The next decade in risk: financial and economic risks

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Finance and Economics Risk Research Lead Ken Deng opens the 2019 Risk Summit session on economic threats in the coming decade
Finance and Economics Risk Research Lead Ken Deng opens the 2019 Risk Summit session on economic threats in the coming decade

While stock markets can rarely be predicted and economic recessions can hardly be timed, the financial and economic events, trends, and research which appeared in the last decade have still been informative in assembling a risk outlook for the ten years to come.

Ten years ago, we were still in the grip of the Great Financial Crisis and subsequent recession, feeling a widespread loss in GDP especially across developed markets. At the time, the recession was unprecedented in severity, the worst period of financial loss since the Great Depression in the 1930s. Research after the fact tended to supply the collapse of the US housing bubble compounded with unsustainably high household leverage that eventually triggered a chain of default as the key cause of the crisis. Also to blame were the under-regulated shadow banking system and complicated yet insufficiently understood financial product market that had extended subprime credit to consumers and firms in the 2000s.

The lack of pre-recession warnings indicated deficiency in understanding of the complex financial system through which a major crisis could play out. If the Great Recession was compared to a heart attack, stagnant consumption and investment meant that the lifeblood of finance – money – stopped circulating, starving the “organs” of the economy. This cardiovascular system alluded to the global banking system which was hit the hardest during the crisis. At the core of the system are Global Systemically Important Banks (G-SIBs), which are mostly subsidiaries of international financial institutions. Within each jurisdiction, there is usually a core cluster of banks that are well connected each other, and then many smaller, peripheral banks that are dependent on the core.

The network that banks’ use to capitalise on and diversify investments in times of normalcy thus turns against them in a crisis. Contagion happens when a bank’s distress is almost immediately incorporated into the value of the interbank assets held by a directly connected creditor bank. Conventional views have reasoned that contagion spreads out upon default via fire sales and interbank holdings, but more recent research has suggested that it occurs once word of a crisis enters the figurative water supply. Choosing to repair the roof while the sun still shines is just one way that pre-emptive risk management can shift contagion effects earlier at milder severity going forward.

To restore a prudent financial system following the recession, numerous regulations have been put in place. Basel III, which was developed from Basel II in 2010, introduced more stringent bank capital ratios and further measures on leverage and liquidity. However, it has faced critiques because of its growing reliance on standardised risk measures and lack of regulation on banks’ internal models that usually don’t consider enough correlations of internal risks. Aside from this, treating large and small financial institutions alike is flawed in assumption because they have different contributions to systemic risks. Given the fact that the function of a large bank can be multi-layered in collateral, funding and assets, it is more likely to be systemically important due not only to its size, but also its span across multiple layers. Currently, there are 29 G-SIBs identified by the Financial Stability Board.

Beyond the financial system, impacts of a financial catastrophe are no less substantial. For example, the Great Recession has proved to be the most sustained financial crisis insofar, costing more than $2 trillion in global economic growth at its peak. The current UK economy is 16% – £300 billion equivalently – lower than it would have been had the crisis not occurred in 2008. The lingering effects of the recession can partly be attributed to the highly integrated nature of different markets, though globalisation has also rendered these same markets more resilient to other shocks

On the note of globalisation, the vulnerability of supply chains cannot be underestimated as a future risk vector. The price of oil, for example, is a common means of gauging systemic risk, as oil is so prevalent across industries and regions. The oil price moves with economic conditions: it plummeted for a second time in 2014 due to slowing growth in emerging economies and alternative oil extraction in the North America. However, the price of oil is also sensitive to geopolitical events. Current events such as the Saudi-Iran conflict, the Venezuelan political and economic crisis, and the US-Iran row all threaten the cost of oil in the coming years, given the highly-integrated supply lines involved in these areas. Generally, energy price fluctuations have provided abundant precedent cases to inform hazard outlook.

The concept of energy is evolving beyond modern metrics, however. The urgency of climate change issues and the rising awareness of the public prompt societal transition to renewable energies and low carbon economy. A macro shift into an unexplored territory implies new financial and economic risks such as stranded assets posing systemic risks and stricter ESG requirements, causing more compliance hurdles. More abstractly, people expect that more advanced technologies in the fourth industrial revolution will become the dominant energy of growth for future generations. FinTech including blockchains and cryptocurrencies is transforming the game rules of businesses. Success of Libra, a proposed Facebook currency based on blockchains, could put traditional banking businesses at stake.

As for risk management, we can track long-standing macro threats in time series using aggregate metrics such as GDP@Risk, a metric established by the Centre in 2013, and possibly compare different cities and threats by this measure. More holistically, the Cambridge Taxonomy of Business Risks further suggests inclusion of industry dynamics, such as risks from competitors, and consideration of business models, such as risks from counterparty relations. This helps inform scenario stress testing for individual firms which have various idiosyncrasies. Although the future cannot be foretold, one key method of hedging against known unknowns is to recognise what could go wrong and just how bad the circumstances could be.

The Centre defines emerging risk as a new risk, changing risk, or novel combination of risks where the broad impacts, costs and optimal management strategies are not yet well understood. This implies interconnectivity as a driving force moving risk forward. From this perspective, learning from historical lessons such as financial crises and energy shocks is conducive to risk management in the foreseeable future.

Ken Deng

Ken Deng

Ken Deng is a Research Assistant at the Centre for Risk Studies and has a background in corporate finance, asset pricing and economics in general.

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