The following blog article is based on the opening statements delivered by Chiara Perillo at the panel discussion on “New Conditions for Monetary and Fiscal Policy” with Martin F. Hellwig, Edward C. Prescott, Peter A. Diamond, Christopher A. Sims, 6th Lindau Nobel Laureate Meeting on Economic Sciences, Lindau, August 2017.
The last decades have witnessed the increase of financial interactions among the different actors operating in the global economy, through different financial instruments (e.g., loans and deposits, bonds, equity shares and derivatives). However, a large part of these interactions is intra-financial, which means that a large fraction of banks’ financial contracts has as a counterparty another bank or, more in general, another financial institution (such as an investment fund, an insurance corporation or a pension fund). For example, according to a recent report by Allahrakha, Glasserman and Young (2015), in 2013, a significant part of US banks’ assets was intra-financial. In particular, they estimated that intra-financial over-the-counter (OTC) derivatives were equal to the 48% of banks’ intra-financial assets, followed by intra-financial deposits and loans equal to the 25% of banks’ intra-financial assets.
In the light of this, I asked myself: is the banking sector undertaking its role of intermediary? Checking the data, actually the answer is yes, the banking system is undertaking its role of intermediary, but mainly with itself. In this regard, Allen and Santomero, in a paper of 1998, already realized that markets were evolving in such a way that they were becoming mainly markets for intermediaries rather than individual and firms, so basically today markets are in such a way that “intermediaries intermediate with intermediaries”.
In principle, this intra-financial interconnectedness, and interconnectedness in general, allows for a more diversified structure, which may lead to the increase of individual profitability and the reduction of the risk of the individual entity. On the other hand, the global financial crisis has shown that these intra-financial linkages represent a mechanism for the propagation of financial distress. More specifically, they favor and speed up the propagation of distress and they may lead to the amplification of small shocks. In this regard, an interesting analogy has been proposed by Haldane in a speech in 2009, and this analogy was between the spread of a contagious disease and the spread of financial distress. If an individual is affected by a contagious disease it is not a really good thing if he has multiple interactions with different people, because these interactions allow for the contagion of the disease. In the same line, if a bank under financial distress is strongly interconnected with different actors operating in the financial system, these interconnections allow for the contagion of its distress across the financial system. So, this is the main idea why intra-financial interconnectedness is nowadays recognized as one of the key elements which contributed to the spread of the last global financial crisis.
Since the financial crisis, much work has been done both from the point of view of methods and models and macro-prudential regulation. In fact, during the last decades it has become clear that the financial system should be regarded as a financial network and, in the last decade, different financial contagion models have been developed shedding light on the potential effects of financial interlinkages. From a macro-prudential perspective, a considerable effort has been done as well. For example, now, according to Basel III, specific capital requirements are set for the financial institutions considered systemically important at the global level. Moreover, Basel III imposes to financial institutions the disclosure of their financial exposures, which is an important step ahead in terms of transparency. On the basis of this data, institutions like the European Central Bank (ECB) and the European Systemic Risk Board (ESRB) are putting together large data infrastructure in an attempt to map the financial exposures of the different actors of the economy at a very granular level. This is going to be a slow process, but extremely important to improve monitoring and supervision. Moreover, this Big Data on financial exposures represents an interesting challenge for the academic world to understand how to treat this big amount of new data and how to account for them in the macroeconomic models.
M. Allahrakha, P. Glasserman, H. P. Young, et al., “Systemic importance indicators for 33 US bank holding companies: an overview of recent data.” Office of Financial Research, 2015.
F. Allen and A. M. Santomero, “What do financial intermediaries do?” Journal of Banking & Finance, vol. 25, no. 2, pp. 271–294, 2001.
A. G. Haldane, “Rethinking of Financial Network”. Speech delivered at the Financial Student Association, Amsterdam, vol. 28, 2015.
Chiara Perillo is based at University of Zurich 2016-2019, and her research project is Systemic Risk and Financial Networks (WP2)