A. Introduction

1. London is one of the world’s biggest and most open financial centers. It dominates international financial market activity, and is also home and host to some of the biggest financial institutions in the world. The financial sector in the United Kingdom offers a wide range of services, in areas such as asset management (hedge funds, mutual funds and pension funds), banking (commercial, investment and private banking), insurance and reinsurance, as well as access to major capital and commodity markets.

2. The concentration of financial services and markets in one major hub clearly offers many advantages, to both market participants and the local economy. There is an abundance of skilled labor, service suppliers and infrastructure; the economies of scale offer greater efficiency and cost savings, and provide the critical mass for ongoing innovation and growth. In turn, this contributes towards improving the liquidity, breadth and depth of financial markets, and attracting an increasingly diverse group of participants. The authorities also have strong incentives to ensure sound supervision and governance practices, as well as promulgate effective and efficient regulation to ensure stability and continued growth.

3. The financial sector has been the second-fastest growth sector in the United Kingdom over the 1992–2004 period. It expanded by an average real rate of more than 5 percent per annum during this period—more than double that of the overall economy. The financial sector currently accounts for an estimated 70 billion of national output, or almost 7 percent of GDP.

4. However, London’s role as a center for global finance raises the possibility of contagion through its financial sector. Here, we define “contagion” as the transmission of idiosyncratic shocks among financial institutions. In particular, the banking sector in the United Kingdom represents a potentially important channel for contagion risk. It is the third-largest in the world by total assets, and banks have increasingly diversified their operations, both geographically and in terms of their business lines. Linkages could stem from direct equity exposures of banks in one another; direct exposures through loan books; deposit and funding sources locally and from overseas; payment and settlements systems; holdings of credit risk transfer (CRT) instruments written on assets held by local and/or overseas institutions.

5. This paper focuses on determining contagion risk among the world’s largest, systemic banks, focusing specifically on the major U.K. banks. It should be noted that the exact nature of the links between the financial institutions is not explored here. Rather, the results are intended to represent “maps” that could guide the allocation of not unlimited surveillance and supervisory resources, so that more detailed links may then be identified as necessary. They could also focus cross-border collaboration and supervision between the U.K. authorities and their overseas counterparts.

6. We essentially test three hypotheses on the global banking system. First, given the increasing internationalization of financial services, are all banks similarly affected by common shocks to the global economy or financial system? Alternatively, is “home bias” still the dominant factor, notwithstanding the effects of globalization, and are banks predominantly influenced by domestic shocks, either because of their domestic focus or the local regulatory environment? Or, are different banks—irrespective of domicile—impacted differently by shocks, due to their increasingly different business and geographic mixes?

7. We use the extreme value theory (EVT) framework to analyze contagion risk across the international banking system. The EVT approach to contagion, which has gained acceptance in recent years, better captures the information that large, extreme shocks are transmitted across financial systems differently than small shocks.² Multivariate EVT techniques are used to quantify the joint behavior of external realizations (or “co-exceedances”) of financial prices or returns across different markets.

8. In this paper, we test for the likelihood that an extreme shock affecting a major, systemic U.K. bank would also affect another large local or foreign counterpart, and vice-versa. We assume that contagion risk is associated with extreme negative co-movements in bank soundness, or distance-to-default. In other words, we try to determine if extreme, but plausible, negative shocks to a particular bank’s stability could be associated with stresses experienced by other major banks in the international banking system.

B. Method and Data

9. We employ a binomial LOGIT model to determine the likelihood that an extreme shock to one major bank would cause stress to another large counterpart. Specifically, we apply the model used in Gropp, Lo Duca and Vesala (2005) to estimate the probability that the (percentage) change in the distance-to-default (“DD”) of one bank falls in the 10^th percentile left tail of the common distribution of the △DDs across all banks (defined as “extreme values”), following large negative shocks to the DDs in another bank.³ This is determined after controlling for country-specific and global factors.

10. Our dataset includes the world’s top 24 largest exchange-listed banking groups by total assets, as at end-2005, according to Bankscope. These comprise institutions from other major banking systems such as Belgium, France, Germany, Japan, the Netherlands, Spain Switzerland, the United Kingdom and the United States. All these banking groups are represented in London, and are important participants in the financial sector there and in other major overseas financial centers.

11. Three control variables are used to account for common factors. They are: the volatility in the respective local stock market index returns; changes in the slope of the local term structure (between one- and ten-year government bonds) to represent developments in the local real economy; and volatility in the Morgan Stanley Capital International (MSCI) All-Country World index (ACWI) returns to account for global market factors. These data are all obtained from Bloomberg L.P.

12. The sample period, determined by data availability, is May 30, 2000 to August 2, 2006. However, data for six banks are only available from later dates. Thus, only 18 banks are tested for the full sample period (the “main sample”); the other banks are subsequently added to the main sample as their data become available, and the tests are rerun.

C. Results

13. Our results reveal several key trends among the major international banks. Broadly, we find that “home bias is a dominant factor in terms of contagion risk, although banks are also affected differently by idiosyncratic shocks to their major counterparts, possibly due to their different business and geographic mixes (Table 1). Individual banks are not similarly affected by common shocks to the real economy or financial markets, although the global banking system as a whole tends to be more exposed to these shocks during more turbulent periods, compared to the more benign times. Importantly, contagion risk across the major global banks has risen in recent years (Table 2).

Table 1.

Significant Coexceedances, 2000-2006

(in percent of total bank transmission channels)

Source: IMF staff calculations.

Table 1.

Significant Coexceedances, 2000-2006

(in percent of total bank transmission channels)

	Transmission to:
	U.K. banks	Other banks
Initial shock to:
U.K. banks	67	9
Other banks	4	13

Source: IMF staff calculations.

View Table

Table 1.

Significant Coexceedances, 2000-2006

(in percent of total bank transmission channels)

	Transmission to:
	U.K. banks	Other banks
Initial shock to:
U.K. banks	67	9
Other banks	4	13

Source: IMF staff calculations.

Table 2.

Change in Significant Coexceedances, 2000-03 to 2003-06

(in percentage points)

Source: IMF staff calculations.

Table 2.

Change in Significant Coexceedances, 2000-03 to 2003-06

(in percentage points)

	Transmission to:
	U.K. banks	Other banks
Initial shock to:
U.K. banks	0	9
Other banks	2	2

Source: IMF staff calculations.

View Table

Table 2.

Change in Significant Coexceedances, 2000-03 to 2003-06

(in percentage points)

	Transmission to:
	U.K. banks	Other banks
Initial shock to:
U.K. banks	0	9
Other banks	2	2

Source: IMF staff calculations.

14. At a more specific, bank-by-bank level, the results are robust across the samples consisting of 18–24 banks. A summary of the results follows:

• Contagion risk is significant among U.K. banks, with Barclays representing the consistent risk factor for its local counterparts; Barclays is also most exposed to contagion risk from foreign banks. The risk of contagion from U.K. to non-UK banks has increased over time, with HSBC representing the biggest contagion risk factor for foreign banks.

• The exposure of U.S. banks to each other appears to have intensified in recent years; the impact of U.S. banks on foreign banks has also increased. Morgan Stanley and Goldman Sachs are largely insulated from other banks; Morgan Stanley consistently represents the biggest contagion risk for other foreign banks, while Citigroup has also become more important in recent years.

• Contagion risk appears quite significant among European banks. Contagion risk from the French banks appears have increased over time, with shocks to Societe Generale having had the widest impact. In the meantime, banks such as Fortis (Belgium) and Santander (Spain) have become more exposed to shocks from elsewhere.

• Contagion risk for major Japanese banks has been limited. Japanese banks appear to pose little contagion risk to the other major international banks; Japanese banks are also largely insulated from shocks to major foreign banks.

D. Conclusion

15. London is indisputably one of the world’s most important financial hubs. The dynamism of its financial sector offers significant Error! Bookmark not defined. opportunities to financial services providers. However, the accessibility, innovation and integration that represent London’s major competitive strengths also heighten participants’ exposure to the risk of contagion through numerous channels when market events occur. Specifically, the banking sector is a potentially key conduit for contagion risk within the local financial sector and between financial systems across countries, with several U.K. banks among the largest in the world and close to 500 international banks represented in London.

16. Using an EVT framework, our findings provide some information on areas where risks may be concentrated in the international banking system. Our results highlight relationships which may require closer supervision and surveillance, and a more detailed understanding of linkages by the local authorities. Overall, the risk of contagion among local banks is highest, while inter-linkages with foreign banks appear to have increased over time. Our findings could also help country authorities focus their collaborative supervisory efforts on specific areas, given their limited resources.

17. Risk management has become very important for the banking sector. The U.K. authorities appropriately emphasize that responsibility for mitigating risks to the financial system is shared between the private sector and the public authorities (BoE, 2006). In the private sector, risk management by banks has increasingly become more professionalized, ahead of the proposed introduction of new bank capital standards under Basel II. However, the authorities have identified several areas where risk management could be improved; they are also promoting greater use of stress-testing as a key risk management tool.⁴

18. Greater emphasis is being placed on improving international cooperation in financial crisis prevention and management. The U.K. FSA, its European regulatory counterparts and the European Commission support more efficient, risk-based cross-border collaboration among supervisors. Internationally, the existing tripartite of Switzerland, the United Kingdom and the United States is considered one of the most fully-developed examples of home/host collaboration in supervision. The U.K. authorities also acknowledge that managing the impact from a failure of a major global financial institution would require significant cross-border co-ordination. For example, the U.K. authorities have signed the EU Memorandum of Understanding for crisis management, which includes performing crisis simulation exercises at the EU level. Nonetheless, the U.K. authorities acknowledge that there is a need for further work on cross-border co-ordination and information sharing between national authorities in promoting financial stability.⁵