THIS article is an attempt to create an awareness of systemic risk by pulling out information from the 2nd Semester 2021 Financial Stability Report of the Financial Stability Coordination Council (FSCC) chaired by the Bangko Sentral ng Pilipinas (BSP) Governor. The FSCC institutional members are the BSP, Department of Finance, Securities and Exchange Commission, Philippine Deposit Insurance Corp. and the Insurance Commission.
In finance, systemic risk is “the risk of a cascading failure in the financial system rather than simply the failure of individual parts.” (Systemic Risk & Management in Finance, CFA Institute)
The familiar incidents that lead to systemic risk are bank panics or bank runs, where depositors lose confidence and withdraw their money all at the same time; and bank crises caused by a heavy decline in the price of bank assets (think real estate). A memorable systemic risk event of recent vintage was the filing of bankruptcy proceedings and eventual collapse of the big-time investment banker, Lehman Brothers, on September 15, 2008.
The two features of systemic risk are, first, its domino effect which quickly spreads the crisis in one company or sector to other companies and sectors; and second, the ultimate outcome which is the collapse in the entire financial system or entire economy.
The Financial Stability Report (FSR) warns that “Systemic risks matter but there is much that is unclear about it. They matter because the effects are not limited to target constituents but eventually affect the rest of the economy. And they matter because the dislocations feed off each other…where small (even private) shocks can get passed on, magnified and eventually become a problem to all. They matter because there will always be a next occurrence, and we need to prepare for them, ideally, before these systemic risks come to fruition.”
This warning was triggered by the systemic risk that was, or is, Covid-19. And the FSCC was talking about preparations, not so much for Covid-19 now, but for the “next occurrence,” even now concerned as we are gearing up for economic recovery.
The BSP Governor notes that “There continues to be ample liquidity in the financial system, and the unemployment rate is down to 7.4 percent from as high as 17.7 percent as the pandemic was unfolding in 2020.” Then he concludes: “There is momentum towards recovery and the immediate task is to build on the gains of 2021 and face 2022 on an even stronger footing.”
The BSP Governor continues: “… the interlinkages that have propelled our economy forward in normal times are the same interlinkages that can instigate systemic risks when stress conditions arise. This is exactly what this pandemic is about, a systemic risk that has arisen from the ability of the Covid-19 virus to spread, literally among individuals and figuratively across business activities. The point then is to be prepared and take a pre-emptive stance on possible risks.” (Emphasis supplied) Indeed, the interlinkages in our economy are double-edged.
Four areas of concern
The FSCC takes a pre-emptive stance by identifying four issues that must be addressed to sustain our recovery:
a) public heath infrastructure;
b) current supply bottlenecks;
c) social inequity; and
d) climate change.
Since the FSCC has in its membership the principal regulators of the financial system, controlling the levers of fiscal and monetary policy, and having oversight of the broad activities involving the movement or flow of funds, they are in a position to perform effective pre-emptive interventions to address these issues.
The FSCC policy analysis, for one, has the practical value of pointing out, for both government and private business, what are and where the preferred areas of investments should be, i.e., in health infrastructure and related facilities; in supply chain facilities and services; and in climate mitigation/adaptation projects. As for social inequality, investment in education easily appears as the obvious preferred choice, as well as affordable housing. In this sense, FSCC policy interventions can facilitate the flow of investments to these identified areas of preference which more significantly support economic recovery. In the capital market space, this policy analysis guides the capital market stakeholders—whether on the supply or demand side, whether market intermediaries or market regulators—to be directed in their priorities to develop and choose business projects, and to make investment decisions.
We did want to funnel our discussion to how systemic risks can affect the capital market’s function of matching the demand and supply of capital funds. Some of us do realize that systemic risk in the financial sector is usually transmitted through the payments system which interconnects domestic and international financial institutions. When this system is disrupted, business transactions are effectively blocked, or caused to be more expensive suddenly. (The exclusion of Russia from the SWIFT payments system comes to mind.). Systemic risks like this is what we wish to avoid, if we can.
So our discussion leads us to what’s happening now. New systemic risk threats are brewing from the ongoing Russian invasion of Ukraine that started February 24, 2022. The FSCC Report we use as reference here was written December 2021 and didn’t foresee the Ukraine invasion coming. What systemic risk-induced adversities can we expect now?
I don’t think we—nd I mean the financial practitioners particularly—have thoroughly assessed the potential ultimate impact pf the systemic risk threats arising from the Ukraine-Russian war, now still unfolding. But we do feel the encroaching effects, e.g. disruptions in commodity supplies and in the supply chains; increased commodity prices especially oil; disturbances in the global payments systems; impediments in the normal flow of cross-border flow of funds; and, of course, inflation. Are these systemic risks playing out abroad going to reach our shores in a materially disruptive, destabilizing manner to hinder our economic recovery?
We can take some comfort we have an FSCC and that our BSP Governor also co-chairs the Regional Consultative Group for Asia of the Financial Stability Board. But how I wish FSCC can give definitive answers to our troubled minds. Or can anyone?