What is financial systemic risk? How do derivatives and leverage figure in? What should be done about it?
There is systemic financial risk when contingency plans that are developed individually are collectively incompatible.
For example, imagine that we have banks without deposit insurance. My contingency plan, in case I suspect that my bank is in trouble, is to run down to the bank and withdraw my money before they run out. My bank's contingency plan, in case it experiences an unusual rush of withdrawals, is to go to other banks that have plenty of cash on hand and borrow from them on a short-term basis.
My individual plan looks fine. My bank's plan looks fine. But if every depositor and every bank has the same plan, you can see how it could fall apart. A rumor starts at a couple of banks that they are in trouble, everybody tries to pull funds out at once, rumors spread to other banks, and pretty soon the whole system collapses. Note, for future reference, that the risks of this are reduced to the extent that banks have capital and reserves to protect against short-term losses.
As another example, consider a "stop-loss order" in the stock market. I buy 100 shares of XYZ stock, which is now trading at $50 a share. At some point, I issue an order to my broker to "stop loss" at $45 a share. That is, if the price falls to $45 a share, my broker is supposed to sell my shares before they get below $45 a share, in order to stop my loss.
Once again, as an individual plan, this is fine. But if everybody uses stop-loss orders, then at some point if the stock goes down there will be a cascade of sales, and it will be impossible for everybody to get out at once at their stop-loss price.
On October 19, 1987, this stop-loss cascade actually took place. Major pension funds and endowments bought something called "portfolio insurance" from clever trading firms. You can think of portfolio insurance as a stop-loss order on a large portfolio of stocks. On what we now call Black Monday, some declines in stock prices turned into a rout, as portfolio insurance selling programs kicked in.
Another way to execute a stop-loss order is by purchasing a put option on a stock. In the case of my XYZ shares, a put option would give me the option to sell 100 shares at a price of $45. This option is traded on an exchange, and its exercise does not depend on how many other people are trying to sell XYZ shares at the time.
Exchange-traded options tend to be more reliable than option-replication trading strategies, such as portfolio insurance. But the question remains how the party that sold you the option plans to deal with his risk. His plan may be to sell more XYZ shares as the price is falling, just as your plan would be if you were using stop-loss instead of a put option.
Now, we come to derivatives. Let's say that you hold a bond issued by a city, Anytown USA. You do not want to bear the risk that Anytown will mismanage its affairs and default on its bonds. You can go to a bond insurer, who for a fee will provide you with a guarantee of the bond. However, the bond insurer's plan may be to sell similar bonds short if it sees things go sour for Anytown. Other bond insurers may have the same plan. If things start to go sour, they all try to sell Anytown's bonds at once, and Anytown can no longer raise money in the market except at exorbitant cost. It's a classic run, caused by individual contingency plans that are collectively incompatible.
What we have had this year are runs caused by derivatives. For example, if somebody owns bonds issued by Bear, Stearns, they might buy insurance on those bonds. The firm that insures those bonds might have a plan that if things look uncertain for Bear, they will short Bear's stock in order to hedge the risk that Bear will default. The problem is that not everyone can execute this contingency plan at once. Most of the derivatives in this year's financial crisis were related in some way to mortgage securities.
The moral of the story is that derivatives allow folks to feel comfortable holding risking assets. However, the parties that are selling them that comfort have to formulate plans that only work individually or when conditions are relatively stable. When trouble develops, the sellers of derivatives have to scramble to execute trading plans to hedge losses, and those trading plans can be incompatible, leading to catastrophic declines in security values.
What should regulators do? The problems are tricky. Often, if regulators ban one type of risk management, then firms eventually find their way to a different form of risk management that poses even more systemic risk. There are those who argue that this is how our current crisis emerged. In response to capital requirements and other regulations, financial institutions loaded up on derivatives, creating the current mess.
I don't have a fool-proof solution for systemic risk. Instead, I think that regulators will have to constantly be on the watch for ways in which markets are transferring risk in ways that set up collectively incompatible individual contingency plans. Capital requirements and reserve requirements will need to be adjusted in response to financial innovation.
Market participants and regulators should ask hard questions about where risk protection is coming from. To the extent that it comes from contingent plans to undertake trading hedges, that is dangerous. To the extent that it comes from reserves and capital, that is safer.