United We Fall

The rise of shadow banking makes the U.S. financial sector vulnerable to contagion
United We Fall

The essentials

The U.S. financial system is no more secure today than when it crashed in 2008, says Paul Calluzzo, assistant professor of finance at Smith School of Business. A study he conducted with Gang Nathan Dong of Columbia University showed that while the risk of individual firms collapsing has gone down since 2008, the risk of all banks failing at the same time has actually gone up. This contagion risk is likely related to the rise of the shadow banking system. Financial institutions not in direct banking (such as hedge funds) are so closely tied to banks through lending agreements — yet not as heavily regulated — that they may threaten the security of the banks themselves. The Canadian financial system does not seem to be similarly exposed to contagion risk.

Paul Calluzzo likes to tell the story of the Millennium Bridge in London, England, which once had a fatal flaw. “If everyone walked in the same direction at the same time, then the bridge started to sway,” he says. “What are the odds that everyone takes a step in the same direction?”

As it turns out, quite high. As Calluzzo, an assistant professor of finance at Smith School of Business, tells it, the inevitable occurred when the suspension bridge opened in 2000; people walking on the bridge caused it to sway, triggering all other pedestrians to rebalance themselves and step in the same direction at the same time. This caused a feedback loop in which the more people tried to stop the motion, the more the bridge wobbled.

The bridge is an analogy for Calluzzo’s research on the stability of U.S. financial markets after the 2008 collapse of global financial giants Lehman Brothers and Bear Stearns. In his study, published in the Journal of Banking and Finance, he examines the security of individual firms versus the market as a whole between 2008 and 2011. He found that the U.S. market is no safer today than it was pre-crash. 

“Today the United States remains in an uncertain period of recovery and the debate about whether its financial sector has become safer after the crisis continues,” Calluzzo says. 

Using a variety of complex algorithms, Calluzzo and colleague Gang Nathan Dong of Columbia University crunch numbers gleaned from the Center for Research in Security Prices, Compustat, T-Bill and LIBOR rates from the Federal Reserve Bank of New York, and real estate market returns from the U.S. Federal Housing Finance Agency. Their findings are potentially disturbing: while the risk of individual firms collapsing has gone down since 2008, contagion risk — the risk that affects the market as a whole — poses a real threat. 

“I find it disconcerting that the risk of all banks failing at the same time has gone up,” says Calluzzo. “If and when a crisis occurs, with contagion risk and the current system in place, then you will expect to see all the banks hurting at the same time.”

If and when a crisis occurs, with contagion risk and the current system in place, then you will expect to see all the banks hurting at the same time

Part of the problem, he theorizes, is the rise of the shadow banking sector. “At the market level, the financial crisis highlights the growing importance of the shadow banking system which grew out of the securitization of assets and the integration of banking with capital market developments.” 

Calluzzo feels this sector, which includes financial institutions not in direct banking (such as hedge funds), is so closely tied to the banks through lending agreements — yet not as heavily regulated — that it may threaten the security of the banks themselves. In other words, individual banks may be protecting themselves by spreading their risks, but should the firms to whom they are connected fail, the banks and their other financial partners risk failing as well. “That might be one of the drivers in systematic risk,” Calluzzo says.

What’s the silver lining in all this?

Canada’s financial markets, which the researchers use as a control group, do not find themselves in the same situation. 

“Of all the countries in the world, we felt Canada would be the closest to the United States prior to the financial crisis,” says Calluzzo. “We see that in the U.S., the contagion risk goes up and the individual risk goes down. With Canada, we basically don’t see that same result.”

Calluzzo does not know why Canada seems immune to the contagion risk he feels threatens the U.S. markets; it could be due to a more stringent regulatory environment or a more conservative investment climate. As he points out, the smaller Canadian banking system makes it more difficult to draw cross-sectional conclusions. But he says there are clear differences in the financial markets of both countries, evidenced by the real estate collapse south of border, and the subsequent dramatic reaction of the U.S. financial markets, events that did not occur in Canada. 

“We do see much higher contagion risk [in the U.S.],” says Calluzzo. “That’s caused by something specific to America.”

Since 2008, regulations such as the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Third Basel Accord have been put in place to ensure higher levels of bank capital. But the work of policy makers may not be done. They still have to chart a path between two opposing pressures. On the one hand, Calluzzo writes, regulations need to recognize the importance of financial innovation, housing policies, and global financial imbalances in driving credit, consumption, and property prices. On the other, “there is the systemic risk that is difficult to quantify and dynamically changing over time in a world with integrated financial and goods markets.”

In the face of such pressures, calibrating effective policies will be a tall task indeed.

Anna Sharratt

Smith School of Business

Goodes Hall, Queen's University
Kingston, Ontario
Canada K7L 3N6

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