Robert Engle on Systemic Risk in China and around the World
Nobel laureate Robert Engle discussed systemic risk in China and throughout the globe in late 2015 during a live webcast in Shanghai hosted by CFA Institute, CFA Beijing, CFA China, IAIP, and CFA Singapore.
Engle explained how his dissatisfaction with VaR’s performance in anticipating the global financial crisis led him to develop SRISK, a longer term risk measure where the “S” stands for systemic, and went on to share his assessment of SRISK levels in key markets today.
Beginning in the early stages of the financial crisis, Engle explained, his team published daily volatility forecasts from GARCH models. And it turns out that the GARCH model was able to predict the financial crisis only the day before. “I think the lesson is that VaR, for all of its wonderfulness, is a way of forecasting risk one day in advance,” he said. “But when we forecast risk, there’s a lot of applications where we also need to know what the risks are likely to be in the long run.” Hence the motivation for SRISK.
SRISK is a way of calculating how much capital financial institutions would need to raise to continue to perform their functions normally in the event of another financial crisis. If the bank has sufficient net worth so that the deterioration of its assets doesn’t lead it into insolvency, then it can withstand the financial crisis. And that’s what SRISK seeks to measure. It uses accounting data on liabilities and market data on equities and, of course, the volatility of equity.
SRISK can be defined for a specific financial institution but is more useful when aggregated in a country. “If you are trying to raise capital in the middle of the financial crisis, the main source is going to be the government, taxpayers,” Engle explained. “If we take the bailout for one institution and the bailout for another institution and add them all up, we get a cost to bailing out the financial sector as a whole and that’s what we calculate. And if that’s a large number, we think there is a very severe danger of financial crisis.”
Assessing SRISK around the World
Engle agreed that the global SRISK situation since the 2008 financial crisis is “a mixed picture.”
The good news is that total SRISK globally has come down from about US$ 4 trillion in 2008 to $3 trillion today, largely because SRISK has been falling quite rapidly in the United States. Now it’s actually down to about the same level it was before the 2008 financial crisis. The US banks are improving their SRISK every year, although insurance companies are actually taking on more risk. Engle suspects the insurance industry may potentially compose the systemic risk of the future because it will be forced to take on more risk on the asset side if the low interest rate environment continues.
In Europe, SRISK is improving as banks are being recapitalized. Engle estimated that SRISK in Germany is down to US$150 billion, and in Italy to under US$100 billion. “But the two countries that are having a hard time, getting their banks to stabilize are France and the UK, [with SRISK for each country at] about US$300 billion,” Engle said.
Where SRISK has been steadily increasing since the global financial crisis turns out to be in China and Japan. “China had no SRISK in 2008 and it’s increased pretty much linearly since then,” Engle said. “The country with the largest SRISK in the world right now is China and Japan is the second. So these two giant Asian economies both have banking sectors that look like they are undercapitalized by our measures.”
Scrutinizing China’s SRISK
The first question one faces when studying SRISK in China is whether this type of model works there. Engle thinks it does. In the Western economies, banks that are deemed too big to fail have to be bailed out by the government in a crisis since they would be unable to raise capital in the stock market. “China is very much like the Western countries [in this regard] as there is no possibility that a Chinese state-owned bank is going to fail,” Engle said.
When Engle started tracking SRISK a few years ago, China ranked fifth on the list. It moved up into the first spot two or three years ago. The stock market euphoria since then brought temporary relief, but SRISK has again increased since the market’s collapse. “Right now, it’s just about back on the trend line for what it was before the stock market took off,” Engle said.
So why is SRISK so high in China? Engle pointed to the banks’ lending to state-owned enterprises and municipal governments. As many of these loans are in fact non-performing, they drag down bank stocks’ valuation.
Asked about the future, Engle remained cautious. “I don’t see smooth sailing for the Chinese economy. I don’t think there is so much risk in the banking system, although that’s not necessarily true of the shadow banking system. There is a chance [some wealth management products offering much higher returns] will fail over the not-too-distant future. We are [also] going to see some corporate defaults.” His advice for investors? “Treat credit risk as an important part of your investment [decision-making process].”
Engle also answered questions from both the live audience in Shanghai and members in satellite locations. For full details, check out the entire webcast. Readers can also access his work on China at the Volatility Institute at NYU Shanghai.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: Courtesy of CFA China