IT revolution increases risks in banking: IMF

In South Africa the crisis among the mid-tier banks in the early part of the decade resulted in an increasing concentration among the "big four" retail banks‚ namely Absa‚ FirstRand‚ Nedbank and Standard Bank.

The IT revolution has on the other hand allowed for the emergence of new banks such as African Bank and Capitec.

The IMF noted that over the past 10 years‚ these changes had allowed more financial intermediation to take place in markets instead of through bilateral negotiations. The more market-based system had in turn generated new or expanded forms of financial intermediation: banks deriving income from non-traditional sources and lending to and borrowing from non-traditional banks or financial institutions‚ expanded intermediation by non-traditional banks‚ and new financial products like private-label asset-backed securities and customised derivatives.

"Bank business models have traditionally been built on information obtained from repeated interactions with customers‚ or 'soft' information. Technology and transparency shifted banks towards the use of hard information (for example credit registries or standardised scoring) and 'arm's length' transactions for their traditional deposit and lending business‚ and toward more fee-based business‚" it said.

"Thus‚ transactions that were based on customer relationships lost their natural advantage‚ and banks came to face greater competition. The tilt in intermediation towards non-traditional banking has entailed rising systemic risks‚" the IMF added.

Among the risks are size and complexity, as soft information benefits smaller‚ banks‚ while hard information enables banks to become larger and more complex. Theoretically‚ large banks could benefit from economies of scale and scope. Large and complex banks are hard to resolve‚ which increases the impact of crises.

The IMF noted that when bank assets were tradable‚ banks could change risk profiles rapidly or structure their assets in a way that conceals risks from outside parties. These factors challenge the ability of market discipline‚ corporate governance‚ and supervision to reduce potential systemic risks.

As banks grow‚ in part through mergers and acquisitions‚ the banking industry could become more concentrated‚ which tends to increase profits but reduce the incentives to take risk. However‚ higher concentration could also induce banks to charge higher loan rates‚ which in turn could lead to higher risk taking by banks' borrowers‚ thus increasing systemic risk.

Concentration can also make institutions too important to fail if resolution regimes are inadequate‚ with detrimental effects on financial stability.

With a wider universe of tradable claims‚ banks become more connected with other banks and with non-traditional banks. Interconnectedness improves opportunities for diversifying risks‚ allows a wider range of transactions‚ and facilitates a more globally integrated financial system.

Yet increased interconnectedness can also lead to higher systemic risk. Interconnected systems spread small and idiosyncratic shocks but can be fragile when subjected to large‚ systemic shocks‚ particularly when banks under-estimate their likelihood.

When bank assets are tradable‚ it is easier for a bank to alter the size of its balance sheet and leverage. This exposes the bank to boom-bust financial cycles‚ which can be amplified by mark-to-market rules. The shedding of assets may trigger fire sales and credit freezes‚ with significant negative implications for macro-economic outcomes and financial stability.

Depressed asset values through fire sales pose a contagion risk in that they may lead to additional margin calls and losses for other institutions‚ including previously unaffected firms.

With more tradable assets and less traditional banking business‚ banks can accumulate large‚ skewed exposures to various risks. In a common pattern before and‚ in some cases‚ during the global crisis‚ banks used structured investments and proprietary trading to generate additional returns ("alpha") at the cost of a rise in "tail risk" - the risk of a rare but catastrophic event.

A realisation of such risk is likely to bring about long-lasting bank distress.

The providers of wholesale funding are often senior creditors to a bank who can maintain lending to prop up a troubled bank‚ but they can also rapidly cut it off if the riskiness of the bank becomes excessive or its value falls below a certain threshold.

An abrupt funding freeze may complicate a policy response‚ particularly if such an event affects multiple banks - that is‚ a systemic liquidity event. Lack of disclosure and transparency (particularly with respect to exposures taken by the bank) can undermine the market discipline that should be applied by those providing wholesale funding and by equity investors.

Market discipline can be compromised if the losses by most creditors of distressed banks are cushioned by government interventions.

Another change in the financial sector structure highlighted by the IMF has been the re-emergence of a variety of non-traditional bank intermediaries‚ including money market funds‚ major broker-dealers‚ and various off-balance-sheet vehicles sponsored by banks. Collectively‚ credit intermediation involving entities or activities by non-traditional banks (whether by maturity or liquidity transformation or leverage) has become known as the shadow banking system.

The breakdown in credit markets in 2008 revealed how this type of financial intermediation can contribute to systemic risks.

The interconnection of non-traditional banks and banks led to contagion across both sets of entities as uncertainty caused funding markets to seize up.

Reliance on very-short-term funding resulted in the private creation of money-like financial instruments that were subject to runs once market participants started seeing the instruments as risky instead of safe.

New insurance and investment products (like exchange traded products‚ customised derivatives‚ and synthetic debt obligations) have become easy to construct with greater availability of data and better information technology.

Some of these new products can be complex and opaque; therefore‚ counterparties may not understand the risks that they are assuming causing financial instability when their risks are revealed.