PC guy: Insurers look at classes of business. Premiums rise and fall with the general economy, so there's a big connection there. Characterizes asbestos and Sandy as contagions. Asset side is simple though. Simple, carefully managed, liquid, and low-yield.
What about regulatory contagion? Financial crisis resulted in regulations on energy sector.
Jim: I don't like saying that something could not be foreseen. True we didn't, but could we have? In this case, we were indirectly connected to the banks. Banks -> derivatives, derivatives = highly risky, high risk -> regulation. That was the logic of pulling the energy sector into the regulatory response. I wouldn't call it contagion since it hasn't killed us yet.
Central clearing is applied as a way to reduce interconnectedness. Does that create too much systemic risk? Is there a central point of failure?
Jim: Yes, they've been identified as such, but the rationalization is that they are well capitalized and therefore safe. We've heard this argument before. All the eggs are in one basket, so that basket needs to be watched very carefully.
Allan: Contagion is about reducing counterparty risk, not systemic risk. Clearing houses address counterparty risk. I don't see how they improve systematic risk. We're just trading one set of risk for another.
Adam: Clearing houses do provide other benefits, for instance it simplifies the process in a way that reduces operational risk. They also separate direction risk from counterparty risk.
Jim: Still we appreciate having the ability to use clearing houses, because at times we are concerned with removing counterparty risk. But in exchange you pick up liquidity risk. In my industry, we are accustomed to managing counterparty risk, but liquidity risk is something we're less comfortable with. Consequently there is a potential for systemic risk to increase.
PC guy: Sandy illustrates interconnectedness of bank, insurance, and energy in that insurance losses are mitigated when the power can come on sooner. At one point, a regulator explained his view on rate increases, and while he said that he believes insurers are entitled to reasonable returns, he explicitly said "Do not send me a rate filing that includes a hurricane model, because we don't have hurricanes in this state." The very next week, the governor's mansion was hit by a hurricane. So, what are you going to do about that?
Jim: We discussed giving regulators "big data" to do "big science." What if instead we determined how much/what information on your counterparty is necessary to assess your risk re: that counterparty. I think it might make more sense for each entity to have access to the information (to remove/reduce the information asymmetry) and to each perform their own analysis. Could that reduce the threat to whole system? Could we convince entities to give up that kind of information?
Adam: Regulators can improve the information flow, but so can firms. TBTF is destined to fail because the largest economy will always have the largest firms.
Have business and regulators done enough to prepare for the next crisis?
PC Guy: We are always looking toward the next crisis, but what are we to do when we're regulated into certain assets and certain risks? We have limited ability to do anything to prepare.
Allan: I don't like the term TBTF. TBT-Prosecute, maybe. Better is Too Interconnected to Fail. Look at the car industry. In order to do something about this, the government needs to know what the interconnectedness looks like. During the financial crisis, the government people made all kinds of huge decisions with no data and no evidence. So we need information, we need data standards.
Stuart: Regulators could ask firms to demonstrate how they would manage thing if they were to get into difficulties.
Kimo: I think we're on a good path to understanding interconnectedness. Contagion needs a lot more work. The domino effect isn't known that well for central banks and others. We need formal models for this. For joint-ownership of assets, we don't know anything right now.
End Conference! Thanks for following.
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