Evaluating the determinants of systemic risk in the South African financial sector

Abstract

Systemic risk affects the aggregate global financial sector – banking and non-banking financial institutions – and is seen as one of the most important financial risks, yet it remains one of the least understood. The 2007/2008 global financial crisis and subsequent failure of financial institutions put the need to understand the nature and propagation of systemic risk at the centre of regulatory authorities’ attention. This crisis illustrated how systemic risk could rapidly propagate in the financial sector through common shocks, counterparty and informational contagion. The increased interconnectedness of financial institutions increases the ease with which shocks are propagated. Although large levels of systemic risk are not an inherent part of the South African financial sector, South Africa’s high degree of concentration could increase the ease with which financial difficulties spread and pose systemic problems. This possible contagion and systemic problems was efficiently mitigated by the swift intervention of the South African Reserve Bank (SARB) with the failure of African Bank in 2014. The development level, country-specific characteristics and degree of financial integration of countries should be considered when assessing their systemic risk. Considering that the structure of the banking and non-banking sector differs, it follows that the factors influencing systemic risk will also differ. As a result, the effective implementation of and subsequent adherence to regulatory measures will differ between these two sectors. Given the nature of systemic risk and that it manifests differently in different economies, a consensus with regards to a specific definition cannot be reached. In a broad context, systemic risk refers to the capital shortfall a financial institution is likely to experience conditional on a significant market decline, resulting in the undercapitalization of the aggregate financial sector. Systemic risk is proxied by the Systemic Risk Index (SRISK) and Long Run Marginal Expected Shortfall (LRMES). This study empirically investigates the relationship between systemic risk and various firm specific and country-specific variables in the South African banking and non-banking sector. A panel data approach covering the period 2003-2017 for the banking sector and 2005-2017 for the non-banking sector is employed on annual data from publicly listed South African financial institutions. Given the differing characteristics of the banking and non-banking sector, the nature of the relationship between systemic risk and the various factors also differs. Findings indicate the existence of a significant long run cointegrating relationship between a non-bank financial institution’s size and activities with systemic risk and a short run relationship between the size and profitability of the financial institution with systemic risk. Only firm-specific factors were found to have a significant effect on systemic risk in the non-banking sector. In contrast, the banking sector does not display a long run cointegrating relationship between systemic risk and any of its determinants. The banking sector’s panel regression found both firm-specific characteristics, such as the bank’s leverage as well as country-specific factors, such as capital inflows to be significant determinants of systemic risk. In light of these findings, the regulatory implications and recommendations for both these sectors differ. For the non-banking sector, a decrease in the financial institution’s size combined with an increase in their activities and profitability is likely to decrease the amount of systemic risk produced by the non-banking sector. For the banking sector, it would be of importance to reexamine the regulations relating to a bank’s leverage. Also, considering the volatile nature of capital flows and the possible swift reversals thereof, it is recommended that internal factors affecting capital flows - such as domestic interest rates and credit ratings - should be investigated in detail. Regulations addressing the activities, size and profitability of non-bank financial institutions as well as the leverage and size of banks need to be addressed. Financial institutions need to adhere to both the Basel accords as well as country-specific regulations, whilst ensuring that they have adequate capital reserves as to mitigate the effects of potential systemic crises.