Systemic Risk: April 2010 Archives

As Greece gets ready to default or restructure its debt, and several other Eurozone countries deal with their rating downgrades, it is useful to keep things in perspective. Here are ten interesting facts based on reports from IMF, Morgan Stanley, Citigroup and my ongoing research with colleagues Itamar Drechsler and Philipp Schnabl ("A Pyrrhic Victory? The Ultimate Cost of Bank Bailouts"):

1. Sovereign credit default swap and bond spreads started rising in the Fall of 2008,
especially following the collapse of the global financial system (failures of Lehman Brothers and A.I.G.).  

2. In most cases, the widening of sovereign spreads was initiated by announcement of massive rescue packages for the financial sector and in some cases equally large fiscal stimulus packages. For instance, the immediate cost of UK's rescue package was in excess of 20% of its GDP.

3. As sovereign spreads widened with announcement of rescue and stimulus packages, in the short run bank and financial firm spreads in fact fell. But within a few weeks of the announcement, both sovereign and financial sector spreads started moving in tandem. There was effectively a "merger", a transfer of the "bad bank" assets of the financial sector into the government. Or you could say, we passed on the buck to the governments!

4. But it is not all about the additional debt and risks taken on by governments through the rescue packages. Countries that have experienced the greatest widening of their spreads are those that have also had high levels of debt relative to GDP and relatively low levels of labor productivity and global competitiveness.

5. Most developed countries are now running debt to GDP levels in the range of 50-120%. Typical emerging market defaults on external debt have in fact been at lower debt to GDP levels of 40-80%. The financial crisis of 2007-09 is metamorphosing as a potential sovereign crisis of 2010. 

6. The US debt to GDP level is now at the same level as that after World War II. That should help put in perspective the crisis we have just witnessed (and the fiscal imprudence in the period leading up to it). 

7. With all this credit deterioration of sovereigns, the interest in their credit default swaps (CDS) - a way of buying protection against default on sovereign's debt - has increased dramatically. While there were hardly any trades happening in sovereign CDS prior to the crisis (and in fact, until Summer of 2008), these are among the most widely traded CDS now.

8. The financial sectors of various countries are buying massive protections against sovereign credit risk. Net dealer exposures to Western countries has been rising dramatically since the Fall of 2008. Gross exposures in SovX, the Eurozone CDS index, now exceed exposures to financial CDS. 

9. Since November 2009, the rapid widening of Eurozone sovereign CDS has been accompanied with little widening, if any, of global, investment grade corporations and financials of these countries. Now, it is the "bad countries" of the world that are partially getting merged with safer countries' balance-sheets (Think of Greece and Germany!).

10. The ratio of CDS traded to debt for sovereigns is the highest for Eurozone countries at the current moment, reflecting both their credit risk problems as well as their monetary inflexibility given the currency union. In contrast, CDS to debt ratios for the UK and the US are tiny.

Moral of the story: At least two.

1. Bailing out banks or countries does not mean the credit risk of their bad assets just vanishes in thin air. It simply gets transferred to (other) sovereign balance-sheets. But these sovereign balance-sheets, like corporations, also have limited debt capacity.

2. It may be time for most countries, including the United States, to exercise fiscal restraint and devise a clear strategy to reduce government debt over next 3-5 years. Those who do not act now put at risk any economic recovery witnessed since the Fall of 2008. Sometimes, less is more!

Why Financial Reform May Just Work

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by Matthew Richardson and Nouriel Roubini

The economy is in ruins. Unemployment is at levels not seen in decades. The public seethes. Congressional hearings call for the heads of bankers. Bankers lobby behind the scenes. Politicians fight over the seeming minutiae of regulatory reform.

The year might sound like 2010, but it was actually 1933.

As President Obama visits the city that was at the core of the crisis - and the city that is key to our revival - history can teach us a valuable lesson. Namely: In the wake of a massive shock to the system, stronger rules of the road for large institutions are a prerequisite for sustained recovery.

Read the full opinion editorial at

by Matthew Richardson and Nouriel Roubini

Between the fall of 2008 and the winter of 2009, the world's economy and financial markets fell off a cliff. Stock markets in the United States, Asia, Europe and Latin America lost between a third and half of their value; international trade declined by a whopping 12 percent; and the size of the global economy contracted for the first time in decades.

When economists and Wall Street types toss around the term "systemic risk," that's pretty much what they're talking about. The particular risks that led to the crisis -- i.e., big institutions with too much leverage, too little capital and too many implicit and explicit government guarantees -- were not impossible to anticipate. (In fact, some of us warned about the financial pandemic that was to come.) Now, the question is: How do we keep this all from happening again?

To create a truly safe financial system, we have to focus on two goals. First, we have to drive a stake through the heart of the "too big to fail" mantra that only fattens our financial beasts. Second, we should stop focusing on the problems of individual banks and look at the broader risk that the largest and most complex financial institutions pose.

For the full opinion editorial in Sunday's April 11th Washington Post, please go to the following link




Some Contingencies for Contingent Capital

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A number of academics and policy makers have favored the forced debt-for-equity conversion bonds or contingent capital. With any regulation, the key is to know strengths and weaknesses. The strengths of contingent capital have been mentioned a number of times here and there (for most recent FT article, see Here, I outline some contingencies for contingent capital that regulators must keep in mind.

Prisoners of Our Own Device

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by Barry Adler

The Dodd bill, just released by the Senate Banking Committee, would impose extensive new restrictions on the provision of financial services in the United States. These restrictions represent a fair price to pay for institutions that desire government backing, but they may prove insufficiently effective and unnecessarily stifling to companies that would prefer to go without government support.

To illustrate this point, consider what has come to be known as the Hotel California Provision, under which bank holding companies that have received TARP funds would be unable to avoid Federal Reserve supervision even if they eliminated their banks.  In the words of the iconic pop lyrics: "You can check out any time you like, but you can never leave."

In an April 7th, Wall Street Journal Opinion piece, authors Peter Wallison and David Skeel argue that the current version of the Senate bill should be opposed because "the simplest and clearest (reason) is that the FDIC is completely unequipped by experience to handle the failure of a giant nonbank financial institution." (see the full article in the Wall Street Journal.)

The Fallacy of Bank Diversification

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by Viral Acharya & Matthew Richardson

In a recent Wall Street Journal article, John Varley, Barclays Chief Executive, was quoted as saying: "We see big banks as diversifiers, not risk aggregators." His comments are part of a chorus of Bank CEOs now questioning various reforms that are aimed at large, complex banks.

He is plain wrong and regulators should be wary of such arguments.


The Dodd-Frank Act, signed into law in July 2010, represented the most significant and controversial overhaul of the U.S. financial regulatory system since the Great Depression. Forty NYU Stern faculty, including editors Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, and Ingo Walter, provide a definitive analysis of the Act, expose key flaws and propose solutions to inform the rules’ adoption by regulators, in a new book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley, November 2010).

About Restoring Financial Stability

Previously, many of these faculty developed 18 independent policy papers offering market-focused solutions to the financial crisis, which were published in a book, Restoring Financial Stability: How to Repair a Failed System (Wiley, March 2009).

About the Authors