The threats to the global financial system and how policy-makers can respond

The threats to the global financial system and how policy-makers can respond

The threats to the global financial system and how policy-makers can respond

The FINANCIAL -- The long-running Greek crisis and China’s recent stock market crash are the latest threats to the stability of the global financial system. But as a new report from the Systemic Risk Centre (SRC) at LSE explains, ‘systemic risk’ – and its periodic appearance in financial crises – has been present ever since the first financial system was created and is an inevitable part of any market-based economy.

Funded by the Economic and Social Research Council, the SRC was established to investigate the risks that may trigger the next financial crisis and to develop practical tools to help policy-makers and private institutions become better prepared. Its co-directors – LSE professors Jon Danielsson and Jean-Pierre Zigrand – describe their agenda:

“We aim to develop a set of tools for policy-makers to adjust regulations to achieve the twin goals of ensuring the efficiency of the financial system and mitigating the incidence and severity of financial crises.

While it is not possible to eliminate systemic risk or incidence of crises entirely, the objective should be a more resilient financial system that is less prone to disastrous crises while still delivering benefits for wider society.”

The new report outlines a number of key messages on the challenges posed by systemic risk, including:

The challenge for policy-makers: Society faces a difficult dilemma when it comes to systemic risk. We want financial institutions to participate in economic activity and that means taking risk. We also want financial institutions to be safe. These two objectives are mutually exclusive.

Endogenous risk: The central insight from the study of systemic risk is that the threat comes not from outside the financial system and the setting in which it is embedded; rather, it comes from interactions within the system.

Amplification mechanisms: Within the financial system, a small event can turn into a major crisis, while a much larger shock may whimper out into nothing. Behind those shocks that become systemic events is the presence of mechanisms that amplify and/or accelerate the impact through the rest of the financial system – ‘positive feedback loops’. 

Policy responses: Laws, rules and regulations which are created to bolster financial stability can often become a channel for the mechanisms that have precisely the opposite effect. 

Financial market regulation: Milton Friedman noted that ‘The great mistake everyone makes is to confuse what is true for the individual with what is true for society as a whole.’ Attempting to ensure the safety of each part of the financial system independently can lead perversely to the system as a whole becoming more unstable, according to LSE.