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Managing the Next Financial Crisis: Market Risk Vs. Political Risk

It’s been nearly a decade since the global financial crisis swept through markets across the world. In the United States, President Donald Trump has advocated weakening the rules that were established in the wake of the crisis, while other world leaders warn against turning back. Global Network Perspectives asked experts across the world about the risk of financial instability in their countries and regions.

What are the odds of major financial market disruption in your country? 

Brazil underwent several crises over the last 20 years, which translated into volatility in currency, interest rates, and equity prices. In all of these events, the financial system has been able to endure the instability in these markets relatively well. Brazilian banks are well-capitalized compared to international standards: they have good risk management processes and little direct exposure to foreign assets, which make them less likely to transmit external shocks into the domestic economy. The Central Bank successfully used a wide array of policy instruments to manage these periods of instability and contain macro-systemic risks. 

What are the major risks right now? 

In the short run, the major risk is indeed political. The recent political events in Brazil, such as the impeachment of President Rousseff in mid-2016; the corruption scandals resulting in over 200 politicians formally investigated by federal prosecutors, as well as the recent alleged wrongdoings of incumbent president Michel Temer, increase the uncertainty on the political future of the country. It is almost impossible to predict what the aftermath of this political crisis will be.

Political risks translate into financial risks in a very unpredictable manner. If the political crisis deepens the recession and affects employment significantly, credit risk will increase. However, Brazilian banks have been reducing their exposure to credit risks along the last two years, as a response to the recession. In addition, as I mention above, Brazilian banks are well capitalized to face eventual losses.

In the longer run, bank concentration is an important risk. Bank consolidation has been occurring throughout the world, particularly after the 2007/08 financial crisis, and Brazil is not an exception. Today, the four largest Brazilian banks hold 73% of the total assets of the banking sector, as compared to 53% ten years ago. Bank concentration exacerbates the so-called Too-Big-To-Fail problem, which has extensively been demonstrated to distort competition and increase systemic risk.

Is your country better prepared to mitigate/manage such risks than it was before the 2008 crisis?

It was not until September 2008 that emerging economies started to face the consequences of the subprime crisis. Brazil was doing particularly well until the third quarter of 2008: inflation was under control; sovereign debt was rated investment grade for the first time in early 2008; and capital markets saw a wave of initial public offerings in 2007 and record foreign capital inflow. Lehman Brothers’ bankruptcy in mid-September 2008 triggered nervousness around the world. In Brazil, small and medium banks lost almost 20% of their deposits to the big banks, and research tells us that this was primarily driven by a Too-Big-To-Fail effect, i.e., depositors fled to big banks because they expected these banks to be saved in case of necessity. The major impact was on credit supply, since small and medium banks had to cut loans, and big banks did not make up for the reduction in supply by other banks. Nevertheless, the banking sector showed resilience to the external turmoil, and there were no major impacts in terms of increased systemic risk.

The Brazilian macroeconomic outlook is worse today than it was in 2007/08, particularly because of the unstable political scenario. Still, the risk of a banking crisis is considered low for the reasons explained above (good capitalization, little foreign exposure and conservative risk-taking of Brazilian banks). In addition, the lessons learned from the 2007/08 crisis indicate that the Central bank is prepared to use the correct macroprudential and liquidity management tools in the event of financial turmoil.