SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Discussant comments on: Quantifying interlinkages between banks and banking systems 30 March 2011 Harry Leinonen Harry Leinonen The views expressed are those of the author and do not necessarily reflect the views of the Bank of Finland. Workshop for Non-Regulatory Central Banks, Bank of England, March 2011, London

SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND General findings: Systemic risk has increased The risk of contagion has increased Harry Leinonen Interbank market and international capital market has grown Capital is more efficiently employed, but risks increase during crises The data are available in banks’ ICT systems and need to be transferred to authorities’ systems

SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Analyses based on  Available interbank direct credit data  Banks’ risk mitigation solutions are not covered –Collateralisation –Bilateral offsetting –Multilateral netting –Continuous netting streams Harry Leinonen Banks’ risk mitigation solutions have major impact in reducing large gross exposures to reasonable net exposures (when mitigation solutions are legally enforceable)

SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND In a homogeneous market all banks will fail independent of contagion when shock > own capital Harry Leinonen Risks reside in portfolios and are materialized by external shocks Bank 1 Bank 2 Bank 3 Identical investment portfolio risks Shock

SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND In a heterogeneous market with strongly interlinked banks, all banks will fail due to contagion when ∑ shock > ∑ own capital Harry Leinonen Interbank linkages distribute shocks among banks and their portfolios. When risks are realized in an interlinked network, it becomes a game of loss-sharing! Bank 1 Bank 2 Bank 3 Same total investments but non-identical individual investment portfolio risks Shock

SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Systemic risks and contagion can be viewed as a shock absorbing loss-sharing mechanism among banks Harry Leinonen

SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Somebody has to cover the losses when assets shrink in bank’s balance sheet Harry Leinonen Assets Own capital Central bank credits Interbank credits Market funding (unprotected) Protected (guaranteed ) deposits Liabilities Shock After shareholders, creditors will cover the rest. What are the rules for loss-sharing?

SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Some creditors can secure their credits Harry Leinonen Assets Own capital Central bank credits Interbank credits Market funding (non-guaranteed) Protected (deposit guaranteed) deposits Liabilities Applied credit risk mitigation mechanisms increase the share of credit losses of other creditors in crises, especially for those providing deposit guarantees Central bank collateral Interbank collateral, offsetting and multilateral netting Market participant collateral, offsetting and multilateral netting ?

SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND there is an upside and a downside in interbank credits and these need to be balanced for optimality Harry Leinonen Interbank credits allocate capital efficiently and distribute the returns among banks but risks are also shared

SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Cross-border contagion with different investment portfolios and bank risks due to different public policies Harry Leinonen Country ACountry B Country N Cross-border benefits and risks Cross-border benefits and risks Are cross-border risks priced correctly? Are risk mitigation procedures neutral/symmetric? How open should the global market be? How homogeneous should national policies be? Allocation barriers will affect allocation benefits! Crises induce protect- ionism?

SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Two statuses (mindsets) in the liquidity market Harry Leinonen Expansive = ReinvestingContractive = Hoarding Change of status produces a shock Rapid recycling Slow recycling (Compare with consumption in inflationary and deflationary economies) Changing mindset from expansive to hoarding is a very rapid process, while the opposite seems to be very slow

SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Strong banks thrive on weak banks during liquidity crises  Weak banks with liquidity problems will become dependent on other banks and especially central banks  Excessive liquidity will pile up in strong banks when weak banks’ liquidity is used for bank runs  Strong banks can buy assets at fire sale prices  Strong banks have an interest to see competitors disappear Harry Leinonen Back to normal, only via sufficient long-term stability in the market Banks need to be perceived again as practically equally strong!

SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Systemic risk = contagion = loss-sharing among banks can be affected via a) limiting banks’ overall risks. b) requiring more own capital. c) changing interbank risk mitigation rules ( d) reducing size of external shocks?) What is the desired loss-sharing model? = What kind of resolution mechanisms are applied? Harry Leinonen

SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND However, banks should be the professionals for assessing credit risks also on those related to other banks? So in the end, are the current problems basically due to wrong type of risk-taking incentives? Harry Leinonen Should risk-taking incentives closer to those of authorities be enforced on banks instead of circumventable rules?