It was recently announced that the largest financial institutions in the U.S. all passed their regulatory stress tests, which gauges their financial soundness against a 2008-style crisis. This “clean bill of health” has also enabled large banks to release a wave of dividends to their shareholders, making for a euphoric day on Wall Street. Yet, as the term “systemic” implies, these types of complex, highly correlated financial risks are not only hard to detect, they are literally ingrained in the global financial system. This raises the question, is the U.S. economy now risk-free because the largest banks appear healthy? Or, has systemic financial risk migrated to another host or unwatched segment of the economy?
Regulatory stress tests, like many aspects of financial risk management, labor under some serious blindsides. The first being the fact that they were designed to respond to yesteryear’s financial crisis and are not geared to register the present threat landscape. For example, testing a bank’s capital adequacy (a backward-looking process), while a good measure of that banks’ ability to survive a run on liquidity, is not a good way to gauge risk-readiness for cyber threats or other emerging risks. Indeed, one regulators clean bill of health for large banks, is a cyber criminal’s “hit list.” This much was true of the SWIFT exploit in which more than $80 million was absconded from the New York Fed under the guise of legitimate transactions. Herein lies one of the most confounding aspects of the new threat landscape, which is not merely the ability to infiltrate data systems, but rather to profoundly change information at its source. Regulatory stress tests do not pick up the Trojan Horse of cyber threats. An additional challenge is that systemic financial risk tends to rear its ugly face in other seemingly uncorrelated areas of the economy. Now that our largest banks have received a clean bill of health, we must ask ourselves where will systemic financial risk reappear? And will regulators know which mallet in their limited tool box to reach for to put new risks in check?
With the reality that the largest banks have hardened their position and many are now sheltered by hubris-inducing fortress balance sheets, it is very likely risk has shifted to so called soft targets. In the same way that express kidnappings emerged when richer, more desirable targets hardened, it is very likely that other financial institutions will be the protagonists in the next “big one.” In keeping with this pattern of systemic risk moving down market, the more than 6,000 community banks (down from 17,400 in the 1980s) and other financial institutions, such as the handful of national payroll providers, may very well play host to future crises. Another cause for concern that is receiving very little regulatory attention is the diminishing health of the once low-risk municipal bond market. With the island of Puerto Rico and its eye-watering $73 billion public debt, and the state of Illinois coming in a distant second with its $15 billion debt burden, the likely correlations between municipal debt markets and other aspects of the economy are not well guarded. Our financial system is much less vigilant to the growing reality that data is our most important asset class, for which we are unhedged to the tune of trillions.
While the clean bill of health among the largest banks should be cautiously celebrated, especially by happy investors, regulators, risk managers and others interested in the overall health of the economy should take heed. Consider the game of financial whack-a-mole that must be played to preempt future economic shocks. One of the first steps in doing this is of course to expand the purview of regulatory regimes encompassing many institutions, which like Lehman Brothers, are not presently deemed to be systemically important. Look at MetLife’s legal battles with regulators to remove the “financial Scarlet Letter” of being labelled systemic. Another area for improvement is to develop and apply a risk management regime that is much more dynamic than the current battery of tests and examinations we rely on. Compelling tools, such as NYU Stern’s Volatility Lab provide a market-based read of systemic risk, financial correlation, and, critically, volatility across a wide range of publicly traded financial institutions. Against this measure, there are a number of areas of concern, including in the global insurance industry, large asset managers, and other segments of finance, that are not equally scrutinized or where regulatory regimes are not well coordinated around the world. This lack of global harmonization creates a regulatory arbitrage that is both well understood and well exploited by financial executives. Risk is like water, enjoying the benefits of patience and flowing through the path of least resistance.
Another critical facet of systemic financial risk that is not entirely observed in regulatory stress tests is how globally interconnected large financial institutions really are. Many of the largest banks around the world have thousands of overseas holdings and are directly correlated to the health of the global economy. The “America first” sloganeering that has settled into Washington, combined with the temporary economic “bump” that has buttressed the economy in the short run, miss the critical linkage between U.S. publicly traded companies and their market access for both supply and demand from the rest of the world. Against this backdrop, we cannot decouple the fortunes of companies from countries and as with all complex risks the era of privatizing gains and socializing losses is not quite behind us. Improving our resilience to systemic financial risk certainly begins with improving the financial soundness of the largest banks, however that is merely the end of the beginning.
While the underlying health of the U.S. economy has certainly improved since the financial crisis of 2008, many long-range challenges remain unchecked. Chief among them is the fact that the U.S. has been preoccupied for far too long by political short-termism, a bitter partisanship now bordering on tribalism, and the prioritization of economic issues that are only registered in the electoral cycle. Long-range challenges, such as our terrible infrastructure scorecard, our ZIP Code lottery educational system, and the future-proofing of our workforce are all receiving little to no attention from policymakers. In fact, what is becoming increasingly clear, is that Washington’s position on many of these issues is being drowned out by a lack of consensus and collaboration from elected officials and a sensationalist 24-hour media cycle obsessed with decoding 140 characters from the White House. This, combined with a series of political and national security misadventures on the world stage are obfuscating our real challenges. Political point scoring might feel nice in the short run, but it will soon prove to be a Pyrrhic victory of national proportions.