M.E.

S
PILLAI’S COLLEGE
OF
ARTS,COMMERCE
AND SCIENCE

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ECONOMIC

PROJECT

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 TOPIC:

BANKING

SECTOR

REFORM

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MEMBERS INVOLVED IN THE PROJECT:

-Abhishek upadhyay
(1353)
-pramod kumar
(1337)
-Hasan mehdi
(13 )
-Ambar raj hardy
(13 )
-Nitheesh pillai
(1333)

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“BANK RUN AND SYSTEMIC FRAGILITY”

A large number of banks experienced financial crisis in the eighties and nineties in
different countries of the world.About 75% of member countries of international
monetary fund experienced serious banking problems between 1980 and 1995.the loss of
output resulting from these crises was huge.

Bank failures have greater adverse effect on the economy and thus are considered more
important than failure of other types of business firms .bank failures are viewed to be
more damaging than other failures because of a fear that they may have contagion effects
throughout the banking system, felling solvent as well as insolvent. The failure of an
individual bank introduces the possibility of system- wide failure or systemic risk. This
perception is widespread. It appears to exit in almost every point in time irrespective of
the existing economic or political structure. As a result ,bank failures have been and
continue to be a major public policy concern in all countries and a major reason that
banks are regulated more rigorously than others firm.

As a result ,it can be argued that the poor performance of banking experienced in almost
all countries in the last two decades reflects primarily regulatory or government
failures,rather than market failure

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 “IMPLICATIONS OF BANKFAILURES:

A bank fails economically when the marker value of its assets declines below the market
value of its liabilities, so that the market value of its capital becomes negative . At such
times ,the banks cannot expect to pay all of its depositors in full and on time. The bank
should be resolved as quickly as possible in order to treat all depositors fairly and not
allow a run by depositors holding demand and short-dated deposits.

Banks failures are not costless. Losses accrue to shareholders and to depositors,
unsecured creditors, and the deposits insurer. Small loan customers may be particularly
inconvenienced by changes in their loan officers, loan standards, and other aspects of
their ongoing bank relationship. But this is on different from the losses and disruptions
firm customer relationship that accompany the failure of almost any business entity of
comparable size.

Banks are viewed as more fragile for three reasons

1-Low capital-to-assets ratios, which provides little room for losses.

2-Low cash-to-assets ratios, which may require the sale of earning assets
to meet deposit obligation.

3-High demand debt and short term debt-to-total debt ratios ,which may require hurried
assets sales of opaque and non-liquid earning assets with potentially large fire sales losses
to pay off running depositors.

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Systemic risk

In finance, systemic risk is the risk of collapse of an entire financial system or entire
market, as opposed to risk associated with any one individual entity, group or component
of a system. It can be defined as "financial system instability, potentially catastrophic,
caused or exacerbated by idiosyncratic events or conditions in financial intermediaries" It
refers to the risks imposed by interlinkages and interdependencies in a system or market,
where the failure of a single entity or cluster of entities can cause a cascading failure,
which could potentially bankrupt or bring down the entire system or market. It is also
sometimes erroneously referred to as "systematic risk".

Explanation

Systemic risk has been compared to a bank run which has a cascading effect on other
banks which are owed money by the first bank in trouble, causing a cascading failure. As
depositors sense the ripple effects of default, and liquidity concerns cascade through
money markets, a panic can spread through a market, with a sudden flight to quality,
creating many sellers but few buyers for illiquid assets. These interlinkages and the
potential "clustering" of bank runs are the issues which policy makers consider when
addressing the issue of protecting a system against systemic risk. Governments and
market monitoring institutions (such as the U.S. Securities and Exchange Commission
(SEC), and central banks) often try to put policies and rules in place with the ostensible
justification of safeguarding the interests of the market as a whole, claiming that the
trading participants in financial markets are entangled in a web of dependencies arising
from their interlinkage. In simple English, this means that some companies are viewed as
too big and too interconnected to fail. Policy makers frequently claim that they are
concerned about protecting the resiliency of the system, rather than any one individual in
that system.

However, in practice, policy makers often appear to favor certain financial institutions at
the expense of others. For example, the Federal Governments' treatment of Lehman
Brothers (left to fail), Bear Stearns (sold for $2 per share), and AIG (Effectively taken
over by the government; change of management; and being sold off in pieces) was far
harsher than its treatment of Goldman Sachs and Morgan Stanley (permitted to become
bank holding companies and received massive below market loans from the government;
received 100 cents on the dollar from AIG due to Government Intervention; TARP
funding, no government takeover; no change of management). The government has not
provided a convincing explanation for the discrepancy in treatment, but journalists have
pointed to the large number of Goldman Sachs alumni in key positions in the
government, and the intense competition between Goldman Sachs and Lehman Brothers,
as a possible explanation. "Picking winners" and protecting favored individual

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participants in a system can engender moral hazard in that system and weaken the
resilience of the system as a whole.

Systemic risk should not be confused with market or price risk as the latter is specific to
the item being bought or sold and the effects of market risk are isolated to the entities
dealing in that specific item. This kind of risk can be mitigated by hedging an investment
by entering into a mirror trade.

Consider a portfolio of perfectly hedged investments, we can say that the market risk of
this portfolio is nullified. Yet, if there is a downturn in the economy and the market as a
whole sinks, the hedges would not be of use. This is the systemic risk to the portfolio.

Insurance is often easy to obtain against "systemic risks" because a party issuing that
insurance can pocket the premiums, issue dividends to shareholders, enter insolvency
proceedings if a catastrophic event ever takes place, and hide behind limited liability.
Such insurance, however, is not effective for the insured entity.

One argument that was used by financial institutions to obtain special advantages in
bankruptcy for derivative contracts was a claim that the market is both critical and
fragile. However, evidence overwhelmingly suggests that such special treatment, justified
by arguments about systemic risk, actually exacerbated systemic risk during the financial
crisis and forced the government to bail out derivatives traders.

Systemic risk can also be defined as the likelihood and degree of negative consequences
to the larger body. With respect to federal financial regulation, the systemic risk of a
financial institution is the likelihood and the degree that the institution's activities will
negatively affect the larger economy such that unusual and extreme federal intervention
would be required to ameliorate the effects.

Measurement of systemic risk

According to the Property Casualty Insurers Association of America, there are two key
assessments for measuring systemic risk, the "too big to fail" (TBTF) and the "too
interconnected to fail" (TICTF) tests. First, the TBTF test is the traditional analysis for
assessing the risk of required government intervention. TBTF can be measured in terms
of an institution's size relative to the national and international marketplace, market share
concentration, and competitive barriers to entry or how easily a product can be
substituted. Second, the TICTF test is a measure of the likelihood and amount of
medium-term net negative impact to the larger economy of an institution's failure to be
able to conduct its ongoing business. The impact is measure beyond the institution's
products and activities to include the economic multiplier of all other commercial
activities dependent specifically on that institution. The impact is also dependent on how
correlated an institution's business is with other systemic risks.

Too Big To Fail: The traditional analysis for assessing the risk of required government
intervention is the "Too Big to Fail" Test (TBTF). TBTF can be measured in terms of an

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institution's size relative to the national and international marketplace, market share
concentration (using the Herfindahl-Hirschman Index for example), and competitive
barriers to entry or how easily a product can be substituted. While there are large
companies in most financial marketplace segments, the national insurance marketplace is
spread among thousands of companies, and the barriers to entry in a business where
capital is the primary input are relatively minor. The policies of one homeowners insurer
can be relatively easily substituted for another or picked up by a state residual market
provider, with limits on the underwriting fluidity primarily stemming from state-by-state
regulatory impediments, such as limits on pricing and capital mobility. There are
arguably either no or extremely few insurers that are TBTF in the U.S. marketplace.

Too Interconnected to Fail: A more useful systemic risk measure than a traditional
TBTF test is a "Too Interconnected to Fail" (TICTF) assessment. An intuitive TICTF
analysis has been at the heart of most recent federal financial emergency relief decisions.
TICTF is a measure of the likelihood and amount of medium-term net negative impact to
the larger economy of an institution's failure to be able to conduct its ongoing business.
The impact is measured not just on the institution's products and activities, but also the
economic multiplier of all other commercial activities dependent specifically on that
institution. It is also dependent on how correlated an institution's business is with other
systemic risk.

Factors

Factors that are found to support systemic risks are:

1. Economic implications of models are not well understood. Though each

individual model may be made accurate, the facts that (1) all models across the
board use the same theoretical basis, and (2) the relationship between financial
markets and the economy is not known lead to aggravation of systemic risks.
2. Liquidity risks are not accounted for in pricing models used in trading on the
financial markets. Since all models are not geared towards this scenario, all
participants in an illiquid market using such models will face systemic risks.

Diversification

Risks can be reduced in four main ways: Avoidance, Diversification, Hedging and
Insurance by transferring risk. Systematic risk also called market risk or un-diversifiable
risk is a risk of security cannot be reduced through diversification. Participants in the
market, like hedge funds, can be the source of an increase in systemic risk and transfer of
risk to them may, paradoxically, increase the exposure to systemic risk.

Regulation

One of the main reasons for regulation in the marketplace is to reduce systemic risk.
However, regulation arbitrage - the transfer of commerce from a regulated sector to a less
regulated or unregulated sector - brings markets a full circle and restores systemic risk.

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For example, the banking sector was brought under regulations in order to reduce
systemic risks. Since the banks themselves could not give credit where the risk (and
therefore returns) were high, it was primarily the insurance sector which took over such
deals. Thus the systemic risk migrated from one sector to another and proves that
regulation cannot be the sole protection against systemic risks.

Project risks

In the fields of project management and cost engineering, systemic risks include those
risks that are not unique to a particular project and are not readily manageable by a
project team at a given point in time. These risks may be driven by the nature of a
company's project system (e.g., funding projects before the scope is defined), capabilities,
or culture. They may also be driven by the level of technology in a project or the
complexity of a project's scope or execution strategy.

Systemic risk and insurance

In February 2010, international insurance economics think tank, The Geneva Association,
published a 110-page analysis of the role of insurers in systemic risk.

In the report, the differing roles of insurers and banks in the global financial system and
their impact on the crisis are examined (See also CEA report, "Why Insurers Differ from
Banks"). A key conclusion of the analysis is that the core activities of insurers and
reinsurers do not pose systemic risks due to the specific features of the industry:

• Insurance is funded by up-front premia, giving insurers strong operating cash-

flow without the requirement for wholesale funding;
• Insurance policies are generally long-term, with controlled outflows, enabling
insurers to act as stabilisers to the financial system;
• During the hard test of the financial crisis, insurers maintained relatively steady
capacity, business volumes and prices.

Applying the most commonly cited definition of systemic risk, that of the Financial
Stability Board (FSB), to the core activities of insurers and reinsurers, the report
concludes that none are systemically relevant for at least one of the following reasons:

• Their limited size means that there would not be disruptive effects on financial
markets;
• An insurance insolvency develops slowly and can often be absorbed by, for
example, capital raising, or, in a worst case, an orderly wind down;
• The features of the interrelationships of insurance activities mean that contagion
risk would be limited.

The report underlines that supervisors and policymakers should focus on activities rather
than financial institutions when introducing new regulation and that upcoming insurance

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regulatory regimes, such as Solvency II in the European Union, already adequately
address insurance activities.

However, during the financial crisis, a small number of quasi-banking activities

conducted by insurers either caused failure or triggered significant difficulties. The report
therefore identifies two activities which, when conducted on a widespread scale without
proper risk control frameworks, have the potential for systemic relevance.

• Derivatives trading on non-insurance balance sheets;

• Mis-management of short-term funding from commercial paper or securities
lending.

The industry has put forward five recommendations to address these particular activities
and strengthen financial stability:

• The implementation of a comprehensive, integrated and principle-based

supervision framework for insurance groups, in order to capture, among other
things, any non-insurance activities such as excessive derivative activities.
• Strengthening liquidity risk management, particularly to address potential mis-
management issues related to short-term funding.
• Enhancement of the regulation of financial guarantee insurance, which has a very
different business model than traditional insurance.
• The establishment of macro-prudential monitoring with appropriate insurance
representation.
• The strengthening of industry risk management practices to build on the lessons
learned by the industry and the sharing experiences with supervisors on a global
scale.

Since the publication of The Geneva Association statement, in June 2010, the
International Association of Insurance Supervisors (IAIS) issued its position statement on
key financial stability issues. A key conclusion of the statement was that, “The insurance
sector is susceptible to systemic risks generated in other parts of the financial sector. For
most classes of insurance, however, there is little evidence of insurance either generating
or amplifying systemic risk, within the financial system itself or in the real economy.”[

Other organisations such as the CEA and the Property Casualty Insurers Association of
America (PCI) have issued reports on the same subject.

Discussion

Systemic risk evaluates the likelihood and degree of negative consequences to the larger
body. The term "systemic risk" is frequently used in recent discussions related to
the economic crisis, such as the Subprime mortgage crisis. The systemic risk of a
financial institution is the likelihood and the degree that the institution's activities

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 will negatively affect the larger economy such that unusual and extreme federal
intervention would be required to ameliorate the effects. The failing of financial
firms in 2008 caused systemic risk to the larger economy. Chairman Barney Frank
has expressed concerns regarding the vulnerability of highly-leveraged financial
systems to systemic risk and the US government has debated how to address
financial services regulatory reform and systemic risk. avoid future
Financial Crisis?

GOVERNMENT POLICY TO REDUCE SYSTEMIC RISK.

Systemic risk is very dangerous for economy, as we have seen in last 200 years majority
of the financial failure occurs due to systemic risk. In United States’ history from the
founding of the republic until 1933 it experienced banking panics roughly every fifteen to
twenty years. When the Great Depression struck, it was “in a league of its own in
severity” and the banking system near to collapse, government responded with federal
intervention into the marketplace including creation of federal deposit insurance,
securities regulation, banking supervision, and the separation of commercial and
investment banking under the Glass-Steagall Act. This happens because of systemic risk
involved in the system where failure of one bank leads to failure of another and every
banks are interrelated which causes nearly total banking system failure.

However US govt. followed implicit strategy where they insured and regulated the most
systemically dangerous part of the system, the commercial banks, and exercised a much
lighter touch elsewhere, leaving the rest of the financial system to innovate, be dynamic,
and do everything that markets do so well.

This has worked for US govt. for the next 50 years, they didn’t see any crisis during that
period however significant financial failures returned to the marketplace in the late 1980s
with the savings and loan crisis, followed by a rash of bank failures in the early 1990s
that forced the government to recapitalize the FDIC’s Bank Insurance Fund. Long Term
Capital Management, a largely unregulated hedge fund, came perilously close to collapse
in 1998, threatening the global financial system. The tech bubble burst in 2001.
Accounting scandals destroyed Enron in 2001 and WorldCom in 2002. And the current
global financial crisis, the worst since the Great Depression, has yet to run its course.

As the country experienced no major financial crises for the longest period in the history
lawmakers not only weakened or dismantled New Deal-era regulations, they also failed
to enact new regulations to keep up with financial innovation spurred by technology and

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globalization of markets. Over time, a huge amount of financial activity migrated away
from regulated and transparent markets and institutions and into the lightly regulated or
unregulated shadow markets encompassing mortgage brokers, hedge funds, private-
equity funds, off-balance sheet structured-investment vehicles, and a booming market in
opaque derivatives, especially credit-default swaps. By the summer of 2007, the Treasury
Department estimates, the shadow banking system had accumulated assets reaching
roughly $10 trillion, equivalent to total assets in the entire U.S. banking system.

While new systemic threats had emerged along the way, there was little effort to regulate
them, undercutting the original New Deal strategy of targeting such threats. As a result,
the American financial system was left more vulnerable than ever to a major shock.

Today, financial institutions deemed too big to fail already have a huge marketplace
advantage – hundreds of billions of federal bailout funds unavailable to smaller firms in
financial trouble. That gives big, complex firms a dramatic advantage that is
inappropriate.

Since last fall, there’s also an implicit guarantee of government rescue for any firm that in
the future may be identified as too big to fail. “What’s worse, these firms impose costs on
society by creating systemic risks that they don’t have to bear on their balance sheets.

Implicit strategy has worked for the govt. in the past however it has created a trend
where every big company feels that they can be protected by government whatever they
do. This makes them to create more systemic risk by spreading their wings beyond the
limit in the form of high leverage and overlooking regulated procedures etc.
After the Great Depression & till mid eighties there were not very risky financial
innovation due to which even little unregulated environment doesn’t create panic. But
after mid-eighties we have seen lot of volatile & risky financial innovations like
mortgage brokers, hedge funds, private-equity funds, off-balance sheet structured-
investment vehicles, derivatives and securitization etc. which requires healthy regulated
environment but lawmaker & govt. always overrule it and these innovations were highly
unregulated that ultimately causes biggest crisis since the Great Depression.

In order to protect future of financial market, government should follow Explicit

Strategy rather than implicit. Following steps need to be taken-

• First, identify industry/firm/sector that poses systemic risk and then replace unlimited
implicit guarantee with government defined limited explicit guarantee for the first time.

• Second, companies that create systemic risk should bear the cost of insuring against it,
just as commercial banks pay into an FDIC insurance pool. And the government should
insist on appropriate capital standards and liquidity requirements to limit the type of risks
that these firms impose on society.

• Third, creating a receivership process would allow an efficient handling of failed

companies. It really need to change the perception that no institution is too big to fail. In

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this process all systemic institutions would get limited support during a period of
economic turbulence but if that turns out not to be enough then they are going to be taken
into the receivership process and liquidated or restructured.

One thing that we don’t fully understand that the world in which we live right now will
continues. It’s one of massive implicit guarantees that are open-ended, we need to be
honest about these implicit guarantees, to define and limit them. That’s the purpose of
this whole proposal, not to put systemic firms at a competitive disadvantage but rather to
prevent them from imposing undue costs on the rest of the financial system.

“Implicit approach enhances systemic risk, Explicit approach controls and reduces”

CONCLUSION.

The evidence suggest that banks fail. but so do other firms. Bank failures are costly to
their owners, and some third parties .but so are the failures of other firms. To the extent
that failure reflect market forces, public policies to prevent exit harm other economic
agents ,such as competitors and those who will benefit from entry ,including consumers
of banking services .Nevertheless ,banks failures are widely perceived to be more
damaging to the economy because of the belief that they are more likely to skill over to
other banks and beyond. Thus almost all countrieshave imposed special prudential
regulations on banks to prevent or mitigate such adverse effect.

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