Robert Engle, and the web of geopolitical and systemic risks

Amol Agrawal

RH Patil would be smiling somewhere in his heavenly abode. His contribution to Indian financial markets was underappreciated during his lifetime, but there is some appreciation post his sad demise in 2012.

The NSE (National Stock Exchange) started the RH Patil memorial lectures in 2016 and the annual series has already seen two Economics Nobel Laureates grace the event. The 2018 lecture was given by Robert Merton (MIT, Nobel in 1997 for his work on financial derivatives) and the 2019 one was given Robert Engle (NYU, Nobel in 2003 for his work on financial volatility).

Merton spoke on designing financial products to help the ageing society. In this article, I review Engle’s lecture which is addressing an equally important challenge.

Engle touched on the subject of geopolitical risks and impact of these risks on financial markets. Geopolitical risks basically mean all the risks which arise due to political tensions between two countries/regions on all kinds of aspects: trade wars, terrorism, military and the like. These risks, which ideally should remain within the conflicted regions, spread across the world financial markets, especially if conflicts involve the United States and oil-producing regions — as is often the case.

For students of finance, geopolitical risks are hardly new. Most analysts often attribute the changes in prices of various financial assets they track to geopolitical risks. In fact, the joke is if you cannot find a reason for sudden changes in financial assets, just say geopolitical risk.

In the lecture, Engle pointed out that he and his team have developed a measure for estimating geopolitical risks named ‘GEOVOL’ which is updated regularly.

In sets of slides with fascinating graphs and tables, he adds how this GEOVOL is positively correlated across equity markets across the world. The positive values imply that that geopolitical risks impact all markets similarly. If markets were random, then we should see some markets showing negative values, but this is not the case. This again refutes the efficient markets hypothesis on which much of theory of finance is based.

In addition to GEOVOL, Engle spoke on another measure named SRISK, which stands for systemic risk. Systemic risk has become a widely popular concept, after the 2008 crisis. Financial firms may have low risks when analysed individually, but the financial system as a whole may have high risks if business models of the individual firms are similar.

The GEOVOL could be one of the reasons for rise in the SRISK as we see above that geopolitical risks impact all markets positively. On the ranking of 40 countries, markets in France are impacted the most and Pakistan the least. Indian markets are not high on the list and are third last.

Engle also showed more measures that capture geopolitical risks, saying each has a different dimension and is important. For instance, Blackrock has a geopolitical risk dashboard and is updated regularly as it is valued by its clients.

The SRISK shows how much capital banks need due to several risks over time. For instance, in the 2008 crisis, globally banks would have needed around $3.7 trillion of capital, which declined to $2.5 trillion as the crisis eased. In the European crisis, the banks would have needed $4 trillion. The levels had declined since then, but have moved upwards of $4 trillion lately. This shows risks have risen significantly due to ongoing tensions between the US and China.

Actually, if we look at the US and China separately, we see Chinese banks being more undercapitalised than the US. China tops the list in the SRISK rankings ($1.1 trillion of capital) with India at the 11th place ($100 billion). If we normalise and compute the SRISK as a ratio of total assets, Japan tops the list with 5.5 per cent followed by Korea at 5.2 per cent levels. China drops to the sixth position with a ratio of 4 per cent. In the ratio ranking, India moves higher to the ninth position (3.5 per cent).

In India, not surprisingly, the SBI contributes the most to the SRISK followed by the PNB and the Canara Bank. However, as all three are State-owned, we need not worry about their impact. Yes Bank, which is making headlines for all the wrong reasons, is eighth on the list. In terms of policy measures, bankruptcy reform is one of the ways and India has recently activated the bankruptcy law. China has also established bankruptcy court of late and it has to be seen whether the country can make progress on this front.

Overall, the lecture was useful and timely, given importance of geopolitical and systemic risks in the financial system. Academicians in economics are often attacked for not really focusing on the current economic problems. Engle clearly does not belong to the list and it’s interesting to see him address and answer questions from an audience which mainly comprised market participants.

Engle is an academic who thinks about new problems of financial markets. In a way, this lecture was a perfect tribute to Patil who also thought about similar problems affecting India’s financial markets, though he did it as a practitioner with an academic mind.

Amol Agrawal is faculty at Ahmedabad University. Views are personal.