How does a systemic crisis start?

Summary:

– A systemic crisis can arise from two sources: a simultaneous economic shock affecting a large number of financial institutions, or through contagion.

– Contagion during a systemic crisis can be direct, in the case of a domino effect, or indirect through asset fire sales, deleveraging, or similarities between institutions.

Systemic risk is not a new concept, but has made a dramatic comeback since the 2007 crisis. It is not solely an economic concept, but refers to a threat that could disrupt or even collapse an entire system. Here we are talking about the financial system and, by extension, the economy, given their strong relationship. There are more than 30 definitions of systemic risk [1], but their common ground is well highlighted by the ECB’s definition: « [it is the risk of] financial instability so profound that it threatens the proper functioning of the financial system to the point where growth suffers. » A systemic crisis is characterized above all by the fact that it affects a large number of financial and economic actors. This is what Furfine (2003) highlights in his definition by describing two distinct mechanisms through which the crisis spreads:

1. 1 – A simultaneous shock affecting a large number of financial actors, putting them in difficulty, can lead to a systemic crisis by disrupting the proper functioning of the markets.
2. 2 – a phenomenon of contagion among financial actors, which can have an equally devastating effect on the proper functioning of markets.

First, an economic shock powerful enough to cause a systemic crisis must simultaneously affect a large number of financial players.

This is the case, for example, when a bubble bursts, particularly in the real estate market. Economic agents, mainly households, reduce their need for credit or even default. The credit portfolios of banking institutions deteriorate very rapidly, forcing banks to recapitalize quickly and simultaneously, which causes the cost of recapitalization to skyrocket. This is what happened in 2008 and 2009.

Liquidity crises are another example of simultaneous shocks that can destabilize the system. Financial institutions have become increasingly dependent on market liquidity. However, in the event of a crisis of confidence, such as what happened in 2008, the interbank market or the repo market [2] can be completely frozen, depriving banks of their sources of liquidity. Without refinancing, many financial institutions can very quickly find themselves in difficulty.

The phenomenon of contagion can be classified into two categories, depending on whether the spread is direct or indirect.

In the case of direct contagion, there isa domino effect: the failure of one financial institution can trigger a chain reaction of bankruptcies. This effect is due to direct financial links between institutions, such as interbank loans (banks have claims on each other) or foreign currency financing (a European bank wishing to make a loan in dollars can borrow from an American bank). These financial links create dependencies between institutions. Thus, a loss that is initially localized in one bank can have an impact on the entire interbank network. Similarly, in the event of a crisis of confidence, a banking institution that has doubts about the soundness of its partners will freeze its financial links. By refusing to renew a line of credit, for example, this institution will then put another bank in difficulty.

Contagion can also occur indirectly. Two mechanisms come into play here:asset fire sales(AFS) and deleveraging, i.e., the reduction of asset leverage (ratio of assets to equity). To understand how this indirect contagion occurs, it is important to note that securities held by financial institutions are most often valued at theirfair value, according to a « mark to market » approach[3]. This makes banks’ assets highly dependent on market price fluctuations, as explained by Adrian and Shin (2010).

An initial shock to a bank weakens its position and forces it to sell a larger or smaller portion of its most liquid assets to absorb its losses and reduce its excessive leverage [4]. This behavior has a limited impact if it involves small volumes or a limited number of institutions.However, in times of financial crisis or crisis of confidence, the volumes involved in AFS have a significant impact on the market. This amplifies the initial decline in market asset prices linked to the crisis and can thus cause losses for other banks, as the decline in asset values is reflected in their balance sheets. This in turn forces them to sell off assets, further amplifying the decline in market prices, and so on. Moreover, these losses are all the more damaging to the bank because they affect its most liquid assets, which are usually its highest-quality assets. Admittedly, this spiral does not occur with every downward market movement; it only comes into play over a period of several months. Nevertheless, this negative procyclical spiral in the market can cause the bankruptcy of several institutions and lead to a systemic crisis.

A final type of indirect contagion is contagion by similarity. If an institution that is particularly exposed to a certain market segment is in difficulty, the market will suspect that institutions operating in the same segment are also riskier and will turn away from them, putting them in difficulty in turn. This behavior was observed in 2010, at the beginning of the European debt crisis, when U.S. non-financial institutions virtually cut off all dollar financing to European banks.