By Raghav Madhukar
Systemic risk (SRISK) is the quantum of externality that a firm-level failure can impose on the broader financial sector. Perhaps the most impactful instance of SRISK in recent history was the 2008 collapse of Lehman Brothers, which led to severe repercussions across financial institutions and securities markets. In today’s global context, Chinese companies collectively carry approximately 30% of the world’s systemic risk, compared to US companies, which account for a mere 7%. This gargantuan concentration of SRISK in China warrants a serious investigation into its various causes and implications.
Systemic Crises and Risk:
Systemic crises emerge with low aggregate capitalization in the financial sector. When individual financial firms’ ability to provide financial services to clients is threatened due to low capital availability, other financial firms often step in to fill the gap. However, when capital availability in the aggregate financial sector is insufficient, there is really no scope for other firms to fill the gap - it is in such scenarios that systemic crises materialize. There are broadly two categories of events that trigger such aggregate capital shortage in the financial sector: (1) The economy reels from a shock, or (2) A highly interconnected firm (i.e. a firm with high SRISK) fails.
While there is a vast sea of literature on the sources, nature, and implications of economic shocks, the first serious attempt to quantify SRISK was made only as recently as in 2010, by a team of finance researchers at NYU Stern’s Volatility Lab following the publication of a seminal paper titled ‘Measuring Systemic Risk.’ It was determined that an accurate measure of SRISK could be computed as the product of (a) the expected costs to society from a systemic crisis measured per dollar of capital shortage in the aggregate financial sector, and (b) the anticipated contribution of a firm to the aggregate capital shortage. Part (a) represents the potential financial cost that society will have to incur (in dollar terms) in the instance of a crisis. Part (b) represents a firm’s contribution to the expected losses during a crisis (as a percentage). Therefore, SRISK turns out to signify a monetary value.
SRISK in China:
As of today, global systemic risk stands at $4.4 trillion, with China single-handedly accounting for $1.3 trillion. Four Chinese banks - Industrial and Commercial Bank of China (ICBC), Bank of China, China Construction Bank, and Agricultural Bank of China - have a cumulative SRISK of more than $660 billion, which constitutes more than 50% of the country’s total SRISK. Even more astounding is that the Bank of China and the Construction Bank of China together hold more SRISK than all American firms combined. These staggering figures from China can be attributed almost entirely to two factors: the size of Chinese banks and the leverage they carry.
The Size of Chinese Banks:
Chinese banks have achieved enormous growth over the past two decades. Nineteen of the 100 largest banks in the world by Net Asset Value (NAV) are based in China - four of which top the list. This transformation has been enabled by a combination of various key factors including state intervention, disproportionate corporate debt, and nascent equity and bond markets.
Since the turn of the millennium, the Chinese state has relentlessly pursued a strategy of aggressive lending to both retail and corporate consumers alike, even if at times this may have meant compromising on credit quality. However, since the Chinese government regulates monetary policy while also owning and operating banks, concerns regarding undercapitalization, under-profitability, or rising bad debt rarely arise. This is because the central bank can and will always step in, and even print currency if necessary, for the banks’ protection. Thus, China has successfully cultivated and preserved an environment of fearless lending for over two decades, which is reflected in the vast balance sheets of its banks today.
Another factor contributing to the rapid growth of Chinese banks is their disproportionate asset composition. In China, capital lent to corporations represents nearly two-thirds of total debt in the country, while the remaining third captures retail and government debt. In stark contrast to this lending pattern, the US sees a roughly equal split of debt across corporations, retail consumers, and government entities. Such disproportionately skewed lending to corporations results in a generally higher average loan size for banks, which explains some of the swift development in bank assets. In addition, this approach perfectly aligns with the Chinese government’s agenda to ensure that domestic companies predominantly secure financing from within the ‘Chinese system.’
Finally, companies in China continue to rely greatly on banks as a source of financing - far more than in developed countries like the US or UK - because equity and bond markets in the country are relatively new. For reference, the market capitalization of the US stock market is $49.1 trillion, and the size of its bond market is $39.1 trillion. On the other hand, China’s equity market is worth approximately $9 trillion and its bond market is valued at $11.9 trillion. Therefore the ability of Chinese companies to tap into the public equity and bond markets as a source of financing is limited relative to the US.
Leverage in Chinese Banks:
Leverage contributes as much to inflated SRISK values in China as bank size, if not more. The median Price / Book ratios of the four largest Chinese banks is 0.505, while that of the four largest American banks is nearly double that at 1.195. From our knowledge of the established empirical association between low P/B ratios and high leverage ratios, we can infer beyond reasonable doubt that Chinese banks are more levered compared to their American counterparts. This in turn results in higher firm SRISK values for financial institutions in China, explaining the country’s high overall cumulative measure.
Harmless SRISK?
While intuition may lead us to believe that present levels of concentration of SRISK in China ought to be a cause for grave concern, the reality happens to be quite the opposite. This is evidenced by the low beta values of Chinese stocks implying a low risk-reward relation. With the backing and safety net of the government, virtually no amount of leverage or bad debt can bankrupt any of the banks. Nobel Laureate economist, Robert Engle, affirms that while China may have rapidly rising debt levels, much of this debt is “riskless” as it is “explicitly or implicitly guaranteed” by the government. Therefore, while the scale of systemic risk may be large, the likelihood of it panning out is highly unlikely in the current context.
However, while China’s excessive credit growth may appear riskless given the low probability of a systemic failure, it is prudent to prepare for the worst (a post-crisis bailout) well in advance. There are two commonly upheld views on achieving this: (1) Creating a bad bank, and (2) Upgrading financial markets infrastructure.
The first approach, which is to institute a bad bank, essentially entails the formation of a placeholder institution that purchases nonperforming loans (delinquent loans) off the balance sheets of financial institutions. Such a cleansing exercise allows major financial institutions to continue to stay healthy, capitalized, and well functioning, and prevent a full-blown crisis from occurring at the minimal preventative cost of purchasing bad loans.
The second approach, which is to improve markets infrastructure, can be achieved in two ways. First, a country can develop more robust and structured exchanges to trade financial derivatives. Second, it can create central counterparties (CCPs) in an economy. CCPs are intermediaries in financial transactions that buy from the seller and sell to the buyer, and thereby ensure greater liquidity in the market, while also reducing default risk on the part of buyers because they are required to hold a margin account with the CCP.
Reconsiderations
While both the approaches outlined above might mitigate potential symptoms of owning high SRISK, they don’t solve for its root cause: artificial growth enabled by state-intervention. In the long term, perhaps the only viable approach to containing the ballooning SRISK in the country is to scale back on government intervention, push for privatization, resort to autonomous monetary policy, and allow new domestic private firms and foreign banks to set up shop and scale operations. These measures will help decrease the firm-level SRISK of existing banks and therefore reduce the possibility of a systemic crisis in the years to come.