Modern Financial Systemic Risk: A Primer

Arnold,

I know this might be naive. But, is this an externality in financial markets by economic theory standards? If it is a negative one, then regulation makes sense, but if it isn't, are we not saying that the IDEA of financial markets has failed? What is a libertarian to believe?

Very informative, thanks Arnold.

On the first example of a bank run, I would think banks themselves could prevent this from happening by simply suspending withdrawals during a run. Customers would have to trust the bank not to abuse this ability, but at least their assets would no longer be at the whim of the fear of the masses.

Why aren't stop-loss cascades stopped by others buying up the stock as the price falls? You'd think as soon as market actors realized what was going on, they'd start buying in order to cash in on the great deals.

Mass bond insurance failures sound hard to prevent, especially in opaque markets. From what I'm reading, it almost sounds like insurers need to share information. I understand doing so would be a bit of a public good to that industry, but after this fiasco mightn't it be something buyers of financial insurance would demand? I could see how regulators could force them to, but I'd think they'd be trying to do it themselves anyways. I really don't want to play the "wall street is stupid/childish" tune the media always does, but simple cooperation is common in other industries, and unless I'm grossly mistaken, seems to be a no-brainer here?

Or maybe if there was some way to aggregate information of the industry's actions as a whole? A prediction market, maybe?

Grant says:

I would think banks themselves could prevent this from happening by simply suspending withdrawals during a run.

Indeed! Or you can ration by queuing.

But would you deposit in a bank that had a stated policy of closing its doors during a run?

Grant... another solution to bank runs would be to... oh i dunno.. force banks to be solvent so they actually have the money they claim to have?

"force banks to be solvent so they actually have the money they claim to have"

Banks already have capitalization requirements. That doesn't seem to have helped.

Bob,

But would you deposit in a bank that had a stated policy of closing its doors during a run?

Nate,

Grant... another solution to bank runs would be to... oh i dunno.. force banks to be solvent so they actually have the money they claim to have?

The contingency plan should come from capital. One good place to start would be to lower the corporate tax rate. Tax policy gives a big advantage to using debt financing, so firms lever up for the tax shield.

Tushar, the current system is only a pseudo-market. Not something I think many libertarians would choose if they could start from scratch.

Everyone takes central banks for granted now, but I'd love to see an outlandish post from Bryan talking about how free banking could really work in a modern society. :)

The bigger the fund, the fewer the transactions yielding volatile estimates. So, when the tendency is to aggregate funds, the particular fund market is incomplete in the sense of having insufficient transactions.

So, why the tendency to over aggregate if it promotes monopoly? Why is it we cannot see opportunity locally in time or geography?

You put your bet on number one and it comes up every time.
The other kids have all backed down and they put you first in line.
And so you finally ask yourself just how big you are --
and take your place in a wiser world of bigger motor cars.
And you wonder who to call on.

Jethro Tull -- Thick as a Brick

Matt C,

The part of the market that caused all this is about as pure a market as there can be....because it was so quickly developing and opaque that the regulators watched in dumb amazement. It was wild west time with all that those words mean.

Tushar,

You should know by now is that no matter what happens in the real world, the one thing you will never see is a libertarian rethinking the market. I guess they never visit Overcoming Bias...

Robb L,

I'm not sure how you can separate out a "part of the market" so narrowly. You need to look at all relevant parts. The Fed is not a free market institution. Period. Many economists attribute part of this bubble to extended low rates controlled by the Fed. Also, the government encouraged Fannie and Freddie to create demand for risky mortgages, by setting up targets for the GSEs and providing financial incentives. It was the implicit government backing that allowed Fannie and Freddie to become as dangerously leveraged as they were.

It could be the case that the financial markets need different or even more regulation, but let's not ignore the role that the government played. Let's be honest about how much government intervention there was first before choosing to restrict economic freedoms in response.

Dave,
Obviously there are regulated parts of the system. The point is that there was essentially none where the real problem started. That is independent brokers selling subprime mortgages with no "skin in the game". This was completely a creation of the market. A lot of people underwrote and sold a lot of really bad loans becaue they could and because they made a lot of money (at least for while :-) ) So while everyone is making money in what is obviously an unsustainable run up in prices, the seed of ruin geminates and evenually the fall comes

This is exactly what a market gives you...ups and downs around an equilibrium point. Unfortunately this particular market is so frickin big that the down is potentially going to destroy everything. Thus the panicking of the "experts" that run everything.

I am not sure what exactly the problem is! The bond insurers will make money during the times when the bonds don't default. In addition, their specialty in evaluating the soundness of bonds should improve the quality of bonds issued and thus reducing the risk of default. Together, this should make it possible for the bond insurer to make long term profits. In the worst case situation, the bond insurer will lose their original invested capital. Somebody got to take the risk.

RobbL, the mortgage market in the US is not a free or unregulated market. In particular, FNM and FRE hold some of the responsibility for the housing bubble. Arnold has made many posts discussing this over the last few weeks.

In my original post, however, I took Tushar to be talking about the financial system as a whole, and I was pointing out that a system with a central bank is not a free market financial system. I am no expert on free banking prior to the Fed, but from what I know, it was system with no "guarantees" and lots of minor panics, some boom and bust, but no titanic centralized catastrophes. Right now, sounds pretty good.

Your commentary is always very clear.

One thought on derivatives---If all participants in the OTC derivatives markets were "compelled" to live by the margin rules of exchanges, it would limit the amount of derivative exposure permitted system wide. Since derivatives are "cash zero-sum", if mark to market cash needs to be posted, and a counterparty fails to post, the trade can unwind before the exposure gets too large. For example, if AIG had been required to post initial margin on CDS (assume CBOE rules, for example) as well as maintenance margin they could not have gotten that big. Their own cash management would probably prohibit it---but even if it did not they would have been unwound a while ago. (Put aside issue of "what is mark to market" for a moment). We already had an interesting example of this in the energy sector 2 years ago. When the hedge fund Ameranth lost 6 billion inside the energy sector, nothing happened. When LTCM went under in 1998 with uncollateralized derivatives, the FED needed to gather the Street to prevent panic. Your example of 1987 is accurate---but I am skeptical that played a huge hand in the crash.

At the end of the day if every one wants to liquidate, the financial world comes to an end. Nothing can be done about that. But the challenge is to prevent a run for the doors based on bad processes which could have been avoided.

Your analyis on "just give the money to mortgage borrowers" really is instructive. System wide, this seems to suggest we can view the losses as simply sunk costs. I agree, assuming that is your view. This leads to a distinction between the underlying fundamental credit worthiness of borrowers on the one hand and, on the other hand, the wholesale fear and uncertainty with regard to that credit worthiness. You suggest that the Paulson Bernanke method simply "kicks the fear and uncertainty" down the road, without actually addressing it. I think we have had a disconnect between actual credit worthiness and perceived creditworthiness--the latter of course can accelerate the worsening of the former. I believe the latter is at the core of the current problem.

I write a blog called "Law of the Bad Premise" on Townhall. I attached URL. It can always be googled if URL fails. I wrote on this topic today--trying to understand what is "really" happening.

I am puzzled by your definition of systemic risk: ' The contingency plans of individuals cannot be executed collectively.' This would seem to imply that all insurance is a form of systemic risk. Is that right?

nicholas shackel - "This would seem to imply that all insurance is a form of systemic risk"

No, I think the point is each person executing their contingency increases the incentives for and the likelihood of other people to execute their contingency plan, leading to a cascade. This is generally not the case with insurance. If I claim on my household contents insurance policy there is no reason for you to be more likely to.

A bank run has some similarity to a tragedy of the commons. Just like everyone tries to grab all the fish before someone else does, leading to a collapse of the fishery, everyone tries to grab their money before other people do and the bank runs out.