Foundations of Financial Risk. Apostolik Richard

Richard Apostolik, Christopher Donohue

      Foundations of Financial Risk

Foundations of Financial Risk

An Overview of Financial Risk and Risk-Based Regulation

Richard ApostolikChristopher Donohue

      Cover Design: Maryann Appel

      Cover Image: ©iStock.com/Cobalt88

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      PREFACE

      The New World of Banking

      Banking after the Global Financial Crisis

      The global financial crisis of 2007-2009 will shape the ways banks are managed for many decades to come. It will also continue to affect the ways that politicians, regulators, analysts, and the general public think about banks and behave toward them.

      Banking crises are not unusual. The Argentinian currency revaluation in 2001 led to a crisis for its banks, the Asian financial crisis of 1997 led to the insolvency of many of the region's banks, Sweden suffered a banking crisis in the early 1990s, and in the mid-1970s many second-tier British banks suffered huge losses as a result of a collapse in property prices.

      Yet the 2007-2009 global financial crisis stands out from other banking crises due to its global extent, its impact on economic growth, and the far-reaching policy responses that have followed it. In all three respects, what happened in 2007-2009 resembles the financial crash and economic depression of the late 1920s and early 1930s more than it does any of the other banking system crises of more recent years.

      The events of 2007-2009 challenged many of the widely held assumptions about how banks and banking systems worked. In simple terms, many things that would have been dismissed as unthinkable a few years before actually happened.

      For example, it had always been assumed that banks and other commercial institutions would invariably make liquidity available to other financial institutions even if they charged very high rates for it. Yet during the days that followed the collapse of Lehman Brothers in September 2008, short-term financing markets dried up as banks refused to extend liquidity at any price. The level of uncertainty in financial markets was such that banks did not want to increase their exposure to anyone else, however strong they seemed to be.

      Among the other ideas challenged by the crisis was the distinction between off-balance-sheet and on-balance-sheet items, the value of credit ratings, and the ability of many new capital instruments to absorb losses.

      More generally, the long-term trend toward deregulation of financial markets that had begun in the 1970s and gathered pace during the 1990s fell out of favor. The belief that bankers themselves best understood the risks that they were taking was discredited. Politicians who had to explain to their voters why the failure of private sector banks had led to higher unemployment and public sector wage freezes wanted to exert control over the way banks operated in the future to try to ensure that a similar global crisis could not reoccur.

      As a result, the level of regulation and public scrutiny of banks is far greater today than it has been for many decades, and this is unlikely to change in the near future.

      Although the crisis was global in the sense that banks and economies throughout the world were affected, some were affected more than others. Emerging market banks that did not rely on global funding streams and had little exposure to assets and financial instruments originated in Western economies were barely affected. For example, in 2007-2009, the performance of Egyptian banks was driven more by the progress of their central bank's domestic financial reform program than by events in global financial markets.

      Nevertheless, the fact that it was banks and economies in developed markets, particularly the United States and Europe, that were most affected has had far-reaching consequences for banks everywhere. Officials from North American and European countries and from the developed economies of Asia dominate bodies such as the Basel Committee on Banking Supervision that set standards for international banks and other financial institutions. It was banks from these countries that were most affected by the global financial crisis, so officials from these countries have been determined to put in place new standards – for example, on minimum capital levels and corporate governance – that they hope will reduce the possibility of another global financial crisis happening.

      The standards that are set by bodies such as the Basel Committee are applicable to banks worldwide. So, for example, Egyptian banks may have been minimally affected during the financial crisis, but they are now judged