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Contracts and Systemic Risk in Europe

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Lecture held at the University of Trieste School of Law on the relationship between systemic risks and contractual arrangements. The views expressed are of the author only and do not represent in any way the views of the ESRB

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Contracts and Systemic Risk in Europe

  1. 1. Comparative Contract Law University of Trieste 21 April 2016 Contracts and Systemic Risk in Europe Luca Amorello (ESRB Secretariat) Disclaimer: The views here expressed are mine and do not necessarily represent the views of the ESRB
  2. 2. 2 Outline • Financial Contracts • Understanding the financial system as a complex web of contractual links • Market Agents as contractual constructions • Financial Contracts: from Plain Vanilla to Complex Synthetic Products • Principal-Agent Problem & Information Asymmetry • The role of Pricing and Risk Discounting • The relationship between Systemic Risk and Contracts • A contractual approach to financial crisis: ‘the Financial Instability Hypothesis’ • The Procyclical Nature of Financial Interactions • Systemic contagion: “Domino Effect” with spillovers in the real economy • Chasing the beast: from policy analysis to regulatory strategies • The function of regulators and the role of law • A case study: ‘Bail-In’ and ‘Bail-inable Instruments’. EFC Financial Stability
  3. 3. • The financial system is among the most intricate of inventions. • The financial system can be understood as an intricate web of claims and obligations that links households and firms to a wide variety of financial institutions such as banks, insurance companies, and investment firms. • The global financial crisis of 2007 illustrates how intertwined the financial network has become, while also making clear the potential for widespread losses and instability. • The connections in this vast system have evolved organically and are opaque – they have to be inferred through detective work from data that gets disclosed – but those who have pieced together pictures of the connectivity show that this is driven by historical, personal, and social relationships. These relationships are persistent but variable and evolving over time. • As we will see, the architecture of the financial system plays a central role in shaping systemic risk. The intertwined nature of the financial markets has not only been submitted as an explanation for the spread of risk throughout the system, but also motivated many of the policy actions both during and in the aftermath of the crisis. Such views have even been incorporated into the new regulatory frameworks developed since. The financial system as a complex web of contractual links 3
  4. 4. 4 Modelling the Financial System: a Snapshot
  5. 5. Market Agents as Contractual Constructions 5
  6. 6. Financial Contracts: from Plain Vanilla to Complex Synthetic Products 6
  7. 7. One example: Credit-Linked Note (CLN) 7
  8. 8. Principal-Agent Problem & Information Asymmetry 8 • Principal-Agent Problem: the principal is one who, within predefined terms, assigns a task to an agent, who performs the task on the principal’s behalf. If the agent’s incentives are not aligned with those of the principal and the principal cannot monitor the agent’s actions, the agent has both the motivation and the ability to act undetected against the principal’s interests. • Conflicts usually exist when contracts are written due to uncertainty and risk taken on by both parties. The principal hires the agent to perform specific duties that represent its best interest. The work that is performed can be costly to the agent and not in the principal's best interest. In short, the work done by the agent doesn't actually reflect the best interests of the principal. • The two parties have different interests and asymmetric information. The deviation of the agent from the principals interest is referred to as “Agency Costs”. • This Principal-Agent Problem is particularly troublesome when parties are part of a contract involving risk transfer. Each party to a contract must recognize that the other parties may change their behavior after the contract has been struck. The interconnectedness of financial markets has created a myriad of agency relationships in which monitoring is difficult, and many of these relationships involve risk transfer or risk sharing within groups. • The key question is how to structure the contract to minimize potential problems and reduce ‘Moral Hazard’ of the principal.
  9. 9. • In financial markets it is of primary importance that contracts reflect at any point in time the actual fair value of securities. This is because price of financial instruments is supposed to incorporate all relevant information of a transaction on the market. • Therefore, one can easily say that when investors have asymmetric information, the market allocates risk and transmits information among investors through the security prices. • The capacity of contracts to reflect accurately the risk pricing makes the market more or less efficient. If markets were able to price accurately any securities and transmit all the information across the investors, we would have efficient capital markets. • However, the market is far from being efficient. Instead, its inner nature is characterized by a plethora of market failures. Investors are not always fully aware of the risks they are taking, while the price of securities not always reflect the fail value of the underlying assets. Moreover, the market is not always able to efficiently allocate the risk among market participants. • There is one typology of risk largely neglected in pricing since it is difficult to monitor and quantify. This is the ‘systemic risk’. The role of Pricing and Risk Discounting 9
  10. 10. A contractual approach to financial crisis: ‘the Financial Instability Hypothesis’ 10 See: H. P. Minsky (1992)
  11. 11. The Procyclical Nature of Financial Interactions 11
  12. 12. • Financial instability can spread across countries via balance sheets of financial intermediaries. A hit to the balance sheet of banks or other leveraged financial institutions can push them to sell their assets and stop their lending activity. • This reaction could lead to a liquidity dry-up in the market as banks may be no longer able to finance themselves at a reasonable cost. As the market dries up the systemic contagion spreads across the market and the financial crisis ultimately affects the real economy. • But this contagion is inherently related to the structure of the contractual relationship between the parties involved. The systemic shock can be understood as the failure by one party to meet its obligation on a given contract. When multiple parties fail to meet their obligations at the same time, this can lead counterparties to default on their own obligations as they can no longer re-finance their liabilities due to the ongoing liquidity shortage. This spiral is source of ‘contractual’ instability that may ultimately build up the financial turmoil. Systemic contagion: “Domino Effect” with spillovers in the real economy 12
  13. 13. • The inherent instability of the financial system is one of greatest market failure of the market. The incapacity to price systemic risk and mitigate its spillover effects are of great concern for the smooth functioning of the financial relationships. • The existence of market failures requires policy-makers to design effective policy instruments aimed at preventing dangerous externalities. • These policy instruments are embedded into a set of regulatory standards and legislative proposals whose aim is to address the criticalities emerged. In other words, regulators and policy-makers are require to develop a consistent framework of policy analysis that should permit the identification, the monitoring and the mitigation of the risks that may arise due to the market inefficiencies. • If one of this failure arises, policymakers should be able to address it on time by using proper regulatory instruments. The role of the law – in finance - is thus disclosed: the law serves the purpose of tackling – to the extent possible – the externalities that may arise from a financial system’s failure the market is unable to discipline alone. Chasing the beast: from policy analysis to regulatory strategies 13
  14. 14. The function of regulators and the role of law 14
  15. 15. A case study: ‘Bail-In’ and ‘Bail-inable Instruments’ 15
  16. 16. • Hyman P. Minsky (1992). The Financial Instability Hypothesis. The Jerome Levy Economics Institute of Bard College, Working Paper No. 74. • Olivier De Bandt, Philipp Hartmann, (2000). Systemic Risk: A Survey. ECB Working  Paper Series, No. 35 • Kartik Anand, Prasanna Gai, Sujit Kapadia, Simon Brennan and Matthew Willison (2012). A network model of financial system resilience. Bank of England Working Paper No. 458 • John Kiff, Jennifer Elliott, Elias Kazarian, Jodi Scarlata, and Carolyne Spackman (2009). Credit derivatives: Systemic risks and policy options. IMF Working Papers, No. 254 • Howell E. Jackson (1999). Regulation in a Multisectored Financial Services Industry: An Exploratory Essay. Washington University Law Review, Vol. 77, Issue 2. • Joanna Benjamin, David Rouch (2008). The International Financial Markets as a Source of Global Law: The Privatisation of Rule-Making? Law and Financial Markets Review, Vol. 2, No. 2 • Lucy Chennells, Venetia Wingfield (2015). Bank failure and bail-in: an introduction. Bank of  England Quarterly Bulletin Q3 2015. Bibliography and Recommended Readings 16
  17. 17. Personal contacts: • Email1: • Email2: • Skype: luca.amorello • Linkedin: 17