The regulatory framework for determining SIFIs before the collapse of Lehman Brother’s has been to rank the institutions by the size of their balance sheets. In- stitutions with the largest balance sheets are deemed to be ”too big to fail”. Gup (2004) notes that this convention traces back to the collapse of Continental Illinois Bank in 1984 when regulators considered that the failure of the bank might trigger a systemic crisis. The bank suffered from several defaults in its energy loans portfo- lio and losses from other non–performing loans. As a result, Moody’s downgraded Continental Illinois Bank from its Aaa rating that led to huge and rapid withdrawal of funds form the bank. Regulators were concerned that the financial distress would spillover to the others. As a result, the bank and ten other large banks in the USA were considered too big to fail and were capitalised.
The importance of interconnections with respect to SIFIs gained further appre- ciation after Long Term Capital Management (LTCM) crisis (Dungey et al., 2006;
42In current financial architecture, there are several examples of complex networks in banking
transactions. Payment systems, interbank markets, repo markets etc. are among the common forms of complex networks. Interbank markets function as a medium of transaction for liquidity transfers between financial institutions. They are the focus of central banks’ monetary policy implementation and have a significant effect on the whole economy (Allen et al., 2009).
Jorion, 2000). LTCM has attracted overwhelming interest from investors who have underestimated its off–balance–sheet structure. When the institution’s huge off– balance–sheet assets and leverage exacerbated negative sentiment in the markets, LTCM suffered from illiquidity. LCTM proved to be insolvent after the liquidity problems and rescued by a government–led program. The issue of LTCM once again showed the uncertainty and fear in the markets cause immense illiquidity that needs government intervention. The example of LTCM has also put an emphasis on the importance of interconnections in assessing the systemic risk of SIFIs which can not be merely measured by size.
The 2008 financial crisis has been the latest example of these incidents showing that an institution with a relatively stable balance sheet but complex networks can also have significant contagion risk once its assets are hit by sudden shocks. The collapse of Lehman Brothers was triggered by the burst of the housing bubble but interconnections in SIFIs should be regarded as another fundamental cause. Interconnections is especially crucial when the shortage of liquidity rapidly spreads to other segments of financial markets and triggers cascaded failures.
Authorities in many developed countries failed to anticipate the scope of the havoc that serial defaults could cause due partly to the lack of regulations on the complexity in financial system. Limited awareness on the complexity of the finan- cial system also hindered regulators to develop necessary tools to monitor systemic risk. The complexity of the financial system made it a challenge to define adequate indicators to assess systemic risk arising from possible defaults of SIFIs. Therefore, the nature of the 2008 financial crisis made it complicated to resolve the problem easily. Authorities in developed countries in particular, has spent huge amount of resources to prevent system–wise defaults and their devastating impact on economy. Pazarbasioglu et al. (2011) state that policy responses in the aftermath of the 2008 financial crisis have been similar to those in previous crises at its initial stage, but showed significant changes over time. According to the authors, responses in the past crisis typically involved three phases:
i. practical solutions to deal with liquidity stress,
ii. resolution and restructuring of insolvent financial institutions and recapitaliz- ing the sound ones, and
iii. restoration of the financial soundness.
The recent crisis also followed the same pattern. Authorities in developed coun- tries responded quickly with liquidity supports on a more massive and widespread scale than in the past crises (see e.g. Ishi et al., 2011). They extended huge liquidi- ties with favourable terms and at longer maturities. Liquidity supports followed by asset purchases and other unconventional quantitative easening facilities. Expan- sionary monetary policies during the 2008 financial crisis were critical in supporting banks and financial markets in developed countries (Werner, 2014), although one of the root causes of the crisis was accepted to be loose monetary policy (Catte et al., 2011). Almost all central banks around the world followed the central banks in the USA and the EU in providing cheap money supply. Several central banks also co- ordinated swap facilities to supply dollar liquidity in the markets. Accommodative monetary policies supported overall asset values and thus protected further losses in balance sheets. Accommodative monetary policies were also bolstered by expan- sionary fiscal policies that would be instrumental in maintaining aggregate demand stable 43.
The supportive environment created by monetary and fiscal policies were also backed by private sector. Pazarbasioglu et al. (2011) report that the ratio of private capital injections to the announced losses for the USA, the EU, and Asian insti- tutions have been realised around 71%, 78%, and 94% respectively. The authors convey that foreign banks that dominated the markets significantly contributed to the recapitalisation process in small countries as well. Ad hoc changes to accounting
43Aghion et al. (2014) empirically show that fiscal policies have a greater effect on firms that
are relatively dependent on external finance. By supporting aggregate demand, fiscal stimulus helped reduce expected defaults on bank loans and thus reduced banks’ recapitalisation needs. Therefore, monetary and fiscal policies adopted in the 2008 financial crisis were different in its nature. In previous crises that had contagious effects, the monetary policies were not supportive. Fiscal policies were often contractionary as well.
and valuation practices also relaxed capital pressures to certain level, since the fair valuation could have induced fire sale of assets and worsen solvency and liquidity conditions. These changes, for instance, enabled to value complex structured secu- rities that were held to maturity at their historical values (Huizinga and Laeven, 2009).
As Pazarbasioglu et al. (2011) argue, the range and the sequence of policy re- sponses in the past crises show key differences. Whilst the liquidity support and government guarantees were also employed in previous crises, the extent of mea- sures has been broader to mitigate the real effect of the crisis in the 2008 financial crisis. After these extensive interventions, policy approaches became less forceful than those typically followed in the past. In particular, progress in comprehensive resolution and asset restructuring have been slower. This gradual improvement in policy responses might be the direct consequence of higher interconnections in the financial markets. Claessens et al. (2010) argue that the comparison of the 2008 financial crisis with the previous ones should consider increased financial integration and interdependence that are liable for the amplification and global spread of crisis. As Pazarbasioglu et al. (2011) convey, nonviable institutions were either shut down or viable parts of them were sold off on a definite and organised restructuring plan in previous experiences44. Such a plan could not be exercised in the aftermath
of the 2008 financial crisis, since complex networks in financial markets complicated devising thorough policy action towards troubled banks. Governments’ inability to completely address interconnections that led to contagion and spillovers has weak- ened the possibility of prompt and effective intervention. Rather, policymakers in major developed countries focused on reducing possible consequences of systemic effects of cascaded failures and therefore often opted for providing quick support to all institutions, regardless of being viable or nonviable (Claessens et al., 2010).
Although governments took control over the banks by extensive liquidity support facilities, at the same time, various stress scenarios were conducted to assess the
44Pazarbasioglu et al. (2011) provides the example of the Indonesian crisis in which the process
impact of possible failures of SIFIs. Systematic assessments of risky institutions disseminated a coordinative action toward giant financial institutions in the USA and the EU. The stress tests restored short–term investor confidence to some extent, but an ultimate compromise could not be established at full satisfaction since the impact of interconnections proved to be significant due to its breadth and complexity. The need for international dialogue was expressed frequently to combat interconnections which have significant potentiality of evolving into a global disaster. It is well noticed that a remedial action solely covering national financial systems would not bring a full–fledged solution in a global financial architecture.