Financial Resilience

ekaterina svetlovaEkaterina Svetlova

Please see our Finance Hub’s Research Call here which closes on 19 November.

Why ‘financial resilience’ rather than ‘financial stability’? We believe that resilience shows greater appreciation of the evolution of the underlying economy and the need for the financial system to respond and adapt, while at the same time being robust to shocks. Financial resilience means how well the system can absorb shocks, while continuing to evolve and fulfil its societal functions.

The OECD has recently looked at economic resilience as a valuable policy objective. A wealth of historical evidence suggests that financial resilience is a necessary condition for economic resilience to be achieved. But how is this different to a financial stability objective and how can the financial system be made more resilient? Can financial resilience go further and even enhance economic and societal resilience?

Resilience in macroeconomics and finance tends to play second fiddle to optimality and even stability. Perhaps this is because resilience is related to the concepts that many models have traditionally had difficulties in addressing: the existence of radical uncertainty, interconnectedness and diversity of actors, complexity and perhaps non-ergodicity (Figure 1). The financial system evolves to exogenous and endogenous shocks. The latter may emerge from inherent adaptation, interconnectedness and the reflexivity of financial actors and institutions. Financial structures can be a source of uncertainty and even instability to the wider economy and society.

 

Resilience and stability are not the same. After shocks, a resilient system does not necessarily return to the previous state, but evolves and can shift to a new regime. It responds and adjusts to changes in the competitive environment. This ability to evolve seems to help to avoid stagnation and over time may be even necessary for the financial system to fulfil its functions. The ability to innovate and accommodate different mind-sets and strategies might unsettle the system at times. But simultaneously, and possibly paradoxically, this can make the system more resilient. The failure of a single firm may enforce greater discipline on the others. The harmonization of financial regulation across borders could actually undermine the resilience of the global financial system.

To understand financial resilience, it might be helpful to look at the trade-offs between uncertainty and calculable risks/certainty, complexity and transparency/simplicity, instability and stability (Figure 2). Resilience can capture some important issues in finance and regulation without focusing on just one isolated aspect or at one level (micro or macro). For example, ‘Does global financial integration support or hinder the resilience?’, ‘How does competition promote financial resilience?’ or ‘What are the consequences of bank resolution for the system as a whole?’

Seeing the wood for the trees?

In our workshop, we considered methods from ecology, epidemiology, environmental science and forestry management that demonstrate the importance of modular systems and super-spreaders of diseases. There may be trade-offs between both unification and compartmentalization – or universal banking and separation of activities. Modularity helps to prevent, say, the spread of forest fires or diseases. Regulation should perhaps focus less on size and more on the super-spreaders, i.e., institutions with the highest interconnectedness. Regulation may even encourage interconnections across boundaries and thereby add to instability.

The Bank of England and Basel Committee of Banking Supervision are looking to understand and measure interconnectivity between and across financial and non-financial institutions. When faced with instabilities emerging within the financial system, the crucial task is to maintain resilience of real economy and society as a whole. To do this, we need to know more about the link between ‘finance’ and ‘macro’ – the issue that came to the fore in the aftermath of the 2008 crisis – and the nonlinear amplification and spill-over effects (represented by the red arrows in Figure 1).

A further challenge to understanding the linkages between resilience of the financial system and society is related to physical sustainability risks, e.g. climate change. The financial system and regulation could bring about desirable outcomes, e.g. contribute to the reduction of carbon risks and support investments in green assets and sustainable companies (illustrated by the green arrow in Figure 1) and enhance the economic and societal resilience. Financial system that ensures this would fit for purpose. However, the links between issues of environmental sustainability and economic and financial risks are still poorly understood.

One way forward is to combine multi-disciplinary and heterodox approaches to examine these broader societal challenges, e.g. behavioural finance and agent-based modelling. Also, in the area of environmental risks, collaboration with natural sciences looks desirable. Identifying the institutional and competitive issues to supporting sustainable and resilient finance may require consideration. We very much hope that you will send your ideas through our Call for Research posted here.

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05 November 2018

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