Over the last few decades, the financial ecosystem has evolved into a globally interconnected web that has delivered many benefits. These benefits include efficiency gains that make it possible to provide financial services faster to an ever-wider range of users as well as the increased diversification of risks and access to international funding sources.
More specifically, cross-border finance has enabled banks and other financial institutions to spread risks internationally rather than on a local scale, providing emerging economies with a greater choice of funding opportunities than previously available.
Related: Dive into the Emerging Risks of Global Financial Interconnectedness
Similarly, the interconnected nature of today’s financial ecosystem has enabled investors to take advantage of new investment opportunities in many parts of the –world, diversifying portfolios across geographies, currencies and asset classes.
However, for all its benefits, interconnectedness also comes with risks, including increased third-party provider and cyber security risks. In response to this continually evolving threat, firms must consider how to identify, monitor and manage the risks related to interconnectedness effectively and continually. When considering how to best prepare and respond, firms should assess four areas related to interconnectedness risks – financial technology, operational exposure, non-bank financial
intermediation and cross-border impacts.
Financial technology
When considering interconnectedness risks related to financial technology, market participants should consider all fintech-related applications within their firm, encompassing a wide array of innovative technologies, business models and applications. The impact of fintech on financial interconnectedness is multi-faceted, as fintech innovations continue to change financial services and as cryptocurrencies continue to increase in their use within the global financial system. To address this risk, firms must conduct detailed analysis of any new technology implementation to ensure it delivers the same, if not better, safety and resiliency as today’s solutions.
Operational exposures
At the same time, firms around the world have demonstrated a growing reliance on third-party vendors which can increase operational exposures. It is no surprise that outsourcing has been on the rise due to its multitude of benefits that include lower costs, increased efficiency, and greater flexibility to meet changing business demands. The pandemic and extensive implementation of remote and hybrid working accelerated the demand for outsourcing, largely in IT. When added to the evolving cyber threat environment, a new channel of third-party risk transmission could be introduced that has systemic implications. As a result, firms must conduct thorough analysis of all third-party engagements and complete vendor risk assessments to ensure risks are understood and addressed.
Non-bank financial intermediation
The growing importance of non-bank financial intermediaries (NBFIs) – including insurance firms, venture capitalists and currency exchanges that are interconnected with banks through a series of direct and indirect links – has increased the potential role that this sector might play in transmitting stress throughout the financial system. Given the rapid expansion of the NBFI sector and the important role it plays, alternative banking services cannot be underestimated. Here, in Asia, NBFI are especially important in developing nations where access to credit for smaller firms may not be easily accessible. To address this area, firms should enhance the resilience of their liquidity supply in stress scenarios and take measures to enhance risk monitoring. At the same time, firms should augment their interconnectedness maps for different types of non-bank entities at various levels of granularity, including cross-border exposures, to take early action when needed.
Cross-border exposure
Cross-border exposure is the interconnectedness risk that is created by banks’ cross-border positions, providing a transmission mechanism that can propagate shocks across the global financial system. Greater cross-border interconnectedness has made countries that rely heavily on foreign capital inflows more vulnerable to systemic shocks. Against the Asian backdrop, financial shocks arising in China, Hong Kong, Singapore and South Korea could have far greater implications as these countries are closer to the centre of the cross-border financial lattice. To address this area of risk, firms should implement stress tests, where appropriate, to assess the ability of cross-border market participants to respond to a shock and to analyze common vulnerabilities and linkages across markets.
While the interconnectedness of the global markets, and firms operating within the ecosystem, offer many important benefits and opportunities, it is also important to recognize that interconnectedness can introduce risks as well. Understanding the complexity of these dynamics, including NBFI, technology, operational and cross-border impacts, requires constant vigilance. Firms must focus on identifying emerging threats and effectively address them, for the safety of individual firms, underlying investors and the broader ecosystem.
This article was originally published to The Asset on November 4, 2022.