Ten years after Lehman Brothers became insolvent, additional work is needed to fully address financial system vulnerabilities, while at the same time new risks have emerged.
Marking the ten-year anniversary since the insolvency of Lehman Brothers, DTCC (the Depository Trust & Clearing Corporation) has published a new white paper identifying key risks facing the financial industry and opportunities to mitigate them to protect financial stability.
“Despite the many enhancements that have been implemented over the past 10 years, the nature of risk has evolved dramatically since 2008,” said DTCC Managing Director, Credit and Systemic Risk Michael Leibrock. “Some of the most dangerous and challenging risks we face today barely registered a decade ago, and the next crisis might be fundamentally different than we can envision right now.”
Global market stability has indeed been strengthened and resilience enhanced, a result of significant deleveraging, bank balance sheet strengthening, improved transparency and increased regulatory requirements.
But, the paper says, in applying monetary policy tools to mitigate the impact of the crisis and keep inflation in check, central bankers have used quantitative easing programmes to purchase assets at an unprecedented scale and pushed interest rates to historical lows, leaving significantly less ammunition to combat another crisis.
“The risk landscape has experienced a significant evolution over the last decade, which has led to a more resilient and stable global financial ecosystem,” said DTCC Managing Director and Group Chief Risk Officer Andrew Gray.
“However, additional work is required to fully address some of the vulnerabilities that triggered the financial crisis as well as to tackle new risks that have surfaced over the past decade.”
Resilience can be further strengthened
The paper identifies additional opportunities to further strengthen financial stability by enhancing system-wide resilience, for instance by expanding central clearing for both the cash and derivatives markets to gain the full risk management benefits provided by central counterparties.
Additionally, in order to harness the full potential for derivatives trade repositories to provide regulators with early warning signals of systemic risk buildup, increased regulatory harmonisation and cooperation is needed among all stakeholders to refine technical guidelines around data consistency, data standardisation and harmonised reporting practices, the paper says.
The use of LEIs (Legal Entity Identifiers) in regulatory reporting need to be mandated for adoption across all jurisdictions and financial markets worldwide. The LEI system not only allows supervisors to better monitor and analyse systemic threats, but it also helps companies improve risk management and reduce costs associated with collecting, cleaning, aggregating and reporting data.
Furthermore, financial firms should make robust enterprise data management capabilities foundational in their risk management frameworks. Current practices are often too inconsistent or incomplete to ensure adequate accuracy and timeliness of data, which is critical to achieving the benefits of new resilience-building technologies, the paper says.
New risks have emerged
The paper also identifies several new challenges that have emerged since the Lehman insolvency, namely with respect to the macroeconomic environment, market-related risks and technology-related risks.
“We must maintain a forward-looking approach to identifying and anticipating threats and developing solutions to reduce them, which could help prevent or mitigate another crisis,” said Gray.
DTCC’s medium-term macroeconomic concerns are related to trade tensions, rising geopolitical risks and high levels of global debt. Additionally, stretched asset valuations can raise the risk of sudden price drops. These threats, while difficult to control or predict, are highly interdependent and should be addressed through a cross-disciplinary approach, the paper says.
With respect to market-related risks, DTCC suggests certain ETFs (exchange-traded funds) and their exposures should be managed more closely, given their growing popularity and tendency towards esoteric and opaque products which may complicate their risk profiles. The paper also recommends a further reduction in exposure to unsettled trades, for example by optimising and accelerating the US equity settlement cycle beyond T+2.
The paper also discusses technology-related risks, represented by a series of innovative technologies generally characterised as fintech developments. Cryptoassets and cloud-based computing do not presently threaten financial stability, but given the pace of development in fintech, careful monitoring, thoughtful supervision and harmonised regulatory requirements are warranted. Specifically, DTCC urges policymakers to create regulatory frameworks that can encourage responsible innovation while still providing adequate oversight to ensure financial stability.
At the same time, DTCC says cyber risk is now considered the single most important near-term systemic risk, as attackers target financial institutions and critical infrastructures more frequently and with greater sophistication. Given current geopolitical tensions and the ever-increasing speed of technological innovation, the occurrence of a successful large-scale cyber-attack is likely a matter of ‘when’, not ‘if’.
Cybersecurity capabilities and plans should continue to be prioritised, emphasising resilience and recovery as much as prevention, the paper says, adding that additional efforts are required to create new and strengthen existing cybersecurity public-private partnerships that effectively leverage the complementary strengths of both sectors.
A forward-looking approach
Ultimately, the paper argues against complacency, while at the same time recognising the progress that has been made. “The sheer unpredictability of financial crises, as well as their myriad potential causes and effects, warrant continued vigilance and caution above anything else,” it says.
According to DTCC, given the considerable changes in the financial ecosystem and the world at large in the last ten years, which have given rise to new and ever-changing threats, the best defense is to take a forward-looking approach that anticipates and mitigates threats that haven’t yet materialised.
The full report can be downloaded here.