Regulatory action since the GFC has reduced the systemic risk posed by the 'interconnectedness' of financial entities, but more remains to be done, argues incoming RBA governor Philip Lowe.
Speaking at an Asian Development Bank and UNSW Institute of Global Finance event yesterday, RBA deputy governor Philip Lowe said connections between banks, firms and countries "lie at the heart of contagion".
Such connections can turn a small disruption into "something much bigger" and are a key element of systemic risk, Mr Lowe said.
"In the global financial crisis, when one entity became distressed their counterparties incurred mark-to-market losses on the value of securities issued by that entity," he said.
"Investors also often started refusing to deal with those counterparties that had – or merely were thought to have – significant exposures to that entity."
Contagion can also have a 'reputational' effect, as investors reassess the risks in one institution or country as being similar, Mr Lowe said.
"We cannot escape the conclusion that greater interconnection is a prominent marker of increased systemic risk," he said.
The global policy response to contagion has been to create incentives against excessive interconnectedness between banks, or between banks and so-called 'shadow banks', Mr Lowe said.
"Contagion is most likely to occur when information is not equally available to all parties. Opacity and a lack of information about exposures were endemic to [over-the-counter] derivative markets during the crisis, making these markets an important locus of contagion," he said.
Following the post-GFC reforms, derivative markets have operated more effectively, Mr Lowe noted.
"Regulatory mandates and supervisory incentives are resulting in a larger share of derivatives transactions being cleared through central counterparties and more are being collateralised and are therefore safer," he said.
"Policymakers also have more visibility about financial market infrastructures now that they play a more central role in financial markets.
"There are, though, some information-sharing issues in this area that still need to be worked out," Mr Lowe said.