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How a special tax could protect SA from systemic risk

Understanding the nature and extent of the country’s systemic risks within its financial sector.

Is South Africa safe from systemic risk in its financial system? Systemic risk can lead to the collapse of financial markets as happened in the 2008/09 global financial crisis. In a new study Qobolwakhe Dube and Co-Pierre Georg provide new insights into the extent of risk the country’s financial system faces. The Conversation Africa’s Business and Economy Editor Sibonelo Radebe quizzed them about their findings. The Conversation

What is systemic risk?

It’s the risk of a collapse of the entire financial system – rather than the failure of individual parts. The word systemic refers to the fact that all the various players in the financial markets are interconnected and have common exposures.

Systemic risk is when the failure of one financial institution leads to severe instability or even collapse of the entire financial system. An example is the collapse of the US investment bank Lehman Brothers. Lehman was declared insolvent in 2008 following the US government’s refusal to bail it out and after it stumbled over investments in dodgy mortgages. Its collapse had a domino effect–first on banks in the US and then across the world. This led to the crash of 2008 which was followed by a global recession.

The Lehman Brothers case also highlighted the quandary that governments often face about whether or not to bail out a troubled bank to avoid the collapse of the financial system. In many instances financial institutions that are the most systemically important are likely to receive a government bailout should they default. This happened in the UK when the Royal Bank of Scotland ran into trouble just after Lehman. But this has it’s own problems as it can invoke moral hazard – when firms are incentivised to take on additional and sometimes reckless risks.

How prone is South Africa to systemic risk?

The South African financial system is exposed to significant levels of systemic risk. This is because of the way it’s structured. The factors that contribute to South Africa’s high exposure to systemic risk are: high levels of market concentration , the fact that financial institutions are all highly interconnected through complex structures and little competition. All play a significant role in maintaining the constant exposure to significant systemic risk.

A case in point was the collapse of African Bank in 2014. Although a relatively small institution, its collapse had a devastating effect on money market funds and cost South Africans roughly R10 billion.

In our research we found that three financial institutions contribute almost 50% of total systemic risk, with Standard Bank being the biggest contributor, followed by Barclays Africa and FirstRand. They are three of South Africa’s four largest banks.

What this means is that the failure of just one of these institutions would be sufficient to expose the system to the risk of contagion. This in turn would have a significant impact on the economy.

How would you measure systemic risk?

A frequently used metric is the SRISK, a measure of systemic risk used by Nobel laureate Robert Engle and his associates from the New York University’s Stern School of Business.

At the firm level, SRISK is the expected capital shortfall – the amount that it would cost to bailout the institution to maintain stability in the markets – that is associated with the collapse of the institution under stressed market conditions.

This measure is a function of the size of the firm, the extent to which debt is used to finance activity and equity losses would be expected to be incurred in the long term when the system is under distress.

Systemic risk contribution would therefore be estimated by first aggregating SRISK across all the institutions in the market to give a system wide estimation of the expected capital shortage, and then determining how much institution contributes to this.

We conclude that the concentrated distribution of systemic risk among South Africa’s financial institutions will result in huge cost to society should one of these institutions fail. It may therefore be beneficial for regulatory authorities and policy makers to consider imposing a systemic risk tax – or some other form of regulation – to prevent market activity that may lead to financial contagion and mitigate the effects in the event that a systemic institution collapses.

What is a systemic risk tax and how would it work?

A systemic risk tax would involve a special tax which would be raised to support a rescue fund to be used in the event of a crisis. The special tax we propose would be based on the so-called Pigouvian taxation scheme. This is a tax levied on firms active in the market with the intention of encouraging them to curtail undue risk taking and mitigate their contribution to negative externalities generated by market activity

Financial institutions would be taxed in proportion to how much they contribute towards the aggregated risk to the economy. This in turn would incentivise them to act in ways that would minimise their contribution to creating risk. This whole process would need to be done in a transparent way. And would need to be easily updated.

Where has it been done and to what effect?

To date no regulators or policymakers have implemented a systemic risk tax. But there has been a significant amount of discussion about it. This has led to a number of possible ideas on how the tax could be implemented.

But how relevant would a tax be if stricter regulations were put in place? Both are policy tools that can be used to curb systemic risk.

A report presented at a conference hosted by the International Monetary Fund recommends combining such a tax with stricter regulations in the form of liquidity requirements – the level of liquid assets that must be held to meet short-term obligations.

Given the structures in the South African market a similar approach may be the best way to go. A tax regime alone would be insufficient as it wouldn’t address the concerns about market concentration. Combining it with the appropriate regulatory policy would propel South Africa’s financial system in the right direction.

Tresor Kaya, a Masters graduate from the University of Cape Town, also contributed to this article.

Co-Pierre Georg, Senior Lecturer, African Institute for Financial Markets and Risk Management, University of Cape Town and Qobolwakhe Dube, PhD candidate, University of Cape Town

This article was originally published on The Conversation. Read the original article.

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This idea reminds of the guy who could not understand why he struggles to balance his budget, even after he returned R500 worth of “empties” every month.

The fact that the banking system constantly faces systemic risk, is the result of the existence of a Reserve Bank and a fractional reserve banking system. Systemic risk is baked into the cake and no tax will stop the cyclical implosion of the system. A tax may slow the process down, but it will also slow credit creation down, and act as an impediment to economic growth. You will be robbing Peter to pay Paul.

To act as a conduit between the taxpayer and the banking system for the benefit of the state, is the sole purpose of a Reserve Bank. If the solution to the problem of banking failure was as simple as the implementation of a tax, what is the purpose of the Reserve Bank then?

Surely the holding of liquid assets with the Reserve Bank is the purpose of protecting one of the banks from failing

what a splendid idea – more taxes for those unfortunate 100,000 to be earning R1.5m or more – which in world terms is an average income! this type of rubbish should stay on someone’s desk top or consigned to the rubbish bin!

Maybe if you actually read and understood what the research says you wouldn’t be having a fit. It’s not a tax on individuals but on financial institutions. In which South Africa is R1.5m an average income? It’s naive to base your argument on the premise that the rest of the developed world is an appropriate benchmark given the myriad of differences in the complexity of our economies and not to mention the socio-economic issues. Consequently I am pleased to inform you that your line of reasoning is intellectually bankrupt. Maybe these type of comments should be left in your drafts instead 🙂

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