Appendix B
Background Paper

SYSTEMIC RISK AND THE FINANCIAL SYSTEM

Darryll Hendricks, John Kambhu, and Patricia Mosser1

Introduction

This paper is intended as background material for a cross-disciplinary conference, sponsored by the Board on Mathematical Sciences and Their Applications of the National Academy of Sciences and the Federal Reserve Bank of New York, on new approaches to evaluating systemic risks and managing systemic events in the global financial system. A key objective of the conference is to bring together a diverse group of leading researchers who have developed analytical tools for the study of complex systems in a range of fields of inquiry.

The stability of the financial system and the potential for systemic risks to alter the functioning of that system have long been important topics for central banks and for the related research community. However, recent experiences, including the market disruption following the attacks

1

Darryll Hendricks was a senior vice president at the Federal Reserve Bank of New York when this paper was prepared in May 2006; he is now a managing director and the Global Head of Quantitative Risk Control at UBS Investment Bank; John Kambhu is a vice president and Patricia Mosser a senior vice president at the Federal Reserve Bank of New York. The views expressed are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.



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Appendix B Background Paper SySTEMIC RISk AND THE FINANCIAL SySTEM Darryll Hendricks, John Kambhu, and Patricia Mosser1 Introduction This paper is intended as background material for a cross-disciplinary conference, sponsored by the Board on Mathematical Sciences and Their Applications of the National Academy of Sciences and the Federal Reserve Bank of New York, on new approaches to evaluating systemic risks and managing systemic events in the global financial system. A key objective of the conference is to bring together a diverse group of leading research- ers who have developed analytical tools for the study of complex systems in a range of fields of inquiry. The stability of the financial system and the potential for systemic risks to alter the functioning of that system have long been important topics for central banks and for the related research community. However, recent experiences, including the market disruption following the attacks 1 DarryllHendricks was a senior vice president at the Federal Reserve Bank of New York when this paper was prepared in May 2006; he is now a managing director and the Global Head of Quantitative Risk Control at UBS Investment Bank; John Kambhu is a vice president and Patricia Mosser a senior vice president at the Federal Reserve Bank of New York. The views expressed are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. 

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 APPENDIX B of September 11, 2001, suggest that existing models of systemic shocks in the financial system may not adequately capture the propagation of major disturbances. For example, current models do not fully reflect the increas- ing complexity of the financial system’s structure, the complete range of financial and information flows, and the diverse nature of the endogenous behavior of different agents in the system. Fresh thinking about systemic risk is therefore desirable. This paper describes the broad features of the global financial system and the models with which researchers and central bankers have typically approached the issues of financial stability and systemic risk—information that can serve as a shared reference for conference participants. The confer- ence itself will provide an opportunity for participants to discuss related research in other fields and to draw out potential connections to financial system mechanisms and models, with the ultimate goal of stimulating new ways of thinking about systemic risk in the financial system. Systemic risk is a difficult concept to define precisely. A recent report by the Group of Ten (2001) on financial sector consolidation defined sys- temic risk as “the risk that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainty about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy.” This definition is broad enough to permit different views on whether certain recent epi- sodes within the financial system constituted true systemic risk or only threatened to become systemic if they had a significant adverse impact on the real economy. Some argue that even damage to the real economy is not sufficient grounds to classify an episode as systemic; rather, the key characteristic of systemic risk is the movement from one stable (positive) equilibrium to another stable (negative) equilibrium for the economy and financial sys- tem. According to this view, research on systemic risk should focus on the potential causes and propagation mechanisms for the “phase transition” to a new but much less desirable equilibrium as well as the “reinforcing feedbacks” that tend to keep the economy and financial system trapped in that equilibrium. While differences in the definition of systemic risk are clearly impor- tant from a policymaking perspective, this paper includes discussions of episodes that not everyone would agree were systemic in nature. This is because our primary interest is in stimulating further research on the types of propagation or feedback mechanisms that might cause a small financial shock to become a major disturbance, allow a financial shock to have a material impact on the real economy, or mire the financial system in a suboptimal equilibrium. In this regard, the dynamics of nonsystemic episodes may still be very relevant to the modeling of financial market

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 NEW DIRECTIONS FOR UNDERSTANDING SYSTEMIC RISK behavior. Moreover, as noted by a recent private sector report on risk management practices (Counterparty Risk Management Policy Group II [2005]), “Unfortunately, in real time it is virtually impossible to draw such distinctions.” The remainder of this paper is divided into three sections. The first describes the classical case of systemic risk in a banking-dominated finan- cial system and provides some background information on the current workings of the international banking system. The second section focuses on issues that arise in market-oriented “panics” (for example, the Octo- ber 1987 stock market crash) and again seeks to provide some relevant background information. The third section discusses the challenges in understanding the full nature of systemic risk posed by events of the last decade (for example, the Asian currency crises and 9/11 payments system disruptions) as well as key ongoing trends in the financial markets gener- ally. Significantly, this paper is meant primarily to stimulate discussion of relevant issues at the conference; it is not intended to provide a compre- hensive overview of the substantial economic literature on systemic risk and financial instability. Systemic Risk in Banking Systems Banks have long been at the center of financial activity. They remain so today, even though their share of financial intermediation has been reduced by the growth of capital markets and mutual funds and other developments of the last few decades. The largest commercial banks have balance sheets in the $1 trillion range, engage in extensive international operations, and maintain a presence in a wide variety of retail and whole- sale financial business activities. These activities include making loans to corporations and individuals; underwriting debt and equity securities offerings; acting as dealers in foreign exchange, securities, and deriva- tives markets; providing asset management services; providing payments, settlement, and custodial services; and taking deposits. The classical model of a commercial bank is a firm that makes loans on the asset side of its balance sheet and takes demand deposits (check- ing and savings accounts) on the liability side.2 The loans are typically perceived as being long-term “illiquid” assets in the sense that efforts to liquidate them prior to maturity will yield a reduced value relative to their intrinsic worth if held to maturity. However, the bank is obligated to pay back demand deposits at any time the depositor requests. Thus, banks are seen as providing a fundamental maturity and liquidity transforma- tion that is both beneficial and inherently unstable. 2 The following discussion draws heavily on Diamond and Dybvig (1983).

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 APPENDIX B This instability can be seen by considering a case in which each depositor at a particular bank would be willing to leave his or her funds on deposit, but believes that other depositors are likely to withdraw their funds, thus making it necessary for the bank to call in its loans and suffer the associated losses. In this case, all rational depositors will seek to with- draw their funds as quickly as possible, producing a “run” on the bank. In this simplified model, bank runs can be caused by concerns over liquidity even if the bank’s assets are fundamentally sound on a going-concern basis (that is, the bank is solvent). The distinction between illiquidity and insolvency is one that occurs repeatedly in discussions of systemic risk. Moreover, in this model, bank runs can be contagious. The contagion can arise simply as a result of a self-fulfilling prophecy if depositors believe that other depositors will regard a run at one bank as an indica- tion that runs are now more likely at other banks. Somewhat more con- cretely, contagion may be more likely to occur if the issue that sparked the original run—excessive loan exposure to real estate or the oil industry, for example—is perceived potentially to affect other banks, or is the result of concerns about significant interbank exposures (that is, runs at banks seen as having large exposures to the bank subject to the original run). Naturally, in this model, runs are more likely at banks perceived to have a smaller equity capital cushion to absorb declines in asset values and at banks whose financial condition is difficult to assess in the first place. Although the model just described is highly simplified, it nevertheless captures the essence of past bank runs, which occurred with some fre- quency before the 1930s. The primary approaches to dealing with the risks inherent in banking activity have included (1) controlling the relative risk of the loans extended—for example, through regulation, (2) requiring that bank balance sheets contain a larger share of equity capital and a smaller share of demand deposits, and (3) ensuring that government provides a “lender of last resort” function and/or deposit insurance. The lender of last resort role is one of the most distinctive functions of central banks. In this role, central banks such as the Federal Reserve typically have the authority to provide short-term loans to banks against collateral. For example, a bank could pledge some of its loans to the cen- tral bank and obtain cash on a short-term basis. In determining whether to provide funds, the central bank must make a judgment about the bank seeking funds. The conventional wisdom that emerged in the nineteenth century was that central banks should “lend freely at a penalty rate” when they believe that the bank needing funds is illiquid but not insolvent, but should not lend at all to a bank that is truly insolvent. Of course, there is often substantial practical difficulty in distinguishing illiquidity from insolvency.

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 NEW DIRECTIONS FOR UNDERSTANDING SYSTEMIC RISK The provision of deposit insurance in the United States followed the bank runs of the early 1930s. Deposit insurance aims to eliminate the threat of a bank run directly, by assuring depositors that they will be paid regardless of whether the bank ultimately fails. While clearly effective in discouraging bank runs, deposit insurance further reinforced the need for bank regulation to limit the extent of banks’ risk taking. Economists refer to the incentive problems created by the presence of deposit insurance as an instance of “moral hazard.” That is, bank managers will want to take on risk to increase their upside potential, but insured depositors will have no incentive to monitor or constrain their behavior. Thus, the bank runs of the Great Depression served to shape the institutional framework in which banks operate today—a framework that emphasizes official regula- tion and supervision of banks. In considering the systemic risk associated with banking crises, one should also bear in mind the social costs of such episodes. On balance, the economic literature on the Great Depression in the United States con- cludes that much of the social cost of this episode stemmed from the inter- ruption to credit allocation that occurred as a result of the bank runs and contraction of the money supply. That is, the broader, nonfinancial portion of the economy was seriously hurt by the interruption in the financing of its activities and by the reluctance of banks to extend new financing amid a series of bank runs. Concern that financial sector crises may adversely affect the functioning of many other parts of the economy is a recurrent theme in discussions of systemic risk. Although the overall importance of banks within the financial system has declined in the last few decades, the largest banks in the key finan- cial centers remain sufficiently important that their failure to function normally would raise questions of a systemic nature. Significantly, these institutions exhibit several of the characteristics discussed above. • They are highly leveraged, with equity-to-total-asset ratios ranging between 5 percent and 10 percent. • While banks are less reliant on short-term-deposit funding than the stylized model just outlined would imply, such funding remains a mate- rial part of the liability structure for the largest institutions. • The scope and complexity of their activities and legal/organiza- tional structures make assessments of their true financial condition by outsiders difficult, while also posing significant management challenges for the banks themselves. • The largest banks typically have significant exposures to one another, for example, through interbank deposit markets, interdealer transactions in over-the-counter derivatives, and wholesale payment and settlement arrangements.

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 APPENDIX B • According to some commentators, banks remain particularly prone to cyclicality and myopia in their credit processes, tending to forget the last cycle of bad lending too rapidly when economic conditions brighten. The old saying that “bad loans are made in good times” captures the essence of this concern. • Finally, the largest banks appear to be increasingly subject to legal and regulatory risks stemming from actions of their employees, risks that in some cases could result in sudden adverse impacts. Nevertheless, despite the vulnerabilities just outlined, the financial system today does not seem highly prone to contagious runs on very large banks. This reflects the relative profitability and health of banks in many countries, their risk management discipline, and the perception that the largest banks would benefit from liquidity provision or other forms of official assistance should runs appear imminent. In Japan, for example, official intervention following the emergence of significant banking sector problems in the 1990s largely forestalled major bank runs. Interestingly, however, Japan’s policies to prevent runs did not prevent economic weak- ness associated with a banking sector too fragile to play a full and vibrant role in financing broader economic activity. In the United States, policy- makers have indicated that large banks are not “too big to fail” and have worked to ensure that such banks maintain a strong financial condition and adopt rigorous risk management policies and procedures. This last point reflects a concern that inappropriate public policy choices can serve to generate systemic risk. For example, many observers note that the U.S. savings and loan crisis of the late 1980s resulted in part from policies that paid insufficient attention to “moral hazard” concerns. In addition, supervisors failed to deal with insolvent firms promptly, creating strong incentives for the management of such firms to invest in high-risk projects in an effort to restore solvency. The downside risks of these (frequently suboptimal) investments ended up being borne by society at large, both in the cost of government bailouts of depositors and in the opportunity loss of numerous investments yielding little or no return. While the liquidity-based contagious run model of systemic risk applies very directly to banks, it also has relevance to other kinds of insti- tutions. The largest securities firms rely on debt rather than bank deposits as a significant funding source and hold a greater share of their assets in the form of marketable securities than do banks. Nevertheless, some ana- lysts have argued that securities firms may be vulnerable to contagious runs because of their reliance on short-term funding sources such as com- mercial paper, the complexity of their transactions in less liquid securi- ties markets, and their derivatives businesses. As leveraged institutions,

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 NEW DIRECTIONS FOR UNDERSTANDING SYSTEMIC RISK hedge funds that do not effectively manage their liquidity risks could also be subject to runs by their investors and creditors. Indeed, liquidity risk management failures contributed to the problems experienced by the Long-Term Capital Management (LTCM) hedge fund in 1998. The case of LTCM is discussed further in this paper’s final section, as it raises other issues about the sources and propagation of systemic risk. Significantly, a run on an individual firm alone might not be enough to create systemic risk according to the definition outlined above unless the liquidation of assets by the firm or an associated reduction in the firm’s underwriting activities were to have a material impact on eco- nomic growth. For example, in 2001, Enron suffered what amounted to a run on its short-term liabilities in the period immediately preceding its bankruptcy filing, but there appeared to be very limited systemic conta- gion to other energy-trading firms and very little impact on the broader economy. Systemic Risk in Financial Asset Markets While the bank run model of systemic risk has been studied fairly widely in the financial economics literature, more recent examples of events in which concerns about systemic risk arose have often been associated with disruptions to financial markets, rather than runs on particular financial institutions. For example, the 1987 stock market crash was not precipitated by concerns at an individual institution, nor was it the proximate cause of the failure of any large bank. Nevertheless, it was clearly viewed—at the time and since—as an event with potentially systemic consequences that warranted official sector intervention. A market-oriented systemic crisis typically manifests itself as a break- down in the functioning of financial markets for traded assets such as stocks and bonds, and it may develop in response to a sharp decline in the value of one particular type of asset. In addition to the 1987 stock market crash, examples of such crises might include the widening of interest rate spreads and decline in liquidity following the collapse of LTCM in 1998 and the collapse of the junk bond market in 1989-90. In the more distant past, the Dutch tulip mania of the 1630s and similar episodes could, in their end-stage, be viewed as additional examples of this type of crisis. Consider first the characteristics of the 1987 stock market crash. Two aspects of this systemic market episode are particularly important to highlight. First, the episode suggests that asset price declines can in some circumstances become self-reinforcing and even feed into a reduced will- ingness on the part of major financial institutions to bear risk across the full range of their activities. Second, the episode underscores the potential importance of not only the specific institutional arrangements that are in

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 APPENDIX B place for clearance and settlement of transactions but also the credit and liquidity exposures arising from those arrangements. Market-Based Financial Crises, Liquidity, and Self-Reinforcing Price Movements The shift of emphasis from bank runs to “market gridlock” as a source of systemic risk has arisen from a number of factors, not least the success of policies aimed at preventing bank runs mentioned earlier. In addition, financial crises now manifest themselves in markets rather than in institu- tions because financial intermediation has moved into markets and away from institutions. This “disintermediation” in financial activity has been particularly pronounced in the United States in the last thirty years. For example, in 1975, commercial banks and thrifts held 56 percent of total credit to households and businesses; by 2005, this figure had dropped to 33 percent. A large fraction of financial assets—both equity and debt—is sold directly by issuers/borrowers to investors, especially institutional investors, via stock and bond markets, with traditional banking effec- tively bypassed. The shift from a bank-based to a market-based financial system has expanded the types of activities that banks and other financial interme- diaries engage in and the assets that they invest in. The large financial institutions at the core of the system have expanded their activities to intermediate the movement of capital among the various other partici- pants in multiple ways. They assist businesses in the issuance of new stocks and bonds directly into the market (investment banking), interme- diate to buy and sell stocks and bonds (market making) after issuance on behalf of clients (broker-dealers/trading desks), manage asset portfolios on behalf of individuals and institutions (asset management), and lend directly to households and businesses (traditional commercial banking). A general trend toward consolidation of financial activity has led to the formation of large, complex institutions at the core of the financial system. At the same time, however, disintermediation has increased the impor- tance of “end-user” financial institutions that invest in securities on behalf of households and firms. These include mostly unleveraged institutional investors (mutual funds, pension funds) as vehicles for household savings as well as more lightly regulated and more leveraged risk-bearing entities (hedge funds).3 3 Note too that any large market participant itself consists of a very large number of separate legal entities, with many different charters, incentive structures, constraints, and regulations.

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0 NEW DIRECTIONS FOR UNDERSTANDING SYSTEMIC RISK Market-based financial intermediation has a number of advantages over a banking-oriented financial system. One important advantage is that the investment risk in holding securities is dispersed broadly among investors instead of being concentrated in financial intermediaries. For example, debt instruments issued by ultimate borrowers are held directly by savers/investors to a greater degree than in a banking-oriented finan- cial system. Another feature of today’s financial system that works to reduce systemic risk is the replacement of bank deposits by mutual fund shares as an investment vehicle for households. While the fixed face value of a bank deposit is inherently fragile, the value of a mutual fund share fluctuates with market prices daily. As a result, the mutual fund model is better able to absorb and disperse shocks across a wide set of investors. 4 Although superior to a banking-oriented financial system in some respects, market-based financial intermediation carries its own vulner- abilities. The capital markets work best when key markets are liquid. In this context, the term liquidity refers to tradability. When a market is liquid, any single trade to buy or sell a particular asset is unlikely to have a major effect on the price of the asset because of the large number of will- ing transactors on both sides of the market. Market liquidity also ensures that investors can buy and sell securities without undue delay or loss in value from the price impact of the transaction. Almost by definition, then, a market-gridlock systemic crisis is a period when market liquidity is absent. In normal circumstances, market liquidity rests on a number of foun- dations. Foremost among them are market making, trading, and arbitrage. Market makers buy and sell out of inventory they maintain to meet cus- tomer demand. They smooth out short-run imbalances in market supply and demand, and profit from the bid/ask spread. Traders also contrib- ute to market liquidity by trading on bets that prices will converge to long-run fundamental levels. These traders typically take positions that they hold for potentially long periods of time until prices converge to their long-run norms. Traders play an important role in maintaining the stability of markets and speeding up the convergence of prices to their fundamental values. Market-oriented crises tend to begin with a large change—usually a decline—in the price of a particular asset; the change then becomes self-sustaining over time. When asset prices drop sharply, there are gen- erally some participants willing to “swoop in” and buy assets that have 4 Money market mutual funds raise some of the same issues as bank deposits because of their limited ability to bear credit losses; historically, parents of such funds have absorbed impaired money market instruments rather than allowed a credit loss to reduce the fund’s share value below $1.

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 APPENDIX B declined sufficiently in price—an action that largely prevents the stress from becoming worse. In systemic crises, however, investors and traders are either unable or unwilling to step in, perhaps because their own losses have limited their trading capacity or because an infrastructure failure in, say, payments or settlement systems has made such a step difficult. As prices decline, more and more market participants sell, pushing prices lower. Eventually the price declines become so large and persistent that no buyers emerge, market liquidity dries up, market participants reduce their intermediation activities and their risk taking, and market gridlock takes hold. This sequence of events is in some measure self-reinforcing: if price declines are sufficiently large to create losses for traders and market makers, these participants may cease providing liquidity to the market, thereby exacerbating the price declines. Market-based crises are often characterized by a coordination fail- ure in which a wide cross section of participants in financial markets, including market makers, simultaneously decide to reduce risk taking and effectively pull back from financing activities (trading stocks, issuing new stocks and bonds, lending, and so forth). While no one institution is necessarily insolvent or illiquid, each firm reduces its activity and risk to protect capital and profits. In aggregate, however, the firms’ actions combine to slow down or stop financial market activity. In severe cases, the financial system could become almost paralyzed and unable to per- form its core functions of channeling capital to investment opportunities. The period immediately following the 1987 stock market crash is an example of this type of coordination failure, although its consequences were contained. The potential for self-sustaining dynamics in financial price move- ments has been studied extensively in the finance and economics litera- ture. Minsky (1977) and Kindleberger (1978) have advanced theoretical explanations for many varieties of financial crisis in which an exogenous change in the economic environment leads to the creation of new profit opportunities that attract capital fed by an expansion in credit.5 For a time, these investments give rise to even more profit opportunities, leading to a speculative euphoria that, by involving segments of the population typi- cally not involved in such ventures, becomes a “mania” or a “bubble.” However, at a certain point, knowledgeable insiders begin to take profits and sell out. Prices begin to level off and some financial distress may ensue. A crisis occurs when a specific event precipitates the equivalent of a run on the asset class that was the subject of the speculative frenzy. Aversion develops toward that asset class by banks and others that had previously lent against it, and with this aversion arises a desire to obtain 5 The discussion in this paragraph draws heavily on Kindleberger (1978).

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 NEW DIRECTIONS FOR UNDERSTANDING SYSTEMIC RISK liquidity at nearly any cost. The resulting panic culminates when (1) asset prices fall so low that investors are tempted back, (2) trading is cut off, perhaps by the closing of the relevant exchange, or (3) a lender of last resort succeeds in convincing the market that sufficient liquidity will be available if necessary. Although not all economists would subscribe to this broad theory of speculative financial crises, the theory is useful to keep in mind, especially in relation to those features of the financial system that could make the system particularly vulnerable to large, self-sustaining changes in asset prices, and thus to market gridlock. In modern financial systems, debt and leverage are necessary and pervasive. Many market participants, including the largest intermedi- aries, borrow funds in order to expand their balance sheets and thus increase their ability to invest and trade in financial assets. They adopt this strategy to increase their return on equity capital invested (that is, by holding assets expected to yield returns exceeding the cost of the funds borrowed). As noted earlier, the largest banks are nearly all leveraged more than ten to one, implying that such institutions cannot afford to realize losses greater than 10 percent of the value of their assets if they are to remain solvent. The obvious implication of leverage is the need for financial institu- tions to control their losses carefully and to take steps to reduce their risk taking in the face of declining asset values. In other words, leverage creates an incentive to sell assets whose prices are declining, particularly if further price declines are expected in the future. For example, if a firm is leveraged ten to one, then even a 1 percent realized loss in asset value translates to a 10 percent loss in the firm’s capital value. Collectively, of course, widespread selling after an asset price decline will likely push prices even lower and losses higher. This scenario raises the obvious con- cern that such liquidations would further amplify the underlying price movements. Moreover, in some markets, liquidations after losses can be automatic. For example, when an investor trades stocks on margin accounts (by borrowing a percentage of the stock value), a subsequent decline in the value of the stock requires that the investor post (add) collateral—usually cash—in order to bring the margin account back into compliance with the margin rule of the stock exchange. In the 1987 stock market crash, large margin calls required investors to sell stock, thus putting further downward pressure on stock prices. The sudden and large fall in stock prices created large debits in the accounts of investors that had purchased stock on margin at brokers or held long positions in equity-linked derivatives contracts on futures exchanges. These margin account debits created a need to transfer large sums of

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 NEW DIRECTIONS FOR UNDERSTANDING SYSTEMIC RISK supply of bank reserves—the ultimate unit of account. By increasing the supply of reserves, central banks can increase the aggregate amount of liquidity in the financial system. Second, central banks function as the lender of last resort, a role that gives them the ability to lend directly to individual commercial banks. In extraordinary circumstances, the Federal Reserve System also has the power to lend directly to any individual or corporation, although this power has not been exercised since the 1930s. Third, the central bank typically possesses sufficient influence to persuade market participants that a collective decision to make liquidity available in particular circumstances will produce a better outcome than if indi- vidual market participants all seek to “free ride” on the actions of others. Largely because these tools are so effective, the central bank can often forestall liquidity pressures simply by announcing its willingness to make liquidity available should the need arise. Such announcements were made by the Federal Reserve in the wake of the 1987 crash as well as after the events of September 11, 2001. Elaborate assurances of this kind were also given in advance of the Y2K rollover. Of course, central bank actions to forestall financial crises may them- selves have a cost. In line with the moral hazard argument discussed in the section on banking-oriented crises, it is important that market partici- pants not become so complacent that they count on the central bank to defuse any potential market-oriented financial distress and thus underin- vest in their own management of market and liquidity risks. New Sources of Systemic Risk In the last ten to twenty years, financial markets have evolved signifi- cantly. They are more global and involve a wider range of more complex products than ever before. In some areas, market activities have become increasingly concentrated in a handful of very large firms. In other areas, the role of smaller, more specialized entities has grown significantly. From a policy perspective, there does not seem to be a clear consensus on whether the financial system today is more or less vulnerable to systemic disturbances than it was in, say, 1990. Moreover, several of the most significant financial market distur- bances of the last decade manifested features that, though present in earlier financial crises, have become more prominent. As the “supply chain” has evolved from the simplicity of a bank’s making and servicing a loan over its life to the complexity of securitization (involving origina- tors, holders, servicers, trustees, and hedging markets), the focus on core banks and securities firms and major markets must expand to include other potential single points of failure. In addition, the economic forces leading to consolidation have included economies of scale in risk and

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 APPENDIX B liquidity management. The liquidity needed in key market-risk-man- agement markets and in the processing of high-value dollar payments derives in substantial part from the natural offsetting of risks or payments when volumes are high. Finally, the global scale of large banks and securi- ties firms and some major investors has expanded the channels that can transmit systemic risk. These new features raise interesting questions about whether the kinds of conceptual models outlined in the preceding two sections fully capture the range of possible causes and propagation channels for sys- temic risk. The discussion below addresses two cases: (1) the events of 1997 and 1998 that involved currency crises in several Asian countries, the Russian debt default, and the collapse of the Long-Term Capital Manage- ment hedge fund, and (2) the disturbances in payment and settlement arrangements following operational disruptions resulting from the ter- rorist attacks of September 11, 2001. Asia, Russia, and LTCM This sequence of events began in the summer of 1997 as certain Asian countries faced a substantial change in market sentiment that exposed relatively fragile macroeconomic conditions. In particular, several coun- tries had short-term foreign currency debts that far exceeded their inter- national reserves. The countries were thus susceptible to a run on their currencies, with generally negative consequences from a macroeconomic point of view. While currency crises are an extremely well-studied subset of economic crises, the Asian episode was notable in several respects. First, the Asian crisis was characterized by a significant interplay between macroeconomic and financial sector factors. This interplay reflected weakness in the banking sectors of some countries that, while not the root cause of the crisis in all cases, clearly affected how the crisis played out and how well each country absorbed the macroeconomic impact of the crisis. Second, consistent with the model of bank runs outlined earlier, con- tagion figured very prominently in the Asian crisis. Indeed, the events demonstrated a new mode of contagion. Various trading and risk man- agement strategies now commonly used by market participants created linkages between different assets and activities that may not have previ- ously existed, in some cases requiring positions in one currency to be adjusted largely as a result of movements in another. In some instances, a problem triggered by a currency or maturity mismatch in one country or market would lead global investors seeking to reduce risk to identify similar vulnerabilities in other markets. A year later, contagion figured in the relationships between Russian

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 NEW DIRECTIONS FOR UNDERSTANDING SYSTEMIC RISK debt and the debt of Brazil and other emerging economies. Although the economies of Russia and Brazil are not themselves closely integrated, the prices of their debt fluctuated largely in tandem. In part, these paral- lel fluctuations reflected the fact that many of the holders of this debt specialized in holding the debt of emerging market countries, regarded these countries as proxies for each other, and needed to maintain some stability in their overall risk profile. Thus, when Russian debt began to be perceived as increasingly risky and to lose liquidity, some of these participants began to sell their Brazilian debt to reduce their risk profile and to take advantage of the Brazilian debt’s greater liquidity. Ultimately, of course, the correlation between these two assets broke down as Russia defaulted while Brazil did not. The Russian government default of August 1998 occurred against the backdrop of the Asian crisis that had been playing out over the preceding year, but otherwise took place in a period that was characterized both by the strong macroeconomic performance of the United States and by the strong financial condition of the major financial intermediaries. Never- theless, the Russian default set in motion a chain of events that created significant fear among the leadership of those same intermediaries and served to reduce liquidity across most of the world’s capital markets for some months. LTCM was a hedge fund that conducted leveraged trades involving both securities and derivatives on a large scale and used highly sophis- ticated mathematical approaches to manage its risk. The firm suffered a severe loss of capital when prices moved against its positions following the Russian default. While LTCM’s uniquely high leverage made it a fragile enterprise, it may not have been the only leveraged investor to be vulnerable, and this broader vulnerability may have played a role in amplifying the price shocks that occurred in a number of markets follow- ing the Russian default. For a year or two before the crisis, the liabilities of financial intermediaries had increased substantially relative to the liabili- ties of the nonfinancial sector, suggesting that others besides LTCM had also taken on more debt and were similarly vulnerable to price volatility and liquidity shocks. At the onset of the crisis, however, signs of an abrupt scaling back of leverage in trading activity emerged. For example, the repurchase contracts that securities dealers use to finance their own and customers’ trading positions showed a sharp and unusually sustained decline in volume. An implication of the deleveraging was that other trad- ers that might have speculated against the fall in asset prices and thereby stabilized the markets were no longer a support in the markets. As the ensuing market liquidity crisis unfolded during August and September 1998, growing risk aversion made ever larger numbers of investors seek out low-risk assets and retire to the sidelines, and credit

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 APPENDIX B spreads widened sharply beyond what had already occurred following the Russian default. To avoid a disorderly default, and the potentially adverse consequences of the further selling pressures it might have incited, a consortium of LTCM’s trading counterparties undertook a recapitaliza- tion of the hedge fund in what was essentially an informal bankruptcy procedure conducted by the creditors with the cooperation of the fund’s management. Even after the LTCM recapitalization, however, spreads in many mar- kets continued to widen as participants showed an ongoing aversion to risk. Other hedge funds in particular saw dramatic changes in the willing- ness of major intermediaries to finance their activities—a development that prompted further selling and spread widening. By mid-October, reports had grown that the situation was hindering the ability of nonfi- nancial businesses to raise capital and that risk aversion was beginning to manifest itself in payment and settlement procedures. Only after the Federal Reserve surprised markets with an intermeeting rate cut did the markets gradually return to normal. While analysts differ in their views on whether the disorderly col- lapse of LTCM would have been a systemically significant event, the episode nevertheless signals the need to think broadly about the potential sources of systemic risk. In particular, how has the growing emphasis on trading activities—which are increasingly conducted through hedge funds—affected the potential for systemic risk? Does this emphasis cre- ate mechanisms for propagation that did not exist previously? Can these mechanisms be fully captured by the classical models associated with bank runs or market gridlock, or do they introduce fundamentally new elements? Several recent trends in the financial markets bear on these questions. One trend relates to the blurring of distinctions between types of finan- cial firms. Commercial banks that have traditionally focused on making loans have increasingly removed loans from their balance sheets through securitization (pooling loans such as mortgages into securities sold to investors) or outright trading of loans and securities; at the same time, they have increased their investment banking securities underwriting and trading activities. Conversely, some of the largest investment banks and trading houses now lend directly to businesses and households. One result of this broadening of activities has been an increased volume of trading in asset types that have in the past been regarded as illiquid. Traditionally, financial assets have been separated into liquid and illiquid assets: liquid assets (such as stocks and government bonds) are priced and traded regularly after issue on exchanges or in large inter- dealer markets, while illiquid assets (such as bank loans) are held by financial institutions, particularly commercial banks, over long periods

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00 NEW DIRECTIONS FOR UNDERSTANDING SYSTEMIC RISK of time and are rarely traded or priced after origination. In recent years, however, the sharp distinction between liquid and illiquid assets has eroded, and liquidity, or tradability, has become a continuum. While some types of assets still trade very little after issuance, there is a trend toward trading asset types that have traditionally been regarded as illiquid—for example, bank loans, debt and equity of small firms, and debt of bankrupt or distressed firms. Moreover, financial institutions now securitize many previously illiq- uid assets. Securitization involves pooling together collections of illiquid assets such as mortgages, auto loans, or credit card loans and creating a relatively standardized security that pays investors the cash flows from these assets. As a result of these changes, market participants today trade and price a much wider array of risky assets—at least when markets are functioning normally. During times of financial market distress, however, the liquidity of many assets can drop sharply, and differences in liquidity across asset types can widen dramatically. Similarly, the tremendous growth in the use of financial derivatives reflects the increased tradability of financial risk. A substantial amount of current financial market activity involves the repackaging of claims on underlying assets and the redistribution of the underlying risks. This last activity has spawned enormous growth in the trading of derivatives, which are contingent claims in which payoffs are conditioned on the behavior of underlying variables such as interest rates or equity prices. The institutions at the core of the financial markets not only participate in these various activities, but also frequently serve as market-making intermediaries. Derivatives offer a number of advantages in the trading and hedging of the price risks in underlying assets. First, because they are equivalent to a leveraged trading position, derivatives contracts can often be entered into with very little capital up front. Thus, they are an ideal hedging instrument because the underlying risk can be hedged without the cost of committing a substantial amount of capital. At the same time, however, the leveraged nature of derivatives contracts makes them risky trading instruments, and traders that use these instruments to speculate can lose large sums very quickly. Second, the ability to structure and specify the particular underlying risk that a derivatives contract is exposed to enables users to unbundle a collection of risks embodied in an asset and trade the components separately. This precision also makes derivatives an ideal hedging and trading tool, since a hedger can choose which risk to hedge and which to leave uncovered. An important consequence of the widespread use of derivatives con- tracts is the parsing and dispersal of the risks embodied in underlying assets. Overall, this has provided a net benefit to the economy, because

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0 APPENDIX B risks that would have remained locked up and concentrated in under- lying assets are now spread out and allocated to those more willing to bear them. This ability to transfer unbundled risks through derivatives contracts separately from the aggregates in underlying assets enables investors to better select which risks they are exposed to, providing two important benefits: lower risk premia in asset prices because investors are no longer locked into bearing unwanted risks, and the potential for a better allocation of risks to those more able to bear them. Accompanying the growth of trading in less liquid assets and deriva- tives has been the general trend toward fair value accounting for more types of instruments and positions. Fair value, or mark-to-market, accounting imposes a discipline and transparency that can force institu- tions to take action to address emerging problems that might not occur under historical cost accounting. By contrast, historical cost accounting is more likely to allow serious problems to go undetected and unaddressed for longer periods of time. A second significant trend, alluded to earlier, is the increasing role played by a broader range of market participants—not only hedge funds but also other forms of specialized vehicles such as private equity firms and collateralized debt obligation managers. These new agents for risk bearing have the potential to alter the dynamics of how the financial sys- tem as a whole manages risk. By allowing risk to be spread more widely, they have the potential to help insulate the financial system against exter- nal shocks. In the view of some analysts, however, a greater capacity for risk bearing may lead the system to become even more inclined to cyclical behavior. The extent to which these new entrants are stabilizing or desta- bilizing depends in part on whether the extent of aggregate leverage in the financial system is greater today than in the past, since more highly leveraged institutions are more susceptible to large shocks that erode capital. Another critical question relates to the linkages between these new entrants and the traditional financial intermediaries. For example, in a financial crisis, it may not be sufficient for banks to have transferred risks to hedge funds if the ultimate source of financing and liquidity for those hedge funds remains the banks themselves. Again, the overall impact will likely depend on whether the new arrangements increase or decrease the amount of total equity capital at stake (including both bank equity and hedge fund investors’ equity) relative to the size of the risks being taken. A third trend is the strong emphasis that leveraged institutions—not only the large banking and securities intermediaries but also the major- ity of hedge funds—put on quantitative models for the pricing and risk management of their activities. Risk management practices at such orga- nizations owe a significant debt to the efforts over the past fifty years of

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0 NEW DIRECTIONS FOR UNDERSTANDING SYSTEMIC RISK many academics and practitioners to apply statistical and mathematical techniques to the problem of analyzing movements and comovements in market prices and other relevant variables. Such analysis, leavened in most cases by market experience, is used to help assess a firm’s ability to operate safely with different combinations of assets and leverage. Risk management strategies are also obviously critical in influencing how financial market participants will react to changes in market conditions. To the extent that there is commonality in risk management models and strategies, there is potential for a broad cross section of market partici- pants to react similarly to changes in asset prices. In valuing complex derivatives transactions, it is often necessary to interpolate or extrapolate the fair value of such instruments using mathe- matical models calibrated to the observed market values of other, simpler instruments. In some cases, these models are very difficult to test against an objective reality beyond the fact that other participants are using simi- lar models. It is no accident that models are most commonly used to price relatively illiquid assets; thus, during periods of financial distress, actual prices are most likely to differ substantially from modeled prices. A related issue is the degree to which the positions and strategies of the diverse participants in various markets are correlated. To the extent that many participants are pursuing very similar strategies and will behave very similarly in response to market shocks, the diversification of the sys- tem as a whole may be less than it appears during more benign periods. All of these trends—a substantial emphasis on trading, risk transfer, and derivatives; greater market involvement by hedge funds; and a heavy reliance on quantitative risk management models—were at work to some extent in the LTCM episode. While the classical models of bank runs and market gridlock were undoubtedly also relevant to LTCM, the episode highlights the need to expand these models to incorporate more fully the potential endogeneities and feedback effects generated by the trends discussed here. September 11, 2001, and the Reliance on Critical Infrastructure While the growth of hedge funds underscores how financial market activ- ities have expanded beyond the major commercial and investment banks, the financial sector events following 9/11 emphasize the reliance of the financial sector on certain core elements of infrastructure and on a rela- tively small number of organizations. Two related aspects of the post-9/11 period merit discussion in this regard. First, the terrorist attacks of that day did widespread damage to both

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0 APPENDIX B property and communications systems in Lower Manhattan.6 Because many of the largest commercial banks had operating facilities in this area (or had electronic communications routed through hubs in the area), they were unable to make payments as they normally would. Since most large banks normally both send and receive a large volume of Fedwire pay- ments every day, relying heavily on incoming payments for the liquidity to make their own payments, the normal coordination of payments broke down and liquidity shortages developed at many banks. From a systemic perspective, the Federal Reserve attaches extreme importance to keeping the Fedwire system open; otherwise, this central aspect of the financial system nationwide would not be able to function at all. Indeed, in the wake of 9/11, the Federal Reserve extended the operat- ing hours of the system to help provide more time for banks to execute their transactions. In addition, the Federal Reserve made more liquidity available, both to individual banks through its discount window opera- tions and to the system generally through open market operations. These measures, along with the willingness of the Federal Reserve to permit sizable intraday overdrafts, helped restore normal functioning to the pay- ments system. A second set of issues arose in the market for U.S. government securi- ties. The clearance and settlement of these securities (as well as a num- ber of other fixed-income securities) are concentrated in two commercial banks. These same two banks provide the primary mechanism through which the securities portfolios of the major securities firms are financed on a daily basis (the “tri-party repo market”). The financing itself is pro- vided by money market mutual funds and pension funds primarily, but the two banks provide the systems, services, and intraday credit on which this nearly $1.5 trillion market critically depends. Following the 9/11 attacks in New York City, one of these two clear- ing banks suffered very significant operational disruptions, reflecting the proximity of its primary as well as back-up operating sites to downtown Manhattan. Although these disruptions did not completely obstruct the processing of securities transactions, the processing slowed considerably. Further, the destruction of brokers’ offices obstructed the clearing and rec- onciliation of trades, and trade records were not fully reconciled for sev- eral weeks. In the meantime, the uncertainty arising from the disruptions contributed to a significant increase in the number of trades that failed to settle. This “fails” problem became so serious that the U.S. Treasury con- ducted an unprecedented reopening of the auction for the ten-year note in order to increase the supply of that security in the marketplace. 7 6 This discussion draws heavily on McAndrews and Potter (2002). 7 See Fleming and Garbade (2002).

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0 NEW DIRECTIONS FOR UNDERSTANDING SYSTEMIC RISK Although the systemic financial consequences of the events of 9/11 are probably best described as a “near miss,” they do demonstrate the global financial system’s vulnerability. Investigation of the possible outcomes of the attacks indicates that if one of the two clearing banks had not, in fact, been capable of operating for a sustained period of time, the task of replicating such functionality elsewhere would have taken considerable time, possibly as much as a year or more. In the meantime, the underly- ing securities markets that are supported by the financing activities that clear through these banks would be disrupted. In particular, the U.S. government securities market that forms the basis for the implementation of U.S. monetary policy and the financing of U.S. government activities and that is used as “riskless” collateral in countless financial transactions worldwide could be impaired. While this particular vulnerability was highlighted by the events following the 9/11 attacks, it is almost certainly not the only critical “choke point” in the global financial system today. That is, the operational disruption of other relatively modest organizations or physical facili- ties could significantly damage the functioning of the overall financial system. Indeed, the last decade has seen increased concentration in the provision of critical infrastructure services such as payments, settlement, and custody activities. Not surprisingly, the potential systemic risk associ- ated with threats to such critical infrastructure has since 9/11 spurred a significant amount of effort by both the public and the private sectors to increase the resiliency of that infrastructure. Clearly, traditional financial models of systemic risk cannot readily capture the type of systemic risk that arises from the potential for critical points of failure to lead to broader disruptions in the system. For one, the proximate cause is more operational than financial in nature. Nev- ertheless, the financial aspects cannot be ignored. As the example of the breakdown in payments flows illustrates, even if the initial disruption stems from physical damage or computer malfunction, the methods of propagation may still be financial. Thus, there is a strong need for mod- els that are more capable of capturing the complex interactions between operational infrastructure and the financial flows that the infrastructure supports. Similar models would be helpful in understanding the conse- quences of a pandemic event that made it impossible for large numbers of urban employees to work from their offices. Is the existing financial system capable of a smooth transition to a temporarily reduced level of activity? Current models cannot readily even frame such a question. Implications for Systemic Risk Three interesting themes emerge from the events discussed in this sec- tion. First, the number of relevant points of failure has increased with the

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0 APPENDIX B growing complexity of the financial system. Large financial institutions such as banks and major financial markets such as the U.S. equity market continue to be focal points in any assessment of systemic risk. But new sources of risk have arisen with the growth of risk transfer through secu- ritization and derivatives as well as the increasing use of central counter- parties and other specialist financial institutions that fill specific roles in the financial market infrastructure. One further implication is that when individual institutions have problems, the number of business relation- ships and elements of risk has expanded dramatically. Second, as the volume of transactions—payments, derivatives, and secondary-market trading—has increased, the apparently strong econo- mies of scale in risk and liquidity pooling have led to consolidation, typi- cally into a subset of the larger financial institutions. The high velocity of transactions creates substantial efficiencies that are reflected in timing and pricing. However, sharp slowdowns in transaction volume, such as those occurring in the payments system after 9/11, can reverse these efficien- cies and potentially impair the performance of the financial system when key parts of the system are under stress. Similarly, a key institution’s loss of credit standing can diminish the flow of business substantially and increase the cost of managing its derivatives or payments books. Third, in the information-rich global environment that has emerged over the last few decades, the potential for contagion has changed. That potential continues to include direct linkages among large institutions through common credit and market exposures or exposures to one another, although many policy changes and enhancements to private risk management have sought to reduce that potential. Now, however, the potential for contagion has expanded to include associations between risk dimensions created through common investors, similarities in risk profiles and risk appetites, and common exposures to macro-level risk factors such as geopolitical risk. In periods of distress, such as the Asian currency crises, the Russian debt default, or the LTCM collapse, such associations may lead to the propagation of market disturbances in hard- to-predict and probabilistic ways, and therefore make crises more difficult to anticipate and manage. questions for Discussion This background paper covers many different subjects at a relatively high level. Some key questions that conference participants might pursue are as follows: • What types of models of systemic failure or collapse have proved useful in other disciplines? How applicable are these models to the kinds of issues discussed above?

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0 NEW DIRECTIONS FOR UNDERSTANDING SYSTEMIC RISK • Which aspects of the financial system seem most important and/or challenging to capture in considering the potential for systemic risk in the financial sector? • What potential avenues for future cross-disciplinary collaboration on systemic risk issues seem most promising? References Counterparty Risk Management Policy Group II. 2005. Toward Greater Financial Stability: A Private Sector Perspective. Available at . Diamond, D. W., and P. H. Dybvig. 1983. “Bank Runs, Deposit Insurance, and Liquidity.” Journal of Political Economy 91, no. 2 (June): 401-19. Fleming, M. J., and K. D. Garbade. 2002. “When the Back Office Moved to the Front Burner: Settlement Fails in the Treasury Market After 9/11.” Federal Reserve Bank of New York Economic Policy Review 8, no. 2 (November): 35-57. Group of Ten. 2001. Consolidation in the Financial Sector. Available at . Kindleberger, C. P. 1978. Manias, Panics, and Crashes: A History of Financial Crises. New York: John Wiley & Sons. McAndrews, J. J., and S. M. Potter. 2002. “Liquidity Effects of the Events of September 11, 2001.” Federal Reserve Bank of New York Economic Policy Review 8, no. 2 (November): 59-79. Minsky, H. P. 1977. “A Theory of Systemic Fragility.” In E. I. Altman and A. W. Sametz, eds., Financial Crises: Institutions and Markets in a Fragile Environment. New York: John Wiley & Sons. _____. 1982. “The Financial-Instability Hypothesis: Capitalist Processes and the Behavior of the Economy.” In C. P. Kindleberger and J.-P. Laffargue, eds., Financial Crises: Theory, History, and Policy, 13-39. Cambridge: Cambridge University Press.