24/1/16: European Financial Networks: Prepare for Bloodletting to Commence

A recent paper, titled "Transmission Channels of Systemic Risk and Contagion in the European Financial Network" co-authored by Nikos Paltalidis, Dimitrios Gounopoulos, Renatas Kizys, Yiannis Koutelidakis (Journal of Banking and Finance, gated) tackles a very interesting problem relating to the systemic stability of the European banking system and the bi-directional contagion channels shifting/transmitting systemic shocks between the banks and the sovereigns.

Following the euro area banking crisis of 2008-2012 (with residual effects of this crisis still strongly present in the so-called euro area 'periphery'), financial systems analysts and modellers came to the realisation that a number of key questions relating to overall system stability remain un-answered to-date. These include:

• What determines the intensity with which exogenous shocks propagate in the financial system as a whole (and how this intensity carries across banking systems)?
• How do we "identify, measure and understand the nature and the source of systemic risk in order to improve the underlying risks that banks face, to avert banks’ liquidation ex ante and to promote macro-prudential policy tools"? 
• How do systemic risks arise in the cases where such risks are endogenous to the banking system itself?
• How resilient is the euro area banking system (under improved regulatory and supervisory regimes) to systemic risk?
• How "…shocks in economic and financial channels propagate in the banking sector"? 
• And related to the above: "In the presence of a distress situation how the financial system performs? Have the new capital rules rendered the European banking industry safer? What is the primary source of systemic risk? How financial contagion propagates within the Eurozone?"

As the authors correctly note, "These fundamental themes remain unanswered, and hence obtaining the answers is critical and at the heart of most of the recent research on systemic risk."

Lacking empirical evidence (due to proximate timing of events and their extreme-tail nature) the authors create “a unique interconnected, dynamic and continuous-time model of financial networks with complete market structure (i.e. interbank loan market) and two additional independent channels of systemic risk (i.e. sovereign credit risk and asset price risk).”

Summary of the findings relating to sources of shocks:

1. “…A shock in the interbank loan market causes the higher amount of losses in the banking network”;
2. “…Losses generated by the sovereign credit risk channel transmit faster through the contagion channel, triggering a cascade of bank failures. This shock can cause banks to stop using the interbank market to trade with each other and can also lead banks to liquidate their asset holdings in order to meet their short-term funding demands.”
3. “Moreover, we evaluate the impact of reduced collateral values and provide novel evidence that asset price contagion can also trigger severe direct losses and defaults in the banking system.”

So the model does support the view that “the Sovereign Credit Risk channel dominates systemic risks amplified in the euro area banking systems and hence, it is the primary source of systemic risk.” Which is quite interesting from a number of perspectives:

• Firstly, we tend to think about the Global Financial Crisis as a mother of all systemic crises and we tend to attribute the degree of disruption in the crisis to the origins of the crisis shocks: the financialisation of the ‘bubbles’ in real assets (e.g. real estate), leading to liquidity crunch and then to solvency crunch. We think of the sovereign shock channel as being in play only because of banks-sovereign link. And we think that the second order contagion from the sovereign to the banks is secondary in magnitude to the GFC. It appears that things are much more complex and inter-connected both in terms of direction of contagion and orders of disruption caused.
• Secondly, we tend to ignore the relationship between the banks bailouts, QE programmes and equity markets. We think of them as related, but separate acts, e.g.: banks bailouts require funds which are supplied via sovereigns which need to obtain financial resources, which they do via QE, which simultaneously lowers the cost of investment and increases valuations of equities. But the problem is that we also have direct QE —> Equity valuations —> Banks balance sheet pathways. Just as asset prices collapse or illiquidity can trigger a liquidity run by the banks and defaults and losses within the banking system, so are asset prices increases can lead to improved liquidity conditions for the banks and improved banks balance sheets.
• Thirdly, the study provides “…novel evidence that systemic risk in the euro area banking system didn’t meaningfully decrease as it is evident that shocks in the three independent channels -interbank market, sovereign credit risk, asset price risk- trigger domino effects in the banking system.” Which sort of tells us what we suspected all along: the entire ‘firewalls have been built’ brigade of European politicos is eating hopium by truckloads. There are no ‘firewalls’. There are bits of wet cardboard stuck into the cracks and a perennial hope they stay well moisturised by occasional rains. 

Now, let’s give it a thought: since the end of the crisis, we’ve been told that solution to the problem of preventing future crises and alleviating the costs of those that still might happen is more coordination, harmonisation and integration of banking systems under the watchful eye of ECB. In other words, more internationalisation of domestic banks - more linking between them and banks operating in other economies within the Euro area. What does evidence have to say on that? “…we find that the cross-border transmission of systemic shocks depends on the size and the degree of exposure of the banking sector in a foreign financial system. Particularly, the more exposed domestic banks are to the foreign banking systems, the greater are the systemic risks and the spillover effects from foreign financial shocks to the domestic banking sector.”

Ya wouldn’t! No, ya couldn’t! But… baby… we had firewalls and we had EBU and more interconnected system of Euro area-wide banking supervision… and we now have?.. err… Yep, in the words of the authors: “Finally, the results imply that the European banking industry amid the post-crisis deleverage, recapitalisation and the new regulatory rules, continues to be markedly vulnerable and conducive to systemic risks and financial contagion.”