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The Butterfly Effect: From Marginal to Systemic

The Butterfly Effect: From Marginal to Systemic

3rd May, 2023

Scene 1: 2019 | Wuhan, China | Patient 0 contracted Covid-19.

Scene 2: 2023 | Zurich, Switzerland | UBS acquires Credit Suisse after a $69 billion one-quarter deposit outflow, and fears of a global financial industry collapse are spreading like wildfire. Bank CDS[1] are going through the roof, and regulators are edging in their seats and playing bailout[2] whack-a-mole.

The story that links those two seemingly unrelated events is one of epic proportions that spans lockdowns, supply chain disruptions, record-breaking inflation, a global slowdown, a universal recession, interest rate hikes, social-media-fueled fear-mongering, and revised accounting classifications.

So how does this snowball get traction, and where will it stop? From a bird’s eye view, a correlation between many factors is proving to be more and more potent in the financial services industry.

Globalization: Now more than ever, banks are becoming more global. Technology and innovation have increased the reach of finance to transcend geographical borders, with an international depositor base, a cross-border investment spectrum, and a nomadic workforce ready to globetrot on a whim. While this is remarkably positive from a diversity, inclusion, and talent-wisdom point of view, it can also mean that when there is a crisis in any one country or region, there is a very high probability that it will have a direct impact on the banks’ operations. This connection can also amplify the effect of a local problem on a global scale.

Political Instability: Geopolitical tensions majorly affect the banking industry due to heightened uncertainty and volatility in financial markets. Impact on asset valuations has a direct bearing on profitability, risk appetite, and sometimes even the occurrence of non-performance. All of which can eventually lead to systemic risk.

Economic linkage: Specialization and trade are the underlying axioms of economic development. However, when one link in the chain breaks, repercussions can be felt globally. Economic instability shapes Interest rates, lending activity, employment, purchasing power, repayment capability, supply chains, funding availability, and market liquidity. And all those factors trickle down onto the Financial Services industry.

High Leverage: A prevalent methodology for banks to fund their asset base & investment portfolios is to borrow money, often at a ratio of 12:1 or higher. This means a slight loss in their proprietary books can significantly impact their balance sheets, potentially leading to insolvency if the loss is large enough. When faced with such a problem, corrective actions usually have a ripple effect on their clients, further amplifying the feedback loop and impacting the economy in general and other market participants.

Interconnectedness: Banks rely on each other to provide liquidity and funding, and they often have significant exposures to each other through loans and other financial instruments. When one bank experiences financial difficulties, it can quickly spread to other banks, as these interconnections create a domino effect.

Moral hazard: Banks know how essential they are to the stability of the global economic cycle and, in some cases, may grow to become too big to fail. As such, the government will only have recourse to bail them out if they get into trouble. This can lead to reckless behavior as banks take on excessive risk, knowing they won't bear the full consequences of their actions.

Regulatory Capture: In many instances, regulators can become symbiotically entangled with the industry they are supposed to oversee. This can lead to lax regulations and oversight, contributing to excessive risk-taking and the buildup of systemic risk.

Technology and Cybersecurity: The increasing reliance on technology can also create new sources of systemic risk. A major coordinated attack on a firm’s systems or its reputation can balloon and create a self-fulfilling prophecy, disrupting the entire banking system and causing widespread panic and instability.

Herd mentality: When one bank experiences success in a particular area, other banks may try to follow suit, leading to a concentration of risk in specific sectors or asset classes. Alternatively, if a problem arises in that sector, it can quickly spread to other banks exposed to it. On the other side of the coin, a panic event can swiftly grow out of proportion and eventually bring the bank to its knees.

The global financial landscape has evolved tremendously in the last decades, shifting steadily towards a more inclusive, collaborative, international, yet complex profile. While this has been beneficial in expanding funding and investment horizons on a universal scale, it has nonetheless made it much easier for crises to spill over effortlessly across borders. Once considered the ultimate growth enabler, technology also showed that it could prove fatal when used maliciously.

This, however, is common. Every evolutionary event over the ages has come with unique challenges and opportunities. From Homo sapiens to the modern human to bionic hybrid transhumans, the only way to grow and evolve is by having a solid governance culture that equally empowers strategy, innovation, and risk management. From that point on, let the cards fall where they may.

[1] A Credit Default Swap (CDS) is a financial instrument that protects investors against the risk of defaulting on a particular counterparty. An increase in CDS could be considered a proxy for a rise in a company's default probability.

[2] A bailout is a financial rescue operation where the government provides financial assistance to a company or individual experiencing financial difficulties on the verge of bankruptcy or failure.

About the Author
Tarek Z. Aoun, CFA

Management Consultant

Tarek is a Management Consultant with Meirc Training & Consulting. He holds a Bachelor of Arts in Economics from the American University of Beirut (AUB) and is a CFA® Charterholder. In addition, Tarek has obtained several certifications in banking and finance, such as Islamic Finance qualification, Business Conduct, Risk in Financial Services, and Securities from the Chartered Institute for Securities & Investment (CISI).

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