New Directions for Understanding Systemic Risk

A Report on a Conference Cosponsored by the Federal Reserve Bank of New York and the National Academy of Sciences

John Kambhu, Scott Weidman, and Neel Krishnan, Rapporteurs

NATIONAL RESEARCH COUNCIL OF THE NATIONAL ACADEMIES

THE NATIONAL ACADEMIES PRESS

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John Kambhu, Scott Weidman, and Neel Krishnan, Rapporteurs

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THE NATIONAL ACADEMIES PRESS 500 Fifth Street, N.W. Washington, DC 20001 NOTICE: The project that is the subject of this report was approved by the Gov- erning Board of the National Research Council, whose members are drawn from the councils of the National Academy of Sciences, the National Academy of Engi- neering, and the Institute of Medicine. This study was supported by a contract between the National Academy of Sci- ences and the Federal Reserve Bank of New York. The views expressed in this report and during the conference “New Directions for Understanding Systemic Risk” represent the authors’ own views and do not represent the views of the Federal Reserve Bank of New York, the Federal Reserve System, or the United States government. Cover Illustration: The background image (in light blue) is adapted, by permis- sion, from Figure 3 of Christopher J. Neely, 2004, “The Federal Reserve Responds to Crises: September 11th Was Not the First,” Federal Reserve Bank of St. Louis Review 86, no. 2 (March/April): 27-42. The six curves represent daily financial data in the months surrounding the stock market crash of October 19, 1987. The top five curves show the value of the S&P 500 index, the volatility of the New York Stock Exchange as implied by options prices, the yield on 10-year U.S. government bonds, the trade-weighted value of the dollar, and the federal funds rate target against three targets (shown as white dashed lines). The bottom graph shows U.S. official foreign exchange intervention, in purchases of millions of dollars. The ver- tical line through the six graphs denotes the date of the stock market crash. International Standard Book Number-13: 978-0-309-10752-5 International Standard Book Number-10: 0-309-10752-0 Copies of this report are available from the National Academies Press, 500 Fifth Street, N.W., Lockbox 285, Washington, DC 20055; (800) 624-6242 or (202) 334-3313 (in the Washington metropolitan area); Internet, http://www.nap.edu. This report is also being republished by the Federal Reserve Bank of New York. Copyright 2007 by the National Academy of Sciences. All rights reserved. Printed in the United States of America

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The National Academy of Sciences is a private, nonprofit, self-perpetuating society of distinguished scholars engaged in scientific and engineering research, dedicated to the furtherance of science and technology and to their use for the general welfare. Upon the authority of the charter granted to it by the Congress in 1863, the Academy has a mandate that requires it to advise the federal govern- ment on scientific and technical matters. Dr. Ralph J. Cicerone is president of the National Academy of Sciences. The National Academy of Engineering was established in 1964, under the char- ter of the National Academy of Sciences, as a parallel organization of outstand- ing engineers. It is autonomous in its administration and in the selection of its members, sharing with the National Academy of Sciences the responsibility for advising the federal government. The National Academy of Engineering also sponsors engineering programs aimed at meeting national needs, encourages education and research, and recognizes the superior achievements of engineers. Dr. Charles M. Vest is president of the National Academy of Engineering. The Institute of Medicine was established in 1970 by the National Academy of Sciences to secure the services of eminent members of appropriate professions in the examination of policy matters pertaining to the health of the public. The Institute acts under the responsibility given to the National Academy of Sciences by its congressional charter to be an adviser to the federal government and, upon its own initiative, to identify issues of medical care, research, and education. Dr. Harvey V. Fineberg is president of the Institute of Medicine. The National Research Council was organized by the National Academy of Sci- ences in 1916 to associate the broad community of science and technology with the Academy’s purposes of furthering knowledge and advising the federal govern- ment. Functioning in accordance with general policies determined by the Acad- emy, the Council has become the principal operating agency of both the National Academy of Sciences and the National Academy of Engineering in providing ser- vices to the government, the public, and the scientific and engineering communi- ties. The Council is administered jointly by both Academies and the Institute of Medicine. Dr. Ralph J. Cicerone and Dr. Charles M. Vest are chair and vice chair, respectively, of the National Research Council. www.national-academies.org

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BOARD ON MATHEMATICAL SCIENCES AND THEIR APPLICATIONS C. DAVID LEVERMORE, University of Maryland, Chair MASSOUD AMIN, University of Minnesota TANYA STYBLO BEDER, SBCC MARSHA BERGER, New York University PHILIP A. BERNSTEIN, Microsoft Corporation PATRICIA FLATLEY BRENNAN, University of Wisconsin-Madison PATRICK L. BROCKETT, University of Texas at Austin DEBRA ELKINS, General Motors R&D Center LAWRENCE CRAIG EVANS, University of California at Berkeley JOHN GEWEKE, University of Iowa DARRYLL HENDRICKS, UBS Investment Bank JOHN E. HOPCROFT, Cornell University CHARLES M. LUCAS, AIG (retired) CHARLES MANSKI, Northwestern University JOYCE McLAUGHLIN, Rensselaer Polytechnic Institute JILL P. MESIROV, Massachusetts Institute of Technology ANDREW M. ODLYZKO, University of Minnesota JOHN RICE, University of California at Berkeley STEPHEN M. ROBINSON, University of Wisconsin-Madison GEORGE SUGIHARA, University of California at San Diego EDWARD WEGMAN, George Mason University LAI-SANG YOUNG, New York University Staff SCOTT WEIDMAN, Director NEAL GLASSMAN, Senior Program Officer BARBARA WRIGHT, Administrative Assistant For more information on BMSA, see its Web site at , write to BMSA, National Research Council, 500 Fifth Street, N.W., Wash- ington, DC 20001, call at (202) 334-2421, or e-mail at bmsa@nas.edu. v

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Preface Guarding against systemic risk in the financial system is a key undertak- ing for central banks. Defining this type of risk is difficult, but managing it with precision is harder still. Complicating this task is the fact that institu- tional consolidation, a broadening range of financial products, and greater connectivity among firms have in recent decades materially changed the nature of systemic risk in the financial system. To stimulate fresh thinking on systemic risk, the Federal Reserve Bank of New York and the National Research Council’s Board on Mathematical Sciences and Their Applications held a conference, “New Directions for Understanding Systemic Risk,” in May 2006. The main goal of the ses- sions was to explore parallels between systemic risk in the financial sector and in selected domains of engineering, ecology, and other fields of sci- ence. The event attracted more than 100 experts on systemic risk from 22 countries, representing banks, regulators, investment firms, U.S. national laboratories, government agencies, and universities. In addition to bring- ing together many participants with backgrounds in banking, finance, and economics, the conference broadened the discussions by including the perspectives of mathematicians, statisticians, operations researchers, ecologists, engineers, and physicists. Although the topic of systemic risk may call to mind the possibility of deliberate attacks, both cyber and terrorist, on the financial system, after careful consideration the conference organizers decided against empha- sizing this source of systemic risk. They reasoned that such a focus would downplay the many ways in which systemic risks can arise during the vii

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viii PREFACE financial system’s normal operations. Analysis of the risks of deliberate attacks might build on the concepts explored in the conference, but it would require additional considerations and tools. This report was prepared to share some of the insight and excitement generated by the conference and to encourage further cross-disciplinary conversations. It presents no National Research Council recommenda- tions. The views expressed in this report are those of the authors and do not represent the views of the Federal Reserve Bank of New York, the Federal Reserve System, or the U.S. government. We hope that you find it useful and informative. John Kambhu, Scott Weidman, and Neel Krishnan, Rapporteurs

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Acknowledgments The following people planned the conference and contributed in many ways to its success: Franklin Allen, Wharton School, University of Pennsylvania, Tanya Styblo Beder, SBCC, Christine Cumming, Federal Reserve Bank of New York, Darryll Hendricks, UBS, Donald L. Kohn, Federal Reserve Board of Governors, C. David Levermore,* University of Maryland, Simon Levin,* Princeton University, Robert H. Litzenberger, Azimuth Trust, Charles M. Lucas,* AIG Corp. (retired), Robert M. Oliver, University of California at Berkeley (retired), M. Elisabeth Paté-Cornell,* Stanford University, William Pulleyblank, IBM Corp., George Sugihara, University of California at San Diego, and Charles Taylor, Risk Management Association. Many thanks are given to the Federal Reserve Bank of New York for sponsoring the conference, underwriting the costs of this report, and sup- porting the involvement of the BMSA. *These four people were separately appointed by the NRC as a small committee to oversee the conference from the NRC perspective. ix

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x ACKNOWLEDGMENTS This report has been reviewed in draft form by individuals chosen for their diverse perspectives and technical expertise, in accordance with procedures approved by the National Research Council’s Report Review Committee. The purpose of this independent review is to provide candid and critical comments that will assist the institution in making its pub- lished report as sound as possible and to ensure that the report meets institutional standards for objectivity, evidence, and responsiveness to the study charge. The review comments and draft manuscript remain confidential to protect the integrity of the deliberative process. We wish to thank the following individuals for their review of this report: Kenneth J. Arrow, Stanford University, B. John Garrick, Independent Consultant, Nigel Goldenfeld, University of Illinois at Urbana-Champaign, Lord Robert May, University of Oxford, Christopher A. Sims, Princeton University, and Richard Zeckhauser, Harvard University. Although the reviewers listed above have provided many construc- tive comments and suggestions, they were not asked to endorse the con- clusions or recommendations nor did they see the final draft of the report before its release. The review of this report was overseen by Peter J. Bickel of the University of California at Berkeley. Appointed by the National Research Council, he was responsible for making certain that an inde- pendent examination of this report was carried out in accordance with institutional procedures and that all review comments were carefully considered. Responsibility for the final content of this report rests entirely with the rapporteurs and the institution.

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Contents 1 INTRODUCTION 1 Transitioning from a Bank-Based to a Market-Based Financial System, 2 Systemic Risk as a Generic Problem, 6 Systemic Risk in the Financial System, 8 Systemic Risk and Regulation, 9 The Roles of Policymakers, 11 Systemic Risk in Historical Perspective: The Events of 1998, 12 Analytical Issues, 16 References, 19 2 CURRENT TRENDS IN ECONOMIC RESEARCH ON 20 SYSTEMIC RISK Wealth Transfers and Portfolio Constraints, 21 Risk and Liquidity in a System Context, 22 Market Liquidity and Funding Liquidity, 23 Discussion, 25 References, 28 3 SYSTEMIC RISK IN ECOLOGY AND ENGINEERING 29 Useful Concepts from Ecology and Engineering, 30 Methodologies for Prediction and Management, 36 Risk Assessment of Extreme Events Involving National Security, 38 xi

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xii CONTENTS Prediction and Management of Systemic Failure in the Electric Grid, 43 Analogies in Economics and Finance, 47 Discussion, 49 References, 54 4 THE PAYMENTS SYSTEM AND THE MARKET FOR 55 INTERBANK FUNDS Systemic Dynamics in the Federal Funds Market, 56 Network-Based Modeling of Systemic Risk in the Interbank Payments System, 59 Discussion, 62 References, 66 5 CONCLUDING OBSERVATIONS 68 Risk Assessment, 68 Modeling, Prediction, and Management, 70 Potential Applications to Policy, 73 Reference, 76 APPENDIXES A Conference Program 79 B Background Paper 82 C About the Rapporteurs 107