Interdependence Key Factor In Financial System Stability
The Bank for International Settlements Annual Report is well worth dipping into. It provides another detailed analysis of the factors and events behind the unraveling of financial markets following the subprime meltdown, which all seems so obvious in hindsight.
In addition to a generally gloomy outlook for the world economy, it provides a thorough critique of the “originate-to- distribute” model, which began with mortgage-backed securities and led to specialized investment vehicles and other esoteric and poorly understood derivate instruments.
The report does not lay blame on any one party but rather stresses the interdependence of all involved:
“A general lesson derived from the financial turmoil is the close interdependence of markets and institutions in the functioning and resilience of the financial system. The OTD model of financial intermediation is based on the premise that risk is ultimately shifted to the investors through market transactions. However, as the events during the period under reviewdemonstrated, it is the capital of financial institutions that in the end underpins the stability of all these transactions.”
“From a policy point of view, this interdependence between financial institutions and markets argues in favour of strengthening the macroprudential elements in the design of the framework and the calibration of its instruments.”
The shortcomings of the originate-to-distribute model can be attributed mainly to the failure of individual players to develop a holistic view on the risks due to excessive focus on their narrow, individual perspective, losing sight of systemwide drivers of risk and interdependencies.
“Policy that has a similarly narrow focus can also fail to take ex ante preventive action as the risks of disruptiveinteractions build up, ” the BIS says. ” At the same time, the management of the period of stress has already shown that, to be effective, policy responses may entail interventions aimed at easing the strain in the markets while at the same time helping institutions to cope with distress.”
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