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The world has awakened to the danger of production bottlenecks in the wake of the COVID-19 outbreak. Not only are there shortages of personal protective equipment, but governments in Japan and the West fear over-reliance on Chinese nodes in the global supply chain. Those concerns overshadow another growing danger: the prospect of systemic failure that results from deep interconnections among key economic actors.

The phrase “too big to fail” (TBTF) penetrated popular consciousness in 2008 as the collapse of financial institutions in the United States sloshed through the global financial system like a tidal wave in a bath tub.

Financial entities around the world were deeply interconnected, lending and borrowing massive quantities of money to and from each other. As a result, the failure of one threatened to bring down all the others. Entire financial systems were threatened as the contagion spread. The near implosion of the world’s financial system — it’s called the global financial crisis for a reason — prompted regulators and politicians to impose new strictures to prevent this from happening again.

Regulators considered a host of measures, from breaking up the biggest banks to heightened scrutiny and oversight. They ultimately settled on prudential measures to minimize risk-taking and reduce exposure of financial institutions. One key innovation was the Group of 20 push to create the Financial Stability Board (FSB), established in 2009 to monitor and make recommendations about global financial stability.

In June this year, the FSB published its evaluation of those regulatory measures. While critics charge that reforms have been undermined by gaping loopholes and lax enforcement, the FSB assessment concluded that TBTF reforms “contributed to the resilience of the banking sector and its ability to absorb, rather than amplify, shocks. Major banks are much better capitalized, less leveraged and more liquid than they were before the global financial crisis. Systemically important banks in advanced economies have built up significant loss-absorbing and recapitalization capacity…” There is more work to be done, but TBTF efforts appear to be working.

One of the FSB’s most important tasks is the annual publication of a list of global systemically important banks (G-SIBs; when insurers are added to the mix, the FSB refers to global systemically important financial institutions, or G-SIFIs). These are entities whose failure will impact the global financial system and wider economy. Three broad factors go into determining who belongs on the list: size (the volume of financial services provided by the individual entity), substitutability (the extent to which other components of the system can provide the same services in the event of a failure) and interconnectedness (linkages with other components of the system). The 2019 list had 30 entities — one more than 2018 — three of which were Japanese: the Mizuho Financial Group, the Sumitomo Mitsui Financial Group and the Mitsubishi UFJ Financial Group.

The ingenuity of “the wizards of finance” means that regulators are likely to be playing catch-up (if not whack-a-mole) when it comes to a real-time appreciation of the linkages that gird global finance. The all too frequent “anomalies” in markets — pick your “flash crash” — are proof.

More worrisome, however, is a new study that concludes that systemic risk is not just a problem for financial institutions. In “Systemic Risk in the Broad Economy,” released earlier this summer, a team of Rand Corp. economists argued that systemic risk — the ability of small, seemingly isolated risks to grow and spread across heavily interconnected systems — extends beyond the financial sector. Firms that pose systemic risk occupy “a diverse range of sectors whose influence has grown over the past decade, such as technology and telecommunications.” Little attention has been paid to threats that emanate from the real economy (as opposed to financial institutions) even though the historical record demands that we should.

The Rand authors point to the emergency financial support provided to the “Big Three” U.S. automakers — Chrysler, Ford and General Motors — in 2008, which was designed to head off a larger crisis. Ford and GM were hurting, but Chrysler posed a systemic risk. Since Chrysler’s suppliers also provided parts for Ford and GM (54 and 66 percent, respectively), that automaker’s collapse would have brought the other two manufacturers down with it.

Examining reports generated by the Statement of Financial Accounting Standards No. 13 — it mandates that public firms report all key customers and suppliers that account for more than 10 percent of their total sales — the Rand researchers built a dataset of networks of supplier and customer firms, filling in gaps for smaller companies with inference data. They “shocked” the largest 1,000 firms by decreasing their revenue by 1 percent and then estimating total losses to the network, one firm at a time. The results were sobering.

For the 20 firms with the highest estimated network losses, only seven are financial institutions. Amazon tops the list with potential economy-wide losses of $77 billion, Comcast (a telecommunications company) is second ($65 billion) and Walmart (a retailer) fourth ($34 billion). Aggregate size is not the only concern, however. Small companies can have a disproportionate impact if they fail.

The authors use GoDaddy, an internet domain registrar that many companies use, as an example. A 1 percent shock to GoDaddy would only cost the company $200,000 but would generate over $4 million in losses across the economy as its customers’ internet access could vanish. When the Rand researchers examined firms with the highest losses per unit of revenue — companies like GoDaddy that are small but could have an outsize impact — only two were financial institutions.

The Rand analysis builds on the path-breaking work of Austrian researchers who in 2018 identified medium-size firms (assets worth less than €1 billion) in that country that posed systemic risks. For example, they reckoned that one nonfinancial company, only ranked eighth most important on their list, would affect 39 percent of the entire Austrian economy if it defaulted. In fact, 55 percent of the systemic risk on their list came from nonfinancial companies.

Earlier this month, yet another study concluded that Facebook’s collapse — hard to imagine for sure — would “have catastrophic social and economic consequences for innumerable communities that rely on the platform on a daily basis, as well as the users whose personal data Facebook collects and stores.”

Warning signs are flashing. It is time to rethink our understanding of systemic risk in national economies. National security planners have taken steps in this direction by devoting attention to critical infrastructure, but research suggests we are not going as far nor moving fast enough. More attention must be paid to telecommunications companies, like Amazon, which provide an increasingly diverse array of services that are increasingly important to a modern society. Amazon Web Services, its cloud computing service, has become a cornerstone of the digital economy. Other sectors, from energy production to insurance, are also potential sources of systemic risk.

One assignment for the new national economic statecraft division of Japan’s National Security Secretariat is getting a better grip on these risks. Japan like other modern economies needs a keener appreciation of the connections among economic actors and, with that understanding, it should then build greater resilience into its economy. Amidst a 27.8 percent annualized contraction of GDP in the April-June period, it is tempting to think that the economy couldn’t be harder hurt; that would be wrong.

Brad Glosserman is deputy director of and visiting professor at the Center for Rule Making Strategies at Tama University as well as senior adviser (nonresident) at Pacific Forum. He is the author of “Peak Japan: The End of Great Ambitions.”

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