The next crisis will be different

IN its latest white paper on ‘The Next Crisis Will Be Different: Opportunities to Continue Enhancing Financial Stability 10 Years After Lehman’s Insolvency’, The Depository Trust & Clearing Corp (DTCC) discusses what can be done to tackle new challenges related to macroeconomic, market-related and new-technology risks.

The report looks back at how the finance and regulatory landscape has changed over the past decade.

The 10th anniversary of the Lehman insolvency marks a fitting milestone to reflect on the dramatic changes that have transformed global financial markets and risk management over the last decade.

Looking back is not a nostalgic exercise.

Rather, it is a necessary undertaking to understand how the markets and risk itself have evolved so that the industry is better prepared to prevent or mitigate the impact of future events that could have global systemic implications.

“That is our goal in this paper,” says DTCC.

Despite the many enhancements to financial stability that have been implemented since 2008, the nature of risk has morphed dramatically.

Some of the most dangerous and challenging risks the world faces today barely registered or did not even exist on the morning of Sept 15, when Lehman filed for Chapter 11 bankruptcy and the financial system began to melt down.

The emergence of flash crashes in major markets, as well as the creation of digital currencies and other cryptoassets, are just two examples of new developments that are requiring us to rethink all aspects of risk management.

They also illustrate the possibility that the next crisis might be fundamentally different than anything we can envision right now, triggered by new types of risks that didn’t exist 10 years ago or even today.

In this dynamic environment of constant change, the risk management function has evolved to keep pace with and, at times, stay ahead of the risk curve.

Recognising that “fighting the last war” won’t adequately prepare us for the next crisis, DTCC has developed this paper to raise awareness of key risks facing the industry and have provided a series of forward-looking opportunities to help strengthen financial stability for the future.

Over the past decade, the financial industry has made substantial progress in strengthening global market stability and enhancing resilience.

Financial firms have de-leveraged significantly and banks have strengthened their capital structure.

During this same period, supervisors have dramatically increased requirements designed to create a more robust financial ecosystem.

Central bankers have skilfully applied monetary policy tools to mitigate the impact of the crisis while keeping inflation in check.

While this delicate balancing act has been successful so far, it has required unprecedented asset purchases and pushed interest rates to historically low levels in large parts of the world -- leaving significantly less ammunition to fight another crisis with monetary policy tools.

Despite significant efforts to improve post-crisis resilience, DTCC has identified additional opportunities to further strengthen financial stability through enhanced system-wide resilience:

> Global financial stability can be further enhanced by expanding central clearing for both cash and derivatives markets;

> Increased regulatory harmonisation and cooperation among all stakeholders is required to harness the full potential of derivatives trade repositories as early warning signals for the buildup of systemic risk;

> The use of legal entity identifiers (LEIs) in regulatory reporting should be mandated globally to increase risk transparency; and

> Enterprise data management capabilities should become foundational to financial firms’ risk management frameworks.

Additionally, while many aspects of financial resilience have markedly improved since 2008, multiple new challenges have emerged during this period with respect to the macroeconomic environment, market-related risks and concerns related to technology.

Despite a generally positive short-term outlook, several medium-term macroeconomic concerns are emerging related to trade tensions, rising geopolitical risks and high levels of global debt.

Additionally, stretched asset valuations have added to the risk of sudden price drops.

While these potential threats are hard, if not impossible, to control or predict, they are highly interdependent and should be addressed through a cross-disciplinary approach:

Risk management organisations should become increasingly holistic and include cross-disciplinary experts to address an ever-widening array of interconnected risks.

With respect to market-related risks, the rising popularity of exchange-traded funds (ETFs) has the potential to become a growing source of concern, especially if these offerings continue to evolve towards increasingly esoteric and opaque products with highly complex risk profiles.

The level and robustness of market liquidity is another market-related risk that continues to be debated.

The exposure associated with the proliferation and increasingly esoteric nature of certain ETFs should be managed more closely to match their specific risk profiles.

Technology-related risks comprise a very wide and diverse array of risks, including, but not limited to, a series of innovative technologies that are generally characterised as fintech developments.

While fintech-related risks should be assessed on a case-by-case basis, there is widespread agreement that digital currencies and other types of cryptoassets, as well as the growth of technologies such as cloud-based computing, do not threaten financial stability at present. At the same time, there is also a growing consensus that fintech developments are fast-moving along a relatively unpredictable path, which demands that they be carefully monitored and thoughtfully supervised to balance the associated risks and rewards.

Cybersecurity concerns, while not new, have grown exponentially to the point where they are considered by many as the single most important near-term systemic risk.

Post crisis takeaways

> Post-crisis regulatory measures to increase banks’ resilience have been generally successful. However, low profitability and other specific vulnerabilities continue to persist, particularly in the European banking sector.

> While monetary policies have effectively addressed post-crisis challenges, they have left central banks with considerably less latitude to combat the next crisis.

> Further work remains to be done in order to fully implement two major post-crisis areas of reform: the use of LEIs to improve risk aggregation and central clearing of over-the-counter derivatives.

> Banks have significantly strengthened their balance sheets and enhanced their funding resilience in line with the objectives of post-crisis regulatory reforms. Banks’ liquidity buffers have also been strengthened, largely thanks to the introduction of the liquidity coverage ratio and the net stable funding ratio.

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