Panel
Systemic Risk: Inevitable or Preventable?
Milken InstituteScarlet Fu, Dimitri Demekas, Fiona Frick, Michael Piwowar, Paul Sheard, John C. Williams
- Systemic risk is projected to evolve into new forms such as shadow banking and credit intermediation outside traditional banks, requiring regulators to shift from static ring-fencing to activity-based oversight and increased cross-border cooperation.
- The global economy is expected to enter a "new normal" characterized by significantly lower equilibrium interest rates driven by demographics and productivity, with Fed projections suggesting a longer-run nominal rate around 3.25% (1.25% real + 2% inflation) though downside risks could lower the real rate closer to 1%.
- Future interest rate increases may trigger significant downward movements in broad asset classes based on arbitrage relationships with Treasury bonds, potentially forcing pension funds and insurers to adjust return expectations or move into riskier assets.
- A persistent, insatiable demand for "money-like" safe assets, often driven by regulatory capital requirements and Basel standards, is expected to fuel the creation of new financial instruments that may hide risks or provide a false sense of liquidity, particularly within ETFs and open-end mutual funds.
- New systemic risks are anticipated over the next five to ten years emerging from the concentration of risk in Central Counterparties (CCPs), which regulators may create as a new class of "too big to fail" institutions, as well as from the expansion of asset managers with liquidity mismatches.
- Financial risk is predicted to continue shifting from regulated banks to sectors like asset managers, necessitating regulatory frameworks that focus on interconnections and systemic dynamics rather than analyzing institutions in isolation.
- Major economies face headwinds from new capital requirements which may slow short-term growth but improve long-term stability, while the global economy remains codependent, preventing countries from acting entirely independently on monetary policy.
- Significant geopolitical risks include a potential disorderly adjustment or "hard landing" in China or emerging markets, with a "China-style Japan" scenario warned against if debt overhangs are not addressed, potentially creating zombie firms and banks.
- The financial system is expected to remain vulnerable to "too interconnected to fail" dynamics, with stress testing viewed as useful for pro-cyclical risks but potentially ineffective at predicting structural systemic events arising from whole-system dynamics.
- Political will to address systemic risk is forecast to wane as memories of the financial crisis fade, potentially leading to a lack of courage in crisis management and a failure to tackle problems before they escalate.
- Future regulatory frameworks are expected to require greater international coordination, including the development of supervisory and resolution colleges, to manage the resolution of systemically important foreign banking organizations and prevent regulatory arbitrage.
- Governments capable of borrowing in their own currency are expected to face fewer systemic solvency risks than those in currency unions, though debt ceiling threats in the US could still pose risks to financial stability and the dollar's reserve status.
- Regulators are actively developing liquidity risk management programs for funds and are expected to implement rules addressing the potential for market liquidity to become illusory in instruments holding illiquid underlying assets.
- The "lender of last resort" function of central banks is expected to remain a necessary component of the financial system to prevent total collapse, despite associated moral hazard concerns, while regulators will need to balance the dual mandate of growth and stability.
- Risk cannot be fully regulated out of existence, and the primary objective of future frameworks is expected to be building system resilience, often necessitating a "fortress" balance sheet approach to handle unpredictable shocks.
- Global economic developments, including those in Asia, Europe, and South America, will continue to feed into domestic inflation and employment goals, making it impossible for any single nation to ignore external shocks.
- Current approaches to risk management may fail to address risks arising from complex interconnections, requiring regulators to improve transparency and information sharing across borders to effectively manage interconnected sectors.