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Tuesday, 10 May 2011

Get out from the systematic dependence

 

According to the article “Bank caves in over PPI mis-selling” published in the Financial Times on the 9th of May, the customers of the Lloyds Banking Group, Barclays, HSBC and Royal Bank of Scotland massively require compensation for mis-sold loan insurance. Some analysts estimated that the compensation may reach £ 8 bn and that this mis-selling case may be the biggest in the UK. It also may imply that customer protection instruments are used in full scale and the tendency to back up financial decisions by insurance is prevailing.
 
Financial safety nets that involve liquidity support, deposit insurance, investor and policyholder protection schemes and crisis management policies are designed to maintain customers’ confidence and protect them from the financial institutions failure. However, it seems that those risk minimization measures work well only to soften temporary disturbance and illiquidity. Managers may be encouraged by insurance to take excessive risks and increased liquidity may boost inflation. Moreover, in case of the exaggerated instability the higher insurance premiums are imposed to adjust risk to the sectors’ interconnectivity and additional costs are experienced due to tighter supervision.

So, while integrity of financial institutions supports the economy development, the same interconnections may be treated as a cause of systematic risks. The inter relations, like a chain of separate elements, create domino effect. Once the significant part of the system becomes weak, it pulls dawn the other elements.

The possible solution to manage systematic risks efficiently could be the release of connections between financial institutions that facilitate a pull back from the systematic dependence. The way, when participants do not depend on the destructive circumstances, flexibly allocate assets and hedge market risks from high volatility.