Arnold Kling  

Modern Financial Systemic Risk: A Primer

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Morning Reading... An Open Letter to Ben Bernanke...

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.


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The author at NineCents in a related article titled Understanding the Financial Crisis of 2008 writes:
    Theres a TON of buzz going on about the financial crisis.  If the crisis had a myspace page, it would say that its “kind of a big deal,” and it would be right.  However, the problem is really complicated, and even for people who work in t... [Tracked on September 23, 2008 7:31 PM]
COMMENTS (18 to date)
Tushar Saxena writes:

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?

Grant writes:

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?

Bob Knaus writes:

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?

Nate Emmons writes:

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?

Joseph writes:

"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.

Grant writes:

Bob,

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

Well, yes! Does that make me weird?

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?

All the banks I've dealt with have claimed to be compliant with federal regulations, meaning they had at least the federal minimum (10%, IIRC) in real deposits.

scott clark writes:

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.

Matt C writes:

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. :)

Matt writes:

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?

SheetWise writes:

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

RobbL writes:

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...

Dave writes:

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.

RobbL writes:

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.

Matt C writes:

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.

Mike Rulle writes:

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.

nicholas shackel writes:

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?

Robert Scarth writes:

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.

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