International Finance 4:1, 2001: pp.

127–144

COMMENTARY

Financial Markets and Systemic Risk

in an Era of Innovation*

Andrew Crockett and Benjamin H. Cohen

Bank for International Settlements, Switzerland.

Abstract
This essay reviews some of the more significant ongoing changes in the
global financial system over the past decade and identifies implications
these changes have had for systemic stability and for the role of public
authorities. Trends such as disintermediation and financial sector con-
solidation have modified the ways in which systemic shocks are propagated
and distributed among market participants. This has complicated the role
of banks, which continue to stand at the centre of the financial system in
many countries. While the overall results will no doubt continue to be positive
for households and businesses, this complexity increases the potential for
uncertainty, particularly during the period when new markets and institu-
tions are developing. These developments have also complicated the roles of
financial regulators, including central banks. The response has been a move
towards a greater reliance on transparency and market discipline as ways to
improve the spread of information and thus prevent systemic disruption.

*An earlier version of this essay appeared in German in the Handbuch Europäischer Kapitalmarkt
(Wiesbaden: Gabler Verlag, 2000). We are grateful to our colleagues at the BIS and to central
bank participants at meetings organized by the BIS for useful discussions in which many of the
issues in the text were raised. We thank Bruno Allemann, Angelika Donaubauer, Paola Gallardo
and Denis Pêtre for research assistance, and Benn Steil and Adam Posen for their comments.
The opinions expressed, however, as well as any errors, are those of the authors alone.

© Blackwell Publishers Ltd. 2001. 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA
128 Andrew Crockett and Benjamin H. Cohen

There has been an increased recognition of the systemic significance of a

diverse range of markets and channels of intermediation to the health of
the financial system.

I. Introduction

The structure of the financial services industry is undergoing profound

changes throughout the world. These changes have occurred to varying degrees
and have manifested themselves in different ways in different countries, but
the underlying trends have been clear for some time. The result has been, and
will no doubt continue to be, a dramatic improvement in the efficiency of the
financial system. A wider range of services, at lower average prices, is available
to households and businesses than ever before. The ability to isolate and in-
sure against specific kinds of risk has increased the opportunities available to
savers, and facilitated economically valuable investment projects.
Yet even as the financial system as a whole grows more efficient, a period
of rapid change and increased complexity can sometimes by itself contribute
to systemic risk. As new forms of financial activity proliferate, borrowers,
lenders, intermediaries and regulators need to learn what risks and returns are
associated with different products and markets, and what institutional forms
are appropriate to delivering them reliably and at low cost. This learning
process must at least in part occur through trial and error, and the possibility
always exists that errors in judgement regarding one part of the system cast
doubt on the viability of other parts or of the whole. Participants and regu-
lators also need time to learn about the interactions among different markets
and the stability of the system in the face of shocks, before they find the right
tools to manage these risks.
Furthermore, there are certain risks that may never be correctly priced or
sufficiently recognized by market participants. One especially important risk
which institutions may never be able to manage adequately, because of its large
psychological component, is the risk of a sudden increase in the demand for
liquidity. In a more general sense, it is not clear that the decisions of financial
market participants can fully take account of the risk that the system itself will
break down. Because the financial system is a public good, participants may not
always have the correct incentives to take actions that will assure its maintenance.
One of the vital functions of financial regulators and other public author-
ities is to ensure that financial innovation proceeds in a way that does not
harm the stability of the system, while allowing room for experimentation
and change. In this sense, the evolving environment makes the role of public
authorities more rather than less central to the stability of the financial
system. However, that role has changed, from one of setting explicit rules and

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 Financial Markets and Systemic Risk in an Era of Innovation 129

guidelines for the activity of the private sector, to one of promoting trans-
parency and making sure that financial market participants understand and
properly respond to the risks and opportunities the system offers. This shift
reflects a recognition that, while the market is best placed to determine how
to organize financial intermediation most efficiently, there remains a public
sector role in ensuring the provision of public goods, in particular reliable
and timely information about the financial sector. In parallel with the chan-
ging approach to regulation, there has been a shift in the range of potential
responses of the official sector to systemic crises. Traditional responses, such
as the provision of emergency liquidity to troubled institutions, have had to
be augmented or supplanted by an emphasis on ensuring the integrity and
liquidity of capital markets, and on facilitating information flows among the
relevant entities in the public and private sectors.
This essay reviews some of the more significant ongoing changes in the
financial system, and identifies implications these changes have had for systemic
stability and for the role of public authorities. The discussion, and the statistical
data we present, are focused on the developed economies of North America,
Western Europe and Japan, though similar changes either are or undoubtedly
soon will be underway in the emerging economies as well. Section II identifies
some of the key trends that are transforming the financial system. Section III
discusses some of the consequences of these trends for the distribution of risk
within the financial system and for the robustness of the financial system to
shocks. Given the traditional importance of banks in many countries, special
attention is paid to their role. Section IV identifies some policy issues that
these developments raise for central banks and other financial regulators, and
Section V concludes.

II. The Changing Structure of Financial Intermediation

Because many of the changes in financial systems over the last ten to twenty
years have been extensively discussed elsewhere, they are reviewed very briefly
in what follows. We first mention some of the underlying technological,
political and economic developments that have driven change in the financial
system. We then identify four key areas of change: disintermediation, the
emergence and rapid growth of markets for specific categories of risk, the
increased emphasis on shareholder value in the governance of financial in-
stitutions, and changes to the business profiles of these institutions. As noted
in the introduction, these trends have progressed unevenly in different countries
and sectors.
Among the underlying developments, perhaps the most significant have
been advances in communications and information technology. These have

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130 Andrew Crockett and Benjamin H. Cohen

accelerated and broadened the dissemination of financial information, while

lowering the cost of many financial activities. Given that the function of
financial markets is to transmit information about the value of assets among
borrowers and lenders, these advances can be expected to exercise important,
and as yet not fully determined, effects on economies of scale and scope in the
financial industry.
Another key impetus to change, though also a consequence of it, has been
market liberalization. This applies both to the removal of constraints on the
activities of financial institutions of different kinds within a given national
market, and to the liberalization of cross-border capital movements and rights
of market access (Tables 1 and 2). As a result of liberalization, a broader range
of domestic and foreign institutions can now provide banking and other
financial services in a given market; the range of services that can be offered
has expanded; and an increasing number of both markets and institutions are
active across national boundaries.
Third, financial activity has become larger relative to overall economic
activity in most economies. In recent decades, financial activity has grown in
response to the demographically driven increase in the amount of investable
wealth. From a longer-term perspective, it has become clear that economic
development both requires and contributes to the evolution of markets and
institutions that can channel funds between an increasingly active and diverse
range of borrowers and lenders. Payment and settlement activities, which

Table 1: International (Cross-border) Bank Assets by Nationality of Bank

Headquarters (at year-end, billions of US dollars)
Of which
Total Europea USA & Canada Japan

1990 6,252 2,755 834 2,122

1991 6,115 3,124 759 1,934
1992 6,041 3,271 771 1,678
1993 6,253 3,491 748 1,688
1994 6,757 3,748 847 1,824
1995 7,626 4,419 932 1,893
1996 8,515 4,820 1,105 2,077
1997 9,213 5,414 1,261 2,050
1998 9,805 6,205 1,268 1,815
1999 10,390 6,792 1,403 1,638
2000b 10,872 7,093 1,567 1,592

Source: BIS.
a
Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg,
Netherlands, Norway, Spain, Sweden, Switzerland, UK.
b
At end-September.

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 Financial Markets and Systemic Risk in an Era of Innovation 131

Table 2: Cross-border Transactions in Bonds and Equitiesa as a Percentage

of GDP
1975 1980 1985 1990 1995 1996 1997 1998 1999 2000b

USA 4 9 35 88 133 156 208 222 200 224

Japan 2 8 63 120 65 79 95 91 84 98
Germany 5 7 33 57 167 196 256 329 335 597
France 5 21 53 185 256 293 354 358 407
Italy 1 1 4 26 251 462 666 633 696
Canada 3 10 27 65 187 250 350 326 248 332

Source: National balance of payments data.

a
Gross purchases and sales of securities between residents and non-residents.
b
Data for 2000 are partly estimated. Data for Italy for 2000 not yet available.

create short-lived but potentially very large credit exposures between financial
institutions, have also expanded dramatically in recent years. This means
that any sustained disruption to financial markets or financial infrastructure
now has potentially broader economic effects than might have been the case
previously.
These fundamental developments have, in turn, had a number of conse-
quences for institutional and systemic structure. Among the most important
of these from the point of view of the systemic significance of banking has been
disintermediation. Directly issued securities, and assets with values directly tied
to issued securities such as mutual fund shares, are replacing bank deposits
as vehicles for savings (Tables 3 and 4). Firms increasingly rely on capital

Table 3: International Debt Securities Outstanding, by Nationality of

Issuer (at year-end, billions of US dollars)
Of which
Total Europea USA & Canada Japan

1993 2,024 907 322 337

1994 2,392 1,133 367 349
1995 2,705 1,330 435 347
1996 3,117 1,515 564 340
1997 3,484 1,649 733 317
1998 4,292 2,002 1,053 319
1999 5,350 2,492 1,535 337
2000 6,278 3,046 1,912 282

Sources: Bank of England; Capital DATA; Euroclear; ISMA; Thomson Financial Securities
Data; BIS.
a
Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy,
Luxembourg, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, UK.

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132 Andrew Crockett and Benjamin H. Cohen

Table 4: Growth of Investment Companiesa

Total net assets

in billions of by type of fund, in 1999, in 1999

US dollars as a % of assets as a % of
Money Market
1987 1990 1995 1999 market Bond Equity Balanced GDP capitalizationb

USA 770 1,069 2,820 6,846 24 12 59 6 74 31

Japan 305 336 470 503 33 37 24 6 12 7
Germany 42 72 134 237 10 27 56 5 11 15
France 204 379 521 655 27 24 24 25 46 32
Italy 51 42 80 477 4 43 30 23 41 63
UK 68 89 154 371 0 8 81 6 26 13
Canada 16 22 96 270 12 9 57 16 42 30
Spain 4 12 100 207 21 29 27 23 35 38
Netherlands 16 24 59 75 7 23 58 9 19 10
Luxembourg 74c 85 324 660 11 37 41 9 3 1,634

a
Open-end funds invested in transferable securities and money market instruments.
b
Bond, equity and balanced funds as a percentage of equity market capitalization.
c
1989.
Sources: Fédérations Européenne des Fonds et Sociétés d’Investissements; International
Finance Corporation; Standard & Poor’s.

markets, rather than bank loans, to finance investment projects and working
capital. This has led to the deepening of capital markets of various kinds, as
well as to a more important role for institutions which deal in tradable securities.
Information technology and disintermediation have fostered the emer-
gence of markets for risk of different kinds, in which exposures to specific
market or credit risks can be bought and sold separately from underlying
financial assets (Table 5). This encompasses both organized derivatives ex-
changes and over-the-counter markets for more specialized kinds of derivative
contracts. Complex financial instruments and strategies that at one time were
understood only by academic theoreticians and a small number of specialized
practitioners are now part of the everyday toolkit of both providers and
end-users of financial services (Table 6). Economic actors now have more
opportunities to reduce or increase their exposure to specific categories of risk
without having to make commitments of principal.
More active shareholders and market liberalization have contributed to an
increased emphasis on shareholder value as a guiding principle for corporate
decisions by financial companies. Managers increasingly recognize their
primary role as stewards of the capital put at their disposal by their company’s

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 Financial Markets and Systemic Risk in an Era of Innovation 133

Table 5: Exchange-traded Derivatives: Notional Principal Outstanding at

Year-end, by Location (in billions of US dollars)
1993 1994 1995 1996 1997 1998 1999 2000

Total 7,776 8,898 9,283 10,018 12,403 13,932 13,522 14,156

Of which:
Europe 1,778 1,832 2,242 2,829 3,588 4,401 3,955 4,173
USA & Canada 4,361 4,824 4,852 4,841 6,349 7,361 6,932 8,239
Japan 1,194 1,498 1,524 1,525 1,478 1,149 1,415 745

Sources: FOW Tradedata; Futures Industry Association; futures and options exchanges.

Table 6: Time Required to Value Options using Computer Workstations of

Various Vintages (in seconds except where indicated)
Workstation European call American call Compound Path-dependent
vintage option option optiona optionb

1984 0.4 14 28 min. 7 hours

1987 0.1 5 11 min. 3 hours
1989 0.008 0.3 37 9 min.
1991 0.003 0.1 15 4 min.
1993 0.0009 0.04 4 1 min.
1995 0.0005 0.02 2 33
1997 0.0002 0.006 0.8 11

Source: Allen B. Frankel and Michael S. Gibson, ‘Hardware, software, dynamic hedging, and
market information,’ unpublished working paper, Division of International Finance, Federal
Reserve Board, July 1997. The source paper contains details on the workstations and pricing
algorithms used.
a
The compound option is a call on the maximum of two assets.
b
The path-dependent option is an average-price (Asian) call option.

shareholders. Failure to obtain a satisfactory trade-off between the return on

this capital and the associated risk justifiably results in a fall in the company’s
stock price and, in serious enough circumstances, the replacement of the
firm’s management or its acquisition by another firm. Managers have begun
to respond to this pressure by working towards improving the quality and
reliability of their services, reducing costs, and focusing their business strat-
egies on those areas at which they have the greatest comparative advantage.
A final trend, resulting from market liberalization, the increasing diversity
of channels of intermediation and the focus on shareholder value, has been
changes to the business profiles of financial institutions. In many countries, the
services traditionally associated with ‘banking’ are now offered by institutions

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134 Andrew Crockett and Benjamin H. Cohen

that are not legally characterized as banks, while banks are increasingly engaged
in non-banking activities. Mergers and takeovers of smaller institutions (Table 7)
have led to the emergence of huge transnational conglomerates, offering ser-
vices ranging from traditional commercial banking, to investment banking, to
the provision of insurance. At the same time, smaller firms offering expertise
in specific services, such as fund management or finance for leveraged buyouts,
have acquired important roles in some market segments. It is not yet clear
whether a handful of firms acting as financial ‘supermarkets’ will come to
dominate global markets, or whether more focused institutions with geo-
graphical and functional specialities will prove more successful. Most

Table 7: Merger and Acquisition Activity in the Banking Sectora

Countries Number of transactionsb Value of transactions
(in billions of US dollars)
1991–92 1993–94 1995–96 1997–98c 1991–92 1993–94 1995–96 1997–98c

USA 1,354 1,477 1,803 1,052 56.8 55.3 114.9 362.4

Japan 22 8 14 28 0.0 2.2 34.0 1.1
Euro aread 495 350 241 203 17.5 14.6 19.1 100.4
Belgium 22 18 20 21 1.0 0.6 0.5 32.5
Finland 51 16 7 7 0.9 1.0 1.2 4.3
France 133 71 50 36 2.4 0.5 6.5 4.0
Germany 71 83 36 45 3.5 1.9 1.0 23.2
Italy 122 105 93 55 5.3 6.1 5.3 30.1
Netherlands 20 13 8 9 0.1 0.1 2.2 0.4
Spain 76 44 27 30 4.3 4.5 2.3 5.9
Norway 23 24 9 5 0.1 0.2 1.0 1.5
Sweden 38 23 8 8 1.1 0.4 0.1 2.1
Switzerland 47 59 28 22 0.4 3.9 1.0 24.3
UK 71 40 25 17 7.5 3.3 22.6 11.0
Australia 19 20 18 14 0.9 1.5 7.3 2.3
Canada 29 31 16 11 0.5 1.8 0.1 29.1
Total banks 2,098 2,032 2,162 1,360 84.7 83.2 200.8 534.2
Memo item:
Total non-bank
financial 2,723 3,267 3,973 5,156 63.7 122.2 189.9 534.2

Source: Securities Data Company.

a
Classified by the industry of the target; only completed or pending deals; announcement date
volumes.
b
Of mergers and acquisitions in all industries.
c
As at 30 October 1998.
d
Excluding Austria, Ireland, Luxembourg and Portugal.

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 Financial Markets and Systemic Risk in an Era of Innovation 135

likely, there will be room for both. What is clear is that a lengthy period of
restructuring and experimentation lies ahead.

III. Some Systemic Implications of the New Environment

The trends outlined in Section II should eventually result in a stronger, more

stable financial system, even if some systemic risks will probably always
be present due to the inherent nature of financial activity. Institutions that
are more attentive to shareholder value will contribute more to growth in the
broader economy, by using their scarce capital resources to allocate invest-
ment more efficiently. They should also have a better appreciation of what
they do well and should be quicker to make needed changes, including changes
to their business profiles through mergers and demergers, when their busi-
nesses start to perform badly. The increased number of ways in which firms
can manage their risk exposures should improve their ability to anticipate and
respond to potential shocks to the health of their counterparties and to the
markets in which they are active.
However, the transition to this new environment can introduce certain risks
as new activities and markets open up, while some systemic risks will probably
always be present due to the inherent nature of financial activity. This section
reviews some of the specific systemic issues raised by the trends discussed in
Section II, first, in terms of the implications of these trends for the distribu-
tion of risk-bearing in the financial system and, second, regarding the propagation
of systemic shocks. It concludes with a brief discussion of issues relating more
specifically to banks and banking.

A. The Distribution of Risk-bearing

A general result of these trends is that a larger set of risks is borne by a wider
range of economic actors than previously. This marks a significant change
from the traditional system, where banks played a central role in channelling
savings from savers to borrowers, and the variety of financial activities was
small. In the traditional system, the owners of bank capital faced three primary
kinds of economic risk (that is, excluding legal, operational and similar risks):
changes in creditworthiness of borrowers, an unexpected increase in cash
withdrawals by depositors, and, to the degree that bank asset and liability
durations were not matched, changes in interest rates.
In the new financial environment, borrowers can more easily issue claims
directly to savers, in the form of equity, bonds and commercial paper. Financial
institutions can choose to remove credit exposures from their balance sheets

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136 Andrew Crockett and Benjamin H. Cohen

either directly, through a loan sale or securitization, or indirectly, through

the vehicle of a credit derivative. Exposure to exchange rates may be greater
because of increased capital flows, but exposures to both interest rates and
exchange rates can be traded and managed through a wide range of derivative
structures, such as swaps, futures, options and forward rate agreements.
Thus, while credit and market risks can never disappear, the establishment
of markets for risk has meant that they can be purchased and sold in such a
way that their price reflects the exposure that might be desired by a well-
diversified market participant. Which risks an institution (or more precisely,
its shareholders) takes on can today be determined largely on the basis of its
market position and business competencies, rather than as a by-product of
other investment decisions.
The development of markets for risk, however, also introduces increased
complexity to financial markets. This can create certain kinds of systemic risk,
particularly during times when intermediaries and end-users are becoming
accustomed to the new instruments and markets. For one thing, the availability
of derivative instruments increases the ability of institutions imprudently to
increase their exposures to market and credit risks, either intentionally or
through neglect. Second, such instruments can reduce the transparency of
reported financial information and hence its usefulness to banks and other
financial counterparties. Accounting bodies have begun to set standards for
the incorporation of ‘off-balance-sheet’ items into financial reports, but it may
be some time before market participants have learned how to make full use of
this information.
Furthermore, there will always be limits to the capacity of the system to
develop means through which virtually any risk can be managed and reduced.
In particular, an important category of risk which may ultimately prove
impossible for banks to hedge completely is liquidity risk. Banking by defin-
ition involves the provision of financial instruments (deposits) that can be
redeemed on demand. Even if bank assets are increasingly made up of rela-
tively liquid instruments, such as bonds, rather than illiquid loans, there will
always be a gap between the liquidity of bank liabilities and assets.1 This
means that it may never be possible entirely to separate the risks associated
with liquidity provision, namely the risk of a bank run, from banks as institu-
tions, though improvements in the liquidity of markets for bank assets and
improvements to internal procedures for monitoring and adjusting an institu-
tion’s exposure to a potential drain on liquidity can reduce this risk. Some of
the implications of this for financial stability are discussed in part C below.

1
Indeed, Diamond and Rajan (2001) argue that a gap between the liquidity of assets and liabilities
helps banks to perform their economic function better.

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 Financial Markets and Systemic Risk in an Era of Innovation 137

B. The Propagation of Systemic Shocks

To assess the effects on systemic stability of the trends described above, this
section considers in turn their possible effects on each of the components of
a financial crisis: the initial shock, the exposure of institutions and markets to
shocks, and the mechanisms through which disruptions are propagated among
institutions and markets. It is shown that, at each stage, some effects are likely
to enhance stability while others are likely to detract from it.
The kinds of shocks which are likely to disrupt the financial system have
probably not changed. Potential shocks include a sudden change (or news
of a sudden change) in macroeconomic conditions, a collapse of prices in a
key financial market and solvency or liquidity problems at one or more large
financial institutions. However, the trends discussed above have had implications
for whether a given shock will prove systemically disruptive. For example,
because of the increased importance of traded markets, shocks to market
infrastructure, including the capacity of financial institutions to act as
market-makers, have become potentially more important in a systemic sense.
The new environment has also changed the likelihood of these shocks
occurring, though not always in predictable ways. Because of advances in
communications technology, both news and rumours will hit markets more
quickly. Yet these advances also mean that information that defuses a crisis,
such as news that a rumour is untrue or that a market disruption has a spe-
cific, localized cause, will arrive more quickly. Similarly, faster communication
and trading technology may, on the one hand, increase the possibility that
market participants will engage in herd behaviour in response to a given piece
of information and thereby exacerbate short-term price swings. At the same
time, advances in the technological and institutional infrastructures under-
lying traded markets have improved the ability of market participants to take
rapid advantage of swings that are excessive relative to fundamentals, by taking
contrary positions in the expectation that the fundamentals will soon reassert
themselves. As a result, prices might then be expected to adjust both more
quickly and more accurately to new information.2
The increased range of the activity of financial institutions may have
increased the exposure of institutions to such shocks, but it has also provided
them with the means to manage their risks better. Financial institutions of all
kinds are more exposed than previously to events in traded capital markets,
since these have become increasingly important both as sources of funding
and as destinations for investment. Derivatives allow market participants to

2
Whichever of these effects is stronger, there is no evidence of persistent increases in the day-to-
day volatility of core financial markets. See Cohen (1999). Of course the possibility of misalign-
ments in market prices over a longer term, such as a period of several months or years, remains.

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138 Andrew Crockett and Benjamin H. Cohen

take on a very large amount of effective leverage in a short period of time. At

the same time, the growth of derivatives markets and advances in techniques
for real-time risk management and control have enabled institutions to
manage their exposures more effectively. The relaxation of restrictions on
cross-border financial activities may have exposed institutions to shocks in
other countries, but they have also provided them with the means with which
to diversify their income sources geographically.
The involvement of financial institutions in a wider range of markets may
have increased the number of potential channels of propagation of shocks
across both institutions and markets. The credit exposures of institutions to
one another now include not just conventional interbank loans and lines of
credit, but also an increasing volume of claims which are not recorded on
balance sheets and are therefore more difficult to measure. These include the
replacement value of derivative contracts and the day-to-day obligations
undertaken through payment and settlement activity. Because of the liberal-
ization of cross-border flows and activities, shocks in one country may now
be more likely to affect others. Conglomeration itself can be a propagation
mechanism, to the extent that losses incurred through one financial activity
damage an institution’s ability to perform others. Linkages among markets
can also create hidden propagation channels that may only become apparent
in times of market turbulence. Examples of such market linkages are the
use of one kind of security as collateral for loans used to purchase another,
or the hedging of exposures taken in one market with claims traded in
another. Finally, the greater overall complexity of the financial system
may increase ‘informational’ contagion across institutions and markets.
Because of imperfect information, disruptions to one institution may lead
investors to reduce their exposures to similarly placed counterparties, because
their degree of uncertainty about prospects for these counterparties has
increased.
Yet here, too, the effects of the new environment are by no means one-sided.
Derivatives can be used to hedge unwarranted cross-market effects, which in
any case should be weak or non-existent if markets are sufficiently liquid.
Advances in information technology have facilitated the introduction of real-
time gross settlement (RTGS) systems for wholesale payments and delivery-
versus-payment (DVP) systems for securities settlement.3 These have reduced
the large short-term credit exposures that are sometimes taken by participants
in settlement systems that operate on a periodic-netting basis, at the cost of
increased demands for short-term liquidity to allow participants to execute
their obligations. Conglomeration allows firms to diversify their exposures to
different areas of financial activity.

3
See BIS (1997) for a discussion of RTGS systems.

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 Financial Markets and Systemic Risk in an Era of Innovation 139

C. Banking and Systemic Stability

With the increasing diversity of the financial system, the roles of banks and the
nature of banking have also become more varied and complex. To the extent
that large financial conglomerates, most of them built around traditional
banks, now play a more important role in the financial system, any damage to
the health of these institutions could pose risks to the system’s stability. This
is especially true in countries where large bank-centred conglomerates are at
the core of the financial system. In turn, banks’ ability to extend liquidity in
difficult times might be hindered just at those times when it is most needed:
for example, when market breakdowns have paralysed some other part of the
financial system. Given the rapid expansion in payments and settlements
activity and in securities trading volumes, the financial system has become
more dependent on ready access to liquidity. Thus, though traditional bank-
ing activity – loans and deposits – has become smaller relative to overall
financial activity, the role of banks as providers of liquidity remains vital to
the system’s ability to withstand shocks.
The traditional model of systemic risk emphasizes bank runs, that is, a
sudden move on the part of households to exchange bank deposits for liquid
claims. Because reserves are necessarily less than deposits, a widespread bank
run can lead to a collapse in real economic activity through a decline in the
money supply. In a relatively disintermediated financial environment, a
similar, if not exactly parallel, fear is a ‘flight to liquidity’ in markets – a sell-
off by investors of all but the most liquid assets. Since liquidity is to a large
extent a self-fulfilling process, an increased desire by investors to hold
formerly liquid assets (such as short-term government debt) could in turn
reduce the liquidity of those assets as well – the market sees all buyers and no
sellers, and securities dealers become reluctant to perform their market-
making function. Perhaps the only way to reverse such a process may be for
banks to create more liquid claims in the form of deposits. They can do this
by extending short-term loans to market-makers, who are thereby able to buy
securities from panicked investors for cash without first having to sell other
securities into an already depressed market. The knowledge that market-makers
are ready and willing to do this can, in turn, reassure investors and increase their
willingness to hold on to the securities. Thus, even in a capital-market-oriented
financial system, banks remain key players in arresting systemic crises.
For example, the undertaking by banks in the USA, encouraged by the
Federal Reserve, to provide liquidity in the days following the stock market
reversal of 19 October 1987, is thought to have prevented the emergence of a
wider systemic crisis at that time. The decline in stock prices led to very high
demands for liquidity by brokers, who needed to extend credit to their customers
for margin calls, and by ‘specialist’ market-makers, who faced uneven order

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140 Andrew Crockett and Benjamin H. Cohen

flows. The Federal Reserve, fearing a breakdown in securities settlement systems

and the collapse of securities firms, announced its readiness to supply short-
term liquidity and encouraged large banks to lend to securities firms facing
liquidity shortfalls. This contributed to a resumption in credit extension to
securities firms. Because of the revival of confidence in the integrity of
the market, there was not even a need for the Federal Reserve actually to
provide the promised liquidity. While market prices remained volatile over the
subsequent days and weeks, institutional failures and disruptions to prompt
trade execution were avoided.
Another important consequence of disintermediation is that sectoral and
other shocks may no longer have as great an effect on the solvency of the
banking sector as a whole. As a result, at the systemic level, banks may now be
less exposed to potential runs arising from their exposure to other kinds of
risk. For example, in a bank-centred system, news of a productivity decline in
an important industrial sector might threaten to destabilize the financial system
through its effects on the solvency of banks which lent to that sector: this could
induce a run on the most exposed banks. In contrast, in a disintermediated
system sectoral problems would still cause losses among investors, but the
danger of spillovers to bank solvency, and hence potentially to bank liquidity,
might be expected to be less. This would be especially likely if banks were able
to diversify their exposure to sectoral shocks through loan sales and credit
derivatives (although, as noted above, the development of markets for risk can
also facilitate the imprudent taking on of exposures by particular institutions).
As already noted, the transition to the new environment itself holds
dangers, as intermediaries learn how to seek profit from new kinds of financial
activity and how to manage new categories of risk. The experience of Sweden
in the late 1980s and early 1990s offers an instructive example in this regard.
Following credit market deregulation in 1985, Sweden experienced a period of
rapidly expanding bank credit and rising share and real estate prices. This was
accompanied by overheating in the macroeconomy, featuring rising inflation,
an overvalued currency, large current-account deficits and high nominal
interest rates. When the economic cycle turned in the early 1990s, leading to a
wave of bankruptcies, banks throughout the Nordic region experienced severe
solvency difficulties. These problems were exacerbated by the European cur-
rency crisis in the autumn of 1992, particularly for those banks which had
issued short-term debt in foreign currency. This led to the collapse of inter-
national confidence in the Swedish banking system. It is notable that the
initial trigger for the crisis was the sharp reduction in foreign funding, and
that throughout the crisis there was no domestic run on deposits.4

4
See Ingves and Lind (1996) for a full discussion of this crisis and the public sector response
to it.

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 Financial Markets and Systemic Risk in an Era of Innovation 141

More broadly, as channels for financial intermediation proliferate, the

exposure of the system as a whole to a breakdown in any one specific channel
declines. For example, the drying up of liquidity in many traded financial
markets in autumn 1998 seems to have had little effect on corporate access to
credit, because companies were able to draw on their contingent credit commit-
ments with banks. Some have said that disruption to the European financial
system was less than that in US markets during this period because the
European system is relatively more reliant on banks and less on traded
markets.5 Yet markets can sometimes provide a useful back-up for banks. For
example, the real estate-related difficulties at many large banks in the USA in
the early 1990s are thought to have had a relatively limited impact on the real
economy, because of the availability of liquid corporate bond and commercial
paper markets as alternative sources of investment financing. Partly as a result,
the US recession at that time was relatively mild, despite a much discussed
‘credit crunch’, and the banks were able to recover.
One way of characterizing this conclusion is in terms of the distinction
between probability and exposure. As a result of the proliferation of vehicles
for savings and investment and of techniques for the separation and trading
of specific risks, the probability that a disruption may occur to one or another
part of the financial system will probably increase. At the same time, the
exposure of the financial system as a whole (and of the wider economy) to such
disruptions, in the sense of the likelihood that it would lead to a broader
systemic crisis, will probably fall. The banking sector remains at the centre,
however, in that the importance of the ability of the banking sector rapidly and
efficiently to expand liquidity as needed remains. This is especially so given the
growth of large-scale payment systems and the increased importance of the
liquidity-dependent institutions that make markets in traded securities.

IV. Central Banks, Regulators and Systemic Risk

The discussion in this essay has tended towards the ‘two-handed’: while some
aspects of the new environment may increase the number of threats to
systemic stability, particularly during periods when intermediaries and end-
users are still becoming familiar with the risk characteristics associated with
new instruments and markets, other aspects provide the means for mitigating
these threats and ultimately for making the system as a whole more stable.
Perhaps the ideal role of central banks and other financial authorities in
adapting to the new environment could be understood as seeking to promote
the efficiency- and stability-enhancing aspects of change wherever possible,

5
See BIS (1999) for an account of the autumn 1998 crisis.

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142 Andrew Crockett and Benjamin H. Cohen

while assuring that the core functions of the financial system, including the
liquidity-provision role of the banking sector, are as far as possible robust to
disruption.
Thus, for example, authorities have worked to promote sound risk manage-
ment procedures, including the management of mismatches in the interest-
rate and currency exposures of assets and liabilities. Direct regulation of the
activities of financial institutions has been replaced by risk-adjusted capital
requirements, which aim to let institutions measure the profits to be gained
from a given risk exposure against its cost in terms of capital set aside. For
larger, more complex institutions, the shift has gone a step further, from
explicitly prescribing an appropriate capital level based on the quantity and
mix of assets on an institution’s balance sheet, to basing capital requirements
on the institution’s own risk-management models. Attention has also been
paid to reducing the risks undertaken in payment systems and the exposures
of institutions to breakdowns in key markets.
This new approach by regulators is itself undergoing a period of learning
and adaptation. For example, it has been found that granting identical risk
weights to broad classes of assets sometimes leads to excessive credit exposure
to the riskiest counterparties in those classes. Different approaches to model-
ling market and credit risks have been developed in recent years, and experience
is being gained as to the advantages and disadvantages of these approaches.
These experiences are being incorporated into the development of a new
capital adequacy framework by the Basle Committee on Banking Supervision
at the international level, as well as into comparable efforts by other national
and international regulatory bodies.
An emphasis on improved transparency is a vital component of these
new approaches. This reflects a recognition of the role that an institution’s
shareholders and counterparties can play in counteracting excessively risky
behaviour through market discipline. Private sector entities with a direct stake
in the survival and profitability of a financial institution are likely to process
and act on information about the institution more readily than would regu-
lators attempting to follow a set of prescribed rules. Along these lines, some
observers have proposed requiring that banks issue specialized financial
instruments, such as subordinated bonds, the prices of which would provide
accurate signals to the market regarding the institution’s health. To be fully
effective, however, such market discipline requires timely and accurate disclosure
of relevant information about exposures and risk management practices.
Central banks and other public authorities have a role to play in examining
the usefulness of different kinds of information disclosure and specifying
standards where appropriate.
A related set of policy issues concern the appropriate response to incipient
systemic crises. Traditionally, central banks have fulfilled their responsibilities

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 Financial Markets and Systemic Risk in an Era of Innovation 143

in this area through the occasional provision of liquidity to banks or the bank-
ing system as a lender of last resort. In the new environment, the wider range
of institutions which perform significant financial functions, and continued
sensitivity to the ways in which explicit or implicit guarantees of liquidity
provision can promote moral hazard, may call for changes to the set of potential
central bank responses to crises. Instead of liquidity provision, possible responses
to crises might now include actions to facilitate the flow of information
between creditors and debtors, co-ordination of public and private sector
actions to redeploy assets and recapitalize the system, or co-operation with
foreign central banks and regulators to assure that a failed multinational
institution is closed with a minimum of disruption to domestic financial
markets. In response to the Swedish crisis discussed earlier, for example, a
wide range of measures involving the public and private sector contributed to
restoring the system to health. These included temporary government guar-
antees to creditors, conditional liquidity provision by the central bank, the
liquidation or merger of weak banks, the raising of new capital from share-
holders, the establishment of entities that assumed the banks’ non-performing
loans and the creation of a bank-financed deposit insurance system. Central
bankers understandably have differing views as to which specific responses to
systemic shocks are desirable in a given set of circumstances. As a general rule,
central banks prefer to leave themselves the maximum of flexibility to take
action as and when conditions warrant.

V. Conclusion

This essay has argued that, whether or not financial systems have become less
stable in recent years, they have clearly become more complex. Financial
intermediation now occurs through a greater variety of institutions, markets
and instruments, and over a greater geographic range, than ever before. Risks
can now be managed and traded in ever more varied ways. While the overall
results will no doubt continue to be positive for households and businesses,
this complexity increases the potential for uncertainty, which may exacerbate
the tendency to run for cover from certain sectors when shocks occur. In the
short term, experimentation and rapid change introduce further seeds of
potential instability. At the same time, a diverse range of channels of financial
intermediation probably reduces the danger of the system as a whole breaking
down.
These developments have also complicated the roles of financial regulators,
including central banks. The response has been a move towards a greater
reliance on transparency and market discipline as ways to improve the spread
of information and thus prevent systemic disruption. More generally, there

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144 Andrew Crockett and Benjamin H. Cohen

has been an increased recognition of the systemic significance of a diverse

range of markets and activities to the health of the financial system. The pub-
lic sector role in promoting financial stability must thus centre on ensuring
that markets work efficiently to provide the proper signals to intermediaries
and end-users, and that crises are resolved with a minimum of disruption to
the core functions of the financial system.

Benjamin H. Cohen
Monetary and Economic Department
Bank for International Settlements
CH-4002 Basle
Switzerland
benjamin.cohen@bis.org

References

Bank for International Settlements (BIS) (1997), Real Time Gross Settlement Systems.
Basle: BIS.
Bank for International Settlements (BIS) (1999), A Review of Financial Market Events
in Autumn 1998. Basle: BIS.
Cohen, Benjamin H. (1999), ‘Derivatives, Volatility and Price Discovery’, International
Finance, 2, 167–202.
Diamond, Douglas and Raghuram Rajan (2001), ‘Liquidity Risk, Liquidity Creation
and Financial Fragility: A Theory of Banking’, Journal of Political Economy, 109, 287–327.
Ingves, Stefan, and Göran Lind (1996), ‘The Management of the Bank Crisis – In
Retrospect’, Sveriges Riksbank Quarterly Review, 1, 5–18.

© Blackwell Publishers Ltd. 2001