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Fears cyberattack could spark next financial crisis

David Brenchley  |  07 Mar 2019Text size  Decrease  Increase  |  
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As the current US economic expansion creeps towards its 10-year anniversary and, as a result, becoming the longest on record, economists and other industry commentators remain on recession watch.

But, while a recession at some point is an inevitability, other economists are focusing their time on the potential for an even bigger event: the next major adverse economic shock.

History suggests there are a few predictors of recessions, the No 1 being an inversion of the US yield curve. Generally, when the yield on a two-year US Government bond rises above that of the 10-year paper, a recession follows within the next 24 months.

Recessions can be mild, though. More likely, the next major hit to the global economy will be caused by a Black Swan event – something no-one sees coming. A decade ago, that came in the form of the subprime mortgage crisis in the US, before that it was the dotcom boom and subsequent bust.

By definition, a Black Swan event is unpredictable; that doesn’t stop commentators speculating which form the next one will take. The most recent suggestion is that it will emanate from a cyber-attack.

Technology has become so pervasive in the global economy that it regularly tops surveys of the biggest risks faced by businesses today. 

Writing in the Harvard Business Journal in September, Paul Mee and Til Schuermann, partners at consulting firm Oliver Wymans, suggested that a cyber-attack that causes disruptions to financial services capabilities, especially payments systems, around the world, is the most likely culprit for the next crisis.

Separately, Vicky Redwood, senior economic adviser at research firm Capital Economics, released a report suggesting similar in February. “Attention naturally tends to focus on the immediate risks to demand in the global economy from, for example, tighter monetary policy,” she writes.

“But another supply shock will come along to hit the global economy at some point, and technological failure is high up the list of possibilities.”

Threat of cyber crime to companies grows

Cyberattacks rank as the biggest threat facing businesses in North America today – ahead of terrorism, asset bubbles and fiscal crises – according to a 2017 survey carried out by the World Economic Forum.

Writing for the WEF, John Drzik of insurance broker Marsh LLC says the takedown of a single cloud provider could cause economic damage of between $50 billion to $120 billion.

“The annual economic cost of cybercrime is now estimated at north of $1 trillion,” he writes. That’s more than three times 2017’s record-year aggregate cost from natural disasters.

That said, even if the internet were to go down for a few days, Redwood predicts a reduction in global GDP of just 0.1 per cent and a swift rebound in the economy. If this happened regularly, firms would become less efficient and trust in technology may wane leading to less innovation, but eventually we’d muddle through.

Redwood, Mee and Schuermann agree the most likely scenario in which a cyber-attack could trigger a financial crisis would be one carried out by a rogue nation state, so-called hacktivist, or terrorist group on financial institutions or major infrastructure including energy and transport networks.

The first question is whether this is a realistic threat. Walter Price, manager of the Allianz Technology Trust (ATT), tells Morningstar.co.uk that several countries do, indeed, have the capability to disrupt banks, infrastructure, healthcare institutions and manufacturing companies.

“There is no question that the capability is there to do significant damage,” he says. “The reason this has not happened [yet] is that it might be viewed as a hostile act that provokes a military response.”

That leads us on to what kind of impact a cyber-attack might have on the global economy. The first thing to note is that it would be a supply-side shock, says Redwood.

Supply-side shock

In the pre-industrial economy, supply-side shocks – like poor harvests, wars or disease – were the source of virtually all downturns. As the global economy became more industrialised, demand-side shocks became more commonplace – often via credit contractions and falling asset prices – and the magnitude of supply-side shocks diminished.

Indeed, few of the supply-side shocks seen have had truly global ramifications. “Instead, they have tended to be quite local in their effects – for example reflecting local natural disasters, weather conditions or regional wars,” says Redwood.

As a result, it’s difficult to foresee just how much of an impact a technological shock would have on the global economy. Three examples of global supply shocks come in the form of world wars, oil price shocks in the 1970s and 80s, and weather shocks.

All three caused disruption to both global trade and global GDP, but also had an impact on the demand side, too – both positive and negative. “For example, wars have caused the destruction of capital and people, but have also led to a rise in government spending which boosted demand,” Redwood explains.

A cyberattack on all key infrastructure, as posited earlier in this piece, would have the potential to bring economies to a complete halt. “This could bring economies to a complete halt, as no-one would be able to get to work, there would be no power for factories, etc. The immediate hit to confidence would presumably be large,” she muses.

Potentially the most serious scenario Redwood outlines is a cyber-attack on a bank in the form of a large theft from a systematically important institution. That could lead to a loss of faith in the financial system and widespread bank runs.

“One lesson from the global financial crisis is that a shock can affect the financial sector’s plumbing in ways that are difficult to anticipate, and if that leads to a collapse of counterparty confidence, then problems spread quickly.”

Government debt at high levels

While policymakers would likely step in quickly to provide extra liquidity to banks and guarantee people’s bank deposits, Government debt levels are currently at “uncomfortably high levels in many cases”. As a result, the public might question whether governments had the money to back up the guarantees and still choose to pull their cash out.

Indeed, Redwood continues, should a cyber-attack happen at a time when financial assets were looking overvalued, then it is plausible it could be the root of the next financial crisis.

If the most extreme scenario came about, contingency plans that have been put in place to cope with a temporary glitch could prove inadequate. “What’s more, it if led to retaliation against the saboteur, then the incident could escalate and we could end up in a world war.” This, of course, could have major economic ramifications.

If the disruption continued for more than a few days, the economic damage could be vast. “Businesses that were already on the edge might go bankrupt. They would then fail to repay bank loans so banks would suffer losses and cut back lending. And the economy could quickly spiral downwards.”

Some Governments – the US and UK in particular – have been proactive in preparing for these eventualities, Redwood soothes. Indeed, “the greatest preparation appears to have taken place in the financial sector”. The Bank of England’s Financial Policy Committee has introduced stress tests of UK banks in the event of a cyber-attack.

Of course, this is all speculation and may never happen. Still, it pays to keep watch just in case.

is a Reporter for Morningstar.co.uk.

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