Keywords: Non-traditional Shocks, Financial system, Contagion risk, Banking system,... Lastly, as was observed during the financial crisis that occurred in 2008,numerous institutions tha
INTRODUCTION
Research objectives
This study investigates the impact of non-traditional shocks, such as climate change and pandemics, on the financial stability of the U.S banking system, with implications for Vietnam's banking sector Unconventional disturbances pose significant risks to global financial systems, affecting both individual institutions and the broader economy The research aims to assess the immediate and secondary effects of these shocks on financial institutions, market confidence, and interbank lending, while evaluating the resilience of the U.S financial system It also examines the effectiveness of current regulatory frameworks and crisis management strategies in mitigating risks associated with these disturbances By analyzing the similarities and differences between the banking systems of the U.S and Vietnam, the study seeks to identify vulnerabilities in Vietnam's system and propose targeted policy recommendations Ultimately, this comparative analysis aims to highlight best practices and strategic initiatives to enhance the resilience of financial institutions in Vietnam and other emerging economies facing similar challenges.
Research scope
This study will examine the immediate and secondary effects of unconventional disturbances, such as climate change and pandemics, on the financial resilience of the U.S banking sector It will analyze the impact of these shocks on systemic risk by investigating interbank lending, cross-ownership, and the banking system's capacity to endure such challenges Additionally, the research will assess the effectiveness of existing U.S regulatory frameworks in mitigating these risks Insights gained from the U.S experience will inform an analysis of the Vietnamese banking industry, identifying risks and proposing policy recommendations The research will focus on the period from 2000 to 2023, addressing recent events like the COVID-19 pandemic and significant climate-related disasters.
Methodology
This research employs a mixed-methods approach to investigate the impact of non-traditional shocks on the U.S financial system and their implications for Vietnam By analyzing quantitative data, including financial indicators and climate change metrics, the study aims to identify trends and assess their influence on financial stability Additionally, qualitative data gathered from policy papers and expert interviews will be used to evaluate regulatory responses and the resilience of the financial system A comparative analysis of the banking sectors in the U.S and Vietnam will further enrich the findings.
Vietnam aims to identify vulnerabilities within its banking systems and propose effective policy recommendations By integrating statistical analysis with contextual insights, this strategy facilitates a comprehensive understanding of the various effects of unconventional shocks, ultimately offering practical solutions to enhance financial resilience.
Research process
Identifying data frame and periods
Literature review and empirical rcscach
Foward looking to Vietnam policies
Research structure
In addtion to the abstract, the list of acronyms, the list of tables and charts, references and appendices, the research paper is presented in 5 chapters.
LITERATURE REVIEW
Overview
Recent research has explored the relationship between non-traditional and conventional shocks that contribute to the instability of banks Numerous hypotheses and studies have emerged to clarify why banks are the most vulnerable part of the financial system This article will provide a detailed analysis of the reasons banks are the most sensitive element leading to economic crises, regardless of the nature of the shocks they face.
In recent years, the frequency and severity of financial crises have increased, leading to significant economic disruptions and prolonged recovery periods Key factors contributing to this trend include a growing reliance on complex financial instruments, escalating debt levels, and the heightened globalization of financial markets Additionally, deficiencies in the regulation and supervision of the financial sector, along with the shift from information-insensitive to information-sensitive debt, have exacerbated vulnerabilities This transition can render previously stable financial instruments difficult to price and trade, potentially triggering market collapses and financial disasters.
During financial shocks, individuals rush to withdraw their funds to protect their investments, as highlighted in the essay by Douglas D David and Robert J Reilly While deposit insurance offers coverage to all depositors, it primarily benefits those with smaller deposits, leaving larger amounts uninsured Institutional depositors, whose actions significantly impact a bank's stability, are not protected by this insurance The 2008 financial crisis revealed that many non-bank institutions also contribute to financial instability through instruments like commercial paper and money market mutual funds, which are uninsured and vulnerable to overdrafts due to their large deposit volumes.
A minor shock in one region can rapidly spread to a larger area or multiple countries due to the interconnectedness of the global financial system Each nation has its own unique financial structure, yet the transmission of shocks persists, largely because of the subjective links within the banking system For instance, the currency shock in Thailand had widespread effects across Southeast Asia Factors contributing to the crisis's spread include complex contagion, liquidity shock transmission, panic behavior, and the central bank's role in managing financial systems and crisis policies (Graciela L Kaminsky and Carmen Reinhart, 2000; Gabriele Torri and Rosella Giacometti, 2023; Peter Temin, 1993; Franklin Allen and Douglas Gale, 2000).
A conventional financial crisis occurs when a shock leads to the collapse of the financial system, making research on non-traditional shocks relatively scarce However, non-traditional shocks, which are not directly linked to the financial system, can also jeopardize a country's financial stability The 2023 study "Financial or Non-Financial Shocks: Rivals that Play Together" by Hamed Ghiaie highlights preference shocks and housing demand shocks as examples of non-traditional shocks I contend that housing demand shocks should not be classified as non-traditional, as U.S economists had predicted their occurrence before the 2007-2008 financial crisis, citing Mary Mellor's 2010 article on subprime mortgages and credit default swaps Banks, driven by optimism in rising house prices, provided low-cost loans to low-income families without rigorous verification, leading to predictable home demand shocks Furthermore, Tim Drost and Bernd Jan Sikken's 2015 article, "Non-Traditional Risk Sources and Financial System Resilience," identifies various non-traditional crises—such as social, environmental, technological, and geographical crises—that significantly impact financial systems The comparison of these non-traditional crises with traditional ones illustrates that all crises can profoundly affect a nation's financial structure, with non-traditional crises sometimes exerting an even greater influence.
Banks and financial markets will be unstable as a result of unstable policies implemented by commercial banks, central banks, and governments in the event of a shock or crisis
In times of crisis, understanding the contagion mechanisms in financial markets is crucial for preventing significant global economic disruptions This study will explore both traditional and non-traditional shocks that contribute to bank contagion, enabling the development of effective procedures for financial markets By implementing these strategies, the banking sector can better prevent and recover from shocks, ensuring sustained operations.
The stability of banks can be undermined by macroeconomic policy choices made by governments, state banks, or commercial banks In a regular banking system, banks collaborate to buy and sell financial instruments, which helps stabilize their balance sheets The interbank lending channel facilitates the flow of money, but rapid policy changes can disrupt interbank operations and impact economic activity Multinational banks pose additional risks due to their lack of transparency, contributing to systemic risks in the financial system During crises, banks face increased risks, leading to reduced trust in the interbank market and prompting them to hoard liquidity This behavior exacerbates liquidity crunches, as banks limit lending to one another The complexities of interbank relationships can act as a double-edged sword before and during financial crises.
Overlapping investment portfolios and cross-ownership among banks pose significant systemic risk management challenges in financial networks When financial institutions share similar investment portfolios, the likelihood of simultaneous losses increases due to a decline in shared asset values, creating a more integrated yet fragile financial system Cross-ownership occurs when one bank holds the subordinated obligations of another, leading to complex interdependencies that heighten contagion risk Financial distress in one bank can trigger a chain reaction of bankruptcies across the network, affecting both subordinated debt holders and direct creditors Moreover, cross-ownership between banks and enterprises can lead to dual crises; for instance, if a real estate company linked to a bank faces a downturn, it may borrow excessively without oversight, triggering a broader banking crisis Additionally, government management styles and interest rate fluctuations are crucial factors influencing bank liquidity.
Contagion in Financial Markets
Financial contagion, as defined by Bekaert, Harvey, and Ng (2005), refers to "excessive correlation," where the correlation between markets exceeds expectations based on economic fundamentals Forbes and Rigobon (2002) argue that high co-movement during stable periods does not necessarily indicate contagion if it persists post-shock A lack of consensus on the definitions of fundamentals and contagion exists among nations, complicating the understanding of financial systems As countries become more interconnected through diplomacy, culture, and trade, the financial system also expands, with banks forming international networks to support investment and trade While these systemic links can diversify risks, they may also facilitate the spread of economic shocks, potentially leading to downturns in regional or national economies.
The financial crisis initiated in Thailand in 1997, spreading to other Asian nations due to banking sector contagion, as highlighted by Jonathan E Leightner (2007) Contributing factors included speculative attacks on the Thai currency, rapid wage increases, a real estate bubble, and the collapse of financial institutions, exacerbated by International Monetary Fund interventions This crisis laid the groundwork for the global financial turmoil in the U.S during 2007-2008, which began to surface in 2005-2006 amid opaque lending practices AIG, a "too big to fail" entity, faced severe challenges as it sold bad debts to major banks without addressing its credit default swaps, prompting government bailouts to prevent systemic collapse (Paul Glasserman and H Peyton Young, 2016) However, the bankruptcy of Lehman Brothers underscored that rescuing AIG alone wouldn't avert disaster, leading to preemptive actions by creditors and investors who hoarded liquidity and withdrew funds rapidly, ultimately failing to save Lehman Brothers from its fate.
Mechanism of contagion
Asymmetric information and herd behavior are key factors driving contagion in financial markets, as highlighted by research from Lillian Cheung, Chi-sang Tam, and Jessica Szeto (2009) Informed individuals tend to influence less knowledgeable participants, leading to herd behavior where uninformed investors follow the actions of others This phenomenon is particularly evident when speculation arises about a bank's liquidity issues due to bad debts, prompting a wave of withdrawals from clients The escalating withdrawals increase the risk of the bank defaulting on its obligations Additionally, during a financial crisis, consumers and investors often experience fear, unable to distinguish the interconnectedness of markets, which compels them to withdraw funds to protect their assets These behaviors underscore the importance of understanding market dynamics and the impact of information asymmetry on investor actions.
Financial spillovers refer to the transfer of global economic fluctuations to local economies For instance, when there is a tightening of credit in the global market, investors anticipate similar effects locally due to established financial connections This situation has been exacerbated by the non-traditional global crisis stemming from the failure of Silicon Valley Bank, making domestic credit harder to access and complicating economic management Consequently, consumer confidence in China has declined, leading to increased savings and reduced spending, which has pushed the Chinese economy into a state of deflation.
Figure 3: Consumer confidence Index in China
Consumer Confidence Index in China from November 2018 to November 2023 (100 = neutral)
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