On Systemic Risk in Nature and in Banking

As a kid, I liked to play with dominoes. The collapse of SVB and SignatureBank have me thinking about dominoes.

A domino lying flat is in a stable position. But it can also be stood on its short end, thereby placing it in a less-stable or ‘risky’ position.

A bank can arrange its balance sheet to be more or less stable. A bank takes in cash from depositors, and then lends and invests for the short term or long term. It can retain earnings on the spread between income from lending and investing and expense on interest to depositors. Or it can pay out most of those earnings to bank shareholders and executives. Because depositors can withdraw their cash at any time, a bank that deploys cash deposits to long-term loans and investments and pays out most of its earnings is in a risky position – like a domino standing on end.

Of course, banks can (and they do) engage in derivatives transactions to buttress against the risks inherent in a mismatch between liabilities (short-term, because depositors can withdraw at any time) and assets (long-term, because most borrowers needn’t repay before their loan is due). But hedging is a costly activity. Offloading risk into derivative markets requires compensating those who take it on. If banks offload all such risk, they’ll be compensated for nothing more than the transactional costs of banking – opening accounts, distributing cash, moving paper and electrons. So all banks retain, on their own balance sheets, some of the riskiness of the mismatch between their deposits and their sources of income. The domino is buttressed from toppling, but only to a degree.

Because one domino standing on end is a pretty boring setup, we arrange them in groups. An interesting setup of dominoes is one in which each individual tile might interact with another. And that’s where the excitement comes in – through systemic linkages. One false move by one domino and all the others in the set topple over. That’s systemic risk.

Perhaps few would describe a system of banks as exciting. But many would describe them as scary! A run for deposits can overwhelm cash onhand. And if a bank has not or cannot sufficiently buttress itself through derivatives trading and borrowing against its collateral, the bank will topple over. Some depositors will not be able to withdraw their funds, meaning the bank is ‘bankrupt’. And if other banks’ depositors suspect they might not be able to withdraw their funds, they’ll run to their banks. Then more banks will go bankrupt. That’s systemic risk.

While the domino metaphor is simple, and in many ways obvious, its greatest utility comes through considering the ways in which it does not apply. Dominoes don’t act strategically. They simply obey Newton’s second law. And gravity. We needn’t worry that stepping in to avoid systemic collapse might make our dominoes take more risks in the future.

But banks and their depositors do act strategically. If bank owners expect a regulator to prop it up in the event of a run, they will spend less on stabilizing safeguards. Similarly, uninsured depositors will expend less effort verifying the safety of their banks and diversifying their deposits when they know they’ll be compensated for losses. These disincentives to mitigate risk are the consequence of what economists refer to as ‘moralhazard’.

In the case of dominoes, we avoid systemic collapse by propping up the domino about to topple or stepping in with a steady finger (or many steady fingers), or both. In the case of banks, we must step back and consider a more complex set of incentives and interactions. In moments of calm, the policy debate typically centers on balancing short-term stability achieved through a regulatory intervention to support one bank near collapse with the long-run disincentives for risk mitigation efforts by other banks and their depositors. But if we always expect, in moments of crisis, to conclude that the economic consequences of systemic collapse will be too significant to allow bankers or depositors to suffer the consequences of their risk management choices, we should be thinking differently in moments of calm.

In the cases of SVB and Signature Bank, it looks as if policymakers have decided that bank owners – equity holders and creditors – will be wiped out. That should send a clear signal to other banks that reliably lobby for limited oversight, that they will suffer the consequences of insufficient risk management.

But in the case of these first two failures in the present event, deposits above the current standard FDIC-insured limit of $250,000 have also been assured. And because banks only pay insurance premiums commensurate with the standard FDIC limit, depositors are not being incentivized to engage in risk mitigation efforts commensurate with their balances.

Perhaps it is not reasonable to expect regulators – appointed by politicians, elected by the public – to do anything less than fully back-stop depositor-voters at risk of losses in a banking crisis. And if that is the case, we should acknowledge the moral hazard inevitable in that political dynamic by increasing FDIC insurance limits commensurate with the scale of deposits.

Michael J. Orlando is Managing Director of Econ One Research, where he provides economic and strategic analysis and advising for clients in a variety of risk and conflict settings. He also teaches Corporate Finance and Political Risk Analysis and Strategy in the University of Colorado Denver Business School. The views and opinions expressed in this article are those of the author alone, and do not necessarily reflect an official policy or position of Econ One or its members or the University of Colorado Denver.