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- Herausgeber: John Wiley & Sons
- Kategorie: Wissenschaft und neue Technologien
- Serie: Wiley Finance Editions
- Sprache: Englisch
An accessible and detailed overview of the risks posed by financial institutions Understanding Systemic Risk in Global Financial Markets offers an accessible yet detailed overview of the risks to financial stability posed by financial institutions designated as systemically important. The types of firms covered are primarily systemically important banks, non-banks, and financial market utilities such as central counterparties. Written by Aron Gottesman and Michael Leibrock, experts on the topic of systemic risk, this vital resource puts the spotlight on coherency, practitioner relevance, conceptual explanations, and practical exposition. Step by step, the authors explore the specific regulations enacted before and after the credit crisis of 2007-2009 to promote financial stability. The text also examines the criteria used by financial regulators to designate firms as systemically important. The quantitative and qualitative methods to measure the ongoing risks posed by systemically important financial institutions are surveyed. * A review of the regulations that identify systemically important financial institutions * The tools to use to detect early warning indications of default * A review of historical systemic events their common causes * Techniques to measure interconnectedness * Approaches for ranking the order the institutions which pose the greatest degree of default risk to the industry Understanding Systemic Risk in Global Financial Markets offers a must-have guide to the fundamentals of systemic risk and the key critical policies that work to reduce systemic risk and promoting financial stability.
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Veröffentlichungsjahr: 2017
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Table of Contents
Cover
Title Page
Preface
Acknowledgments
About the Authors
CHAPTER 1: Introduction to Systemic Risk
WHAT IS SYSTEMIC RISK?
SYSTEMIC RISK DRIVERS
WHY SYSTEMIC RISK MUST BE UNDERSTOOD, MONITORED, AND MANAGED
KEY POINTS
KNOWLEDGE CHECK
NOTES
CHAPTER 2: How We Got Here: A History of Financial Crises
INTRODUCTION
COMMON DRIVERS OF HISTORICAL CRISES
INTERNATIONAL CONTAGION
KEY POINTS
KNOWLEDGE CHECK
NOTES
CHAPTER 3: The Credit Crisis of 2007–2009
INTRODUCTION
PLANTING THE SEEDS OF A BUBBLE: THE EARLY 2000s
WALL STREET'S ROLE
THE U.S. GOVERNMENT TAKEOVER OF THE GSEs
THE TIPPING POINT: LEHMAN BROTHERS' FAILURE
AFTERMATH OF THE CREDIT CRISIS
COST OF GOVERNMENT BAILOUTS
KEY POINTS
KNOWLEDGE CHECK
NOTES
CHAPTER 4: Systemic Risk, Economic and Behavioral Theories: What Can We Learn?
INTRODUCTION
MINSKY THREE-PART MODEL
DEBT DEFLATION CYCLE
BENIGN NEGLECT
BEHAVIORAL THEORIES
RISK AVERSION BIAS
ASSET PRICES
HOMOGENEOUS EXPECTATIONS VERSUS HETEROGENEITY
KEY POINTS
KNOWLEDGE CHECK
NOTES
CHAPTER 5: Systemic Risk Data
INTRODUCTION
KEY DATA ATTRIBUTES
KEY POLICY CHANGES TO ADDRESS DATA GAPS
DATA SOURCES
DATA COLLECTION CHALLENGES AND REMAINING GAPS
MOVE TOWARD STANDARDIZATION: LEGAL ENTITY IDENTIFIER INITIATIVE
KEY POINTS
KNOWLEDGE CHECK
NOTES
CHAPTER 6: Macroprudential versus Microprudential Oversight
INTRODUCTION
A COMPARISON OF MACROPRUDENTIAL VERSUS MICROPRUDENTIAL
MICROPRUDENTIAL POLICIES
MACROPRUDENTIAL POLICIES
A HISTORICAL PERSPECTIVE ON MACROPRUDENTIAL TOOLS
CHOICE OF MACROPRUDENTIAL POLICY TOOLS
KEY POINTS
KNOWLEDGE CHECK
NOTES
CHAPTER 7: Introduction to the U.S. Regulatory Regime
INTRODUCTION
WHO ARE THE REGULATORS?
U.S. REGULATORY APPROACHES
COMPARISON OF U.S. VERSUS INTERNATIONAL FINANCIAL REGULATORY REGIMES
INTRODUCTION TO THE DODD-FRANK ACT
KEY POINTS
KNOWLEDGE CHECK
NOTES
CHAPTER 8: Introduction to International Regulatory Regimes
INTRODUCTION
THE FINANCIAL STABILITY BOARD
THE BASEL ACCORDS
THE EUROPEAN SYSTEMIC RISK BOARD
PRINCIPLES FOR FINANCIAL MARKET INFRASTRUCTURES
KEY POINTS
KNOWLEDGE CHECK
NOTES
CHAPTER 9: Systemically Important Entities
INTRODUCTION
INTRODUCTION TO SYSTEMICALLY IMPORTANT ENTITIES
CLASSIFICATION OF ENTITIES AS SYSTEMICALLY IMPORTANT BY THE FSOC
GLOBALLY SYSTEMICALLY IMPORTANT BANKS
BROAD IMPACT OF FINANCIAL STABILITY REQUIREMENTS
KEY POINTS
KNOWLEDGE CHECK
NOTES
CHAPTER 10: The Volcker Rule
INTRODUCTION
INTRODUCTION TO THE VOLCKER RULE
THE VOLCKER RULE: DETAILS
IMPLEMENTATION OF THE VOLCKER RULE
VOLCKER RULE: CRITICISM
KEY POINTS
KNOWLEDGE CHECK
NOTES
CHAPTER 11: Counterparty Credit Risk
INTRODUCTION
OVERVIEW OF DERIVATIVE SECURITIES
COUNTERPARTY EXPOSURE
HOW COUNTERPARTY CREDIT RISK IS MANAGED
COUNTERPARTY CREDIT RISK AND SYSTEMIC RISK
KEY POINTS
KNOWLEDGE CHECK
NOTES
CHAPTER 12: The Dodd-Frank Act and Counterparty Credit Risk
INTRODUCTION
MEASURING COUNTERPARTY EXPOSURE IN THE OTC DERIVATIVES MARKET
OVERVIEW OF HISTORICAL DATA
THE EVOLUTION OF THE U.S. REGULATORY APPROACH TOWARD OTC DERIVATIVES
KEY PROVISIONS OF TITLE VII OF THE DODD-FRANK ACT
CRITICISM OF TITLE VII OF THE DODD-FRANK ACT
KEY POINTS
KNOWLEDGE CHECK
NOTES
CHAPTER 13: The Basel Accords
INTRODUCTION
WHAT ARE THE BASEL ACCORDS?
THE APPROACH OF THE BASEL ACCORDS
BASEL I
BASEL II
BASEL III
THE CONTINUING EVOLUTION OF THE BASEL ACCORDS
KEY POINTS
KNOWLEDGE CHECK
NOTES
CHAPTER 14: Lender of Last Resort
INTRODUCTION
LENDER OF LAST RESORT CONCEPT
HENRY THORNTON, WALTER BAGEHOT, AND ALTERNATIVE VIEWS
THE FED'S ROLE IN THE GREAT DEPRESSION
THE CREDIT CRISIS OF 2007–2009
KEY POINTS
KNOWLEDGE CHECK
NOTES
CHAPTER 15: Interconnectedness Risk
INTRODUCTION
A CASE STUDY OF INTERCONNECTEDNESS
INTERCONNECTEDNESS CATEGORIES
POST-CRISIS REGULATORY VIEW OF INTERCONNECTEDNESS
AN APPROACH TO ANALYZING INTERCONNECTEDNESS RISK
KEY POINTS
KNOWLEDGE CHECK
NOTES
CHAPTER 16: Conclusion: Looking Ahead
IT'S NOT A QUESTION OF
IF
, BUT
WHEN
,
WHERE
, AND
HOW
A SUMMARY OF GLOBAL SURVEYS
PREPARING FOR THE NEXT CRISIS
NOTES
APPENDIX: Systemic Risk Models
INTRODUCTION
STRUCTURAL VERSUS REDUCED-FORM CREDIT MODELS
CONTINGENT CLAIMS AND DEFAULT MODELS
MACROECONOMIC MEASURES
PROBABILITY DISTRIBUTION MEASURES
ILLIQUIDITY MEASURES
COUNTERPARTY RISK MEASURES
BEHAVIORAL MODELS
Solutions to the Knowledge Check Questions
Index
End User License Agreement
List of Tables
Chapter 2
Table 2.1 Timeline of Selected Historical Crises
Table 2.2 European External Defaults: 1300–1799
Table 2.3 Cumulative Defaults and Reschedulings: Europe and Latin America (Year of Independence to 2008)
Chapter 3
Table 3.1 Changes in Real Housing Prices
Table 3.2 Allocation of U.S. Government Bailout Funds
Chapter 5
Table 5.1 Financial Turbulence and Systemic Risk Metrics
Chapter 6
Table 6.1 The Micro- and Macroprudential Perspectives Compared
Table 6.2 Capturing the Financial Cycle: Some Useful Indicators
Table 6.3 Policy Instruments and Potential Indicators
Chapter 7
Table 7.1 U.S. Federal Financial Regulators and Organizations
Table 7.2 International Examples of Financial Regulatory Approaches
Table 7.3 Key International Financial Institutions
Table 7.4 The 16 Titles of the Dodd-Frank Act
Table 7.5 Key Examples of Pre-Dodd-Frank Act U.S. Financial Legislation
Chapter 8
Table 8.1 Member Institutions of the FSB
Table 8.2 Key Standards for Sound Financial Systems
Table 8.3 Voting and Non-voting Members of the ESRB
Table 8.4 PFMI Principles and Responsibilities
Chapter 9
Table 9.1 Members of the Financial Stability Oversight Council (FSOC)
Table 9.2 Banks with Assets Greater than $50 Billion as of June 30, 2016
Table 9.3 FSOC-Designated SIFMUs
Table 9.4 Globally Systemically Important Banks
Table 9.5 Third Way Identification of Financial Stability Rules as a Function of Bank Size
Chapter 10
Table 10.1 Securities for which Proprietary Trading Is Permitted Despite the Volcker Rule
Table 10.2 Financial Stability Oversight Council Volcker Rule Recommendations
Chapter 11
Table 11.1 Types of Derivative Security Agreements and the Associated Assets and Liabilities
Table 11.2 Counterparty Credit Risk Following Closeout Netting
Table 11.3 Gross Assets, Market Consisting of Four Counterparties
Table 11.4 Net Assets, Market Consisting of Four Counterparties
Table 11.5 Net Assets, Market Consisting of Four Counterparties and a CCP
Chapter 13
Table 13.1 Basel I Risk Weights by Category of On-Balance-Sheet Asset
Table 13.2 Basel II Standardized Approach Risk Weights for Sovereigns and Their Central Banks
Table 13.3 Basel II Standardized Approach Risk Weights for Corporates
Table 13.4 Basel II Key Principles of Supervisory Review
Chapter 15
Table 15.1 The G-SIB Assessment Methodology
Table 15.2 Global Systemically Important Banks
List of Illustrations
Chapter 11
Figure 11.1 Gross assets, market consisting of four counterparties
Figure 11.2 Net assets, market consisting of four counterparties
Figure 11.3 Gross assets, market consisting of four counterparties and a CCP
Figure 11.4 Net assets, market consisting of four counterparties and a CCP
Chapter 12
Figure 12.1 OTC derivatives notional outstanding, USD billions
Figure 12.2 OTC derivatives gross market value and gross credit exposure, USD billions
Figure 12.3 OTC derivatives gross credit exposure and estimated collateral, USD billions
Guide
Cover
Table of Contents
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Understanding Systemic Risk in Global Financial Markets
ARON GOTTESMANMICHAEL LEIBROCK
Copyright © 2017 by John Wiley & Sons, Inc. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Names: Gottesman, Aron, 1970–author. | Leibrock, Michael, 1966–author.
Title: Understanding systemic risk in global financial markets : a professional guide to accounting arbitrations / Aron Gottesman and Michael Leibrock.
Description: Hoboken, New Jersey : Wiley, [2017] | Series: Wiley finance series; 1935 | Includes bibliographical references and index. | Identifiers: LCCN 2017010796 (print) | LCCN 2017023709 (ebook) | ISBN 9781119348542 (pdf) | ISBN 9781119348467 (epub) | ISBN 9781119348504 (cloth : alk. paper) | ISBN 9781119348542 (ePDF)
Subjects: LCSH: Financial risk management. | Financial crises. | Risk. | Financial institutions.
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ML
To my wife, Roseann, and my children, Jaclyn, Victoria, and Michael
AG
In memory of my mother, Susan Rachel Raizel Gottesman z'l
Preface
This book provides an in-depth introduction to systemic risk. Systemic risk is the risk that developments in the financial system will disrupt financial stability and the economy. We've written this book because the topic of systemic risk is arguably the most critical issue facing the financial services industry today and one whose impact can spill over into the broader economy with devastating effect on individual consumers and investors.
The Credit Crisis of 2007–2009 was an important catalyst for this book. Yet financial crises have been occurring for centuries, often driven by very similar factors to the Credit Crisis of 2007–2009. One of our objectives is to help you develop a deep understanding of systemic risk through meaningful exploration of the lengthy history of crises and the commonalities across the crises.
We also feel there is a need for systemic risk to be viewed by practitioners as a distinct risk discipline, one that can be analyzed and monitored in an organized and repeatable fashion, much like longstanding risks such as market risk, credit risk, and operational risk have been for decades. Hence, another of our objectives is to provide you the contours of the discipline of systemic risk.
This book can be used either as an introductory text or as an accompaniment to a quantitative treatment of risk. We do not assume that the reader has sophisticated understanding of finance or math, nor have we assumed that he or she has hours to decipher our arguments. Instead, this book provides straightforward, plain-talking explanations that are directly related to those issues that matter most to practitioners. Audiences for this book include:
Individuals and university students learning about risk management for the first time who do not have extensive math or finance backgrounds.
Practitioners in “middle-office” and “back-office” roles in financial institutions, such as those in risk management, operations, technology, information security and compliance that require a broad understanding of the types of risks posed by systemically important financial institutions and who have a need to identify such risks to do their jobs.
Practitioners, regulators, and academics who want to understand how regulation and clearinghouses function as risk-mitigating utilities for the financial industry.
This book consists of 16 chapters and an appendix. Here is a brief summary of the material that is covered in each chapter.
The first three chapters of this book introduce the concept of systemic risk and explore its history. Chapter 1 provides a high-level introduction to the topic of systemic risk, including definitions provided by industry, academic, and regulatory experts, and explains the importance of enhancing understanding of systemic risk. Chapter 2 provides a summary of prior systemic events and identifies common drivers of these events based on several hundred years of evidence. Chapter 3 provides an overview of the events surrounding the Credit Crisis of 2007–2009, which had a devastating impact on the both the financial industry and economies of the United States and Europe.
Chapters 4–6 delve deeper into systemic risk. Chapter 4 explores one of several theories that help explain why financial crises have been occurring for centuries, including those that address economic cycles, behavioral biases, and the role the human brain plays in risk taking and decision making. Chapter 5 discusses the critical role that data plays in the effective monitoring of systemic risks, including key industry advancements such as the Legal Entity Identifier and the creation of the Office of Financial Research, aimed at addressing certain information gaps that contributed to the Credit Crisis of 2007–2009. Chapter 6 defines macroprudential and microprudential oversight and offers important distinctions between the two regulatory oversight approaches.
Chapters 7 and 8 introduce regulatory regimes in various jurisdictions. Chapter 7 provides an introduction to U.S. financial regulation and the approaches of the various U.S. regulators and introduces the Dodd-Frank Act of 2010. Chapter 8 turns to international regulatory regimes, providing an introduction to several key international regulators and standards that facilitate international approaches and coordination.
Chapters 9–14 explore in detail many elements of how systemic financial risk is managed. Chapter 9 delves into the designation of entities as systemically important, including Systemically Important Financial Institutions (SIFIs), Systemically Important Financial Market Utilities (SIFMUs), and Globally Systemically Important Banks (G-SIBs). Chapter 10 explores the Volcker Rule of the Dodd-Frank Act, which sets prohibitions, requirements, and limitations in relation to the trading and private fund activities of banking entities and systemically risky non-bank financial companies. Chapter 11 provides an introduction to counterparty credit risk, and studies sources of counterparty credit risk and how counterparty credit risk is managed. Chapter 12 explores Title VII of the Dodd-Frank Act, which works to reduce the counterparty exposure faced by participants in the OTC derivatives market through setting mandatory clearing and other requirements. Chapter 13 explores the Basel Accords—multinational accords that set minimum capital requirements for banks—that were established in order to strengthen the soundness and stability of the international banking system. Chapter 14 studies the concept of “lender of last resort,” including its benefits, risks, various views of its function, and its application.
Chapters 15 and 16 tie together the concepts explored throughout this book. Chapter 15 introduces the topic of interconnectedness, explains how this risk manifested itself during the Credit Crisis of 2007–2009, and illustrates the ways in which interconnectedness has become a key consideration in several post-crisis regulatory developments. Chapter 16 looks ahead to the outlook and likelihood of future systemic events and includes a number of recent examples of top systemic concerns as published by several large financial institutions and regulatory bodies.
This book also includes an appendix that provides a detailed taxonomy and literature review of some of the key quantitative models that are used to measure systemic risk in different ways.
To allow you to test your understanding, each chapter concludes with a number of Knowledge Check questions, the solutions to which are provided in the appendix. The Knowledge Check questions can be used to ensure absorption of the material both when you learn the material for the first time and also when you review.
We hope this book provides you with a comprehensive understanding of systemic risk!
Acknowledgments
ML
I'm grateful to my former professors at Pace University's Lubin School of Business for providing me the foundation of scientific research I relied upon when completing this book. A special thanks to my co-author and doctoral advisor, Aron Gottesman, whose guidance and vision was critical to the success of this book. I'm also grateful to many former industry colleagues from whom I learned so much over the years, particularly while working together through some of the financial crises covered in this book. Finally, this book would not have been possible without the tremendous support of my wife, Roseann, and the patience of my children, Jaclyn, Victoria, and Michael.
AG
I am delighted to have had the opportunity to coauthor this book with Michael Leibrock. I have benefited tremendously from Mike's deep practitioner and academic knowledge. Thank you to the team at Wiley. Thank you to my colleagues at Pace University, including Niso Abuaf, Lew Altfest, Neil Braun, Arthur Centonze, Burcin Col, Ron Filante, Natalia Gershun, Elena Goldman, Iuliana Ismailescu, Padma Kadiyala, Maurice Larraine, Sophia Longman, Ed Mantell, Jouahn Nam, Joe Salerno, Carmen Urma, PV Viswanath, Tom Webster, Berry Wilson, and Kevin Wynne, and a special thank-you to Matt Morey. I also wish to thank Niall Darby, Stephen Feline, Allegra Kettelkamp, John O'Toole, Patrick Pancoast, Carlos Remigio, Lisa Ryan, and the entire team at Intuition. Thank you to Moshe Milevsky, Eli Prisman, and Gordon Roberts of York University and Gady Jacoby of the University of Manitoba, who helped spark my career. Thank you to my many students, from whom I've learned tremendously. Finally, thank you to my wife, Ronit, and our children, Moshe and Libby, Yakov, Raphi, Tzipora, and Kayla, for providing so much love and support.
About the Authors
Aron Gottesman is Professor of Finance and the Chair of the Department of Finance and Economics at the Lubin School of Business at Pace University in Manhattan. He holds a PhD in Finance, an MBA in Finance, and a BA in Psychology, all from York University. He has published articles in academic journals including the Journal of Financial Intermediation, Journal of Banking and Finance, Journal of Empirical Finance, and the Journal of Financial Markets, among others. He has also previously authored or co-authored several books including, most recently, Derivatives Essentials: An Introduction to Forwards, Futures, Options, and Swaps (Wiley Finance, 2016). Aron Gottesman's research has been cited in newspapers and popular magazines, including the Wall Street Journal, the New York Times, Forbes magazine, and Business Week. He teaches courses on derivative securities, financial markets, and asset management. Aron Gottesman also presents workshops to financial institutions. His website can be accessed at www.arongottesman.com.
Michael Leibrock is managing director, chief systemic risk officer, and head of Counterparty Credit Risk for the Depository Trust & Clearing Corporation (DTCC). Michael Leibrock currently serves as co-chair of DTCC's Systemic Risk Council and as chair of the Model Risk Governance Committee. He has conducted numerous newspaper and magazine interviews on risk topics, as well as several video interviews on TabbForum.com, which include “Building an Interconnectedness Risk Program” (Dec. 2016), “Unintended Risks of Regulations” (Dec. 2014), and “The Top Systemic Threats to the Capital Markets” (Aug. 2013). Michael Leibrock holds an MBA in Finance from Fordham University and a doctorate in Finance and International Economics from Pace University's Lubin School of Business. He has previously served as an adjunct professor at New Jersey City University and Monmouth University. Michael Leibrock's prior academic research has covered topics such as predictors of bank defaults, sovereign default analysis, and a doctoral dissertation titled “Systemic Risk and an Extension of the Black Scholes Merton Option Pricing Model for U.S. Banks.”
CHAPTER 1Introduction to Systemic Risk
The topic of systemic risk should be of critical importance to the numerous actors and stakeholders that make up the global financial ecosystem. This includes, among others, financial institutions such as banks, investment banks, and asset managers, financial regulators, policymakers, and central banks, as well as individual investors. It is also important to the general consumer, given that systemic events have the potential of spilling over from the financial system and impacting the real economy. Many historical systemic events have led to national or even global recessions, significant loss of employment, and a spike in both corporate and personal bankruptcies and taxpayer losses. Clearly, the most widely known and recent example of a systemic event was the Credit Crisis of 2007–2009, which involved, among other events, the collapse of the U.S. residential real estate and asset-backed securities markets, as well as the bankruptcy or bailout of many globally recognizable financial institutions, including Lehman Brothers, Bear Stearns, and American International Group (AIG), among others.
Given the high-profile failure or effective failure of these long-established financial firms, combined with the fact that financial crises have occurred with far greater frequency over the last several decades, some people may assume that systemic risk is only a recent phenomenon. However, it is important to understand that systemic events have been occurring for many centuries. Some well-known and relatively recent examples of such events include the U.S. savings & loan crisis, the bursting of Japan's real estate bubble, the Latin American debt crisis, the collapse of the U.S. junk bond market, the failure of hedge fund Long-Term Capital Management, and the bursting of the dot-com bubble.
Before the Credit Crisis the topic of systemic risk was rarely discussed within the financial services industry. Furthermore, organized research on the topic was limited and occurred only within academia and the research divisions of certain financial regulators or central banks. However, given the devastating impact of this event globally and the massive response by global financial regulators, the focus on systemic risk has skyrocketed over the past five years and is now the subject of regular discussion, analysis, and monitoring by all stakeholders across the globe.
This chapter introduces the topic of systemic risk, explores the many definitions that have been published or discussed in recent years, summarizes the key drivers of historical systemic events, and explains why it is critical that this topic be further analyzed and understood.
After you read this chapter you will be able to:
Describe the common definitions of systemic risk.
Understand the key drivers of prior systemic events.
Explain the different impacts a systemic event can have on the financial industry and real economy.
WHAT IS SYSTEMIC RISK?
The area of systemic risk analysis is still in its very nascent stages and there currently is no single, universally accepted definition employed by those involved in analyzing and monitoring systemic risk. Moreover, as research on this topic evolves over time, it is likely that existing definitions will morph or that new definitions will be put forth by the various constituents who have an interest in this topic. Furthermore, it is important to note that having a single definition of systemic risk is not a prerequisite for studying and enhancing one's knowledge of this topic or benefiting from some of the existing approaches to measuring and monitoring systemic risks covered in this book. To provide some context and a foundation for the remainder of this book, listed here are examples of some definitions publicly communicated in recent years by well-known regulators and academics:
“Systemic risks are developments that threaten the stability of the financial system as a whole and consequently the broader economy, not just that of one or two institutions.”
1
“In the context of our economic environment, systemic risk is the threat that developments in the financial system can cause a seizing up or breakdown of this system and trigger massive damages to the real economy. Such developments can stem from the failure of large and interconnected institutions, from endogenous imbalances that add up over time, or from a sizable unexpected event.”
2
“Systemic Risk is the risk of a disruption in the market's ability to facilitate the flows of capital that results in the reduction in the growth of GDP globally.”
3
“One or more global financial centers are mired in a severe crisis that spans two or more distinct regions, with at least three countries impacted in each region. There must also be a corresponding and significant impact on a composite GDP index.”
4
“A risk of disruption to financial services that (i) is caused by an impairment of all or parts of the financial system and (ii) has the potential to have serious negative consequences for the real economy. Fundamental to the definition is the notion of negative externalities from a disruption or failure in a financial institution, market or instrument.”
5
“Systemic risk emerges when the financial sector as a whole has too little capital to cover its liabilities. This leads to widespread failure of financial institutions and/or the freezing of capital markets, which greatly impairs financial intermediation, both in terms of the payment systems and in terms of lending to corporates and households.”
6
“Credit risk, liquidity risk, market risk and operational risk are often difficult to quantify, and more so when the interaction of different types of risk leads to systemic risks. Systemic risks affect a financial system's stability when idiosyncratic shock to an individual financial institution generates contagious effects on others in the system.”
7
One common aspect of these definitions is that to be characterized as a systemic threat, the underlying risk(s) should have the potential to severely impact the financial system and real economy. In contrast to the characteristics of a systemic event, an event that might not rise to the level of a systemic risk is one that may have a significant impact on an industry sector or geographic region, but does not spill over into the broad economy. For purposes of this book we will treat the terms systemic event and financial crisis as synonymous.
SYSTEMIC RISK DRIVERS
Under the broad topic of systemic risk, there have been a wide range of causes for past events. While these events will be discussed in more detail in Chapters 2 and 3, we introduce this topic by providing some of the more common themes behind the many crises that have impacted countless countries and economies across the world.
One of the earliest recorded crises occurred in the middle of the 1200s and was referred to as a currency debasement,8 which can be thought of as the predecessor to today's foreign exchange crisis or devaluation. Occurring during the Middle Ages, when metallic coins represented the primary medium of exchange, currency debasements involved the intentional significant reductions in the silver content of coins. This action helped provide a critical source of war financing for governments.
Currency crashes have been a significant source of past crises, which we will define as an annual depreciation versus the U.S. dollar or the relevant anchor currency for that time (most frequently the U.K. pound, French franc, or German deutsche mark) of 15% or more. While there are many currency crashes throughout history that exceeded this threshold, the largest single crash was experienced by Greece in 1944.
Another frequent driver of systemic events throughout history is the bursting of asset bubbles. A commonly employed definition of a bubble is a non-sustainable pattern of price changes or cash flows. Historically, many asset bubbles have been observed in the real estate sector, particularly over the past 30 years. Major real estate bubbles have burst in Japan, non-Japan Asia, and most recently in the United States, in connection with the Credit Crisis. The bursting of Japan's real estate bubble in the early 1990s led to the widespread failure of banks and a prolonged period of sluggish growth, which came to be known as the “lost decade.”
It is noteworthy that bubbles in real estate and stock markets are often closely linked.9 Three prominent examples of such linkages include (i) the fact that stock markets of many emerging market countries are heavily weighted toward real estate and construction companies, reflecting the growth stage of such nations, (ii) the fact that the wealth obtained by successful real estate investors is often invested into the stock market, and (iii) that the same high-net-worth individuals referenced in the second example deploy profits made from stock market increases into additional real estate holdings.
There are longstanding economic theories that posit asset bubbles are fueled by significant increases in the pro-cyclical supply of credit during economic booms. This “easy money” climate facilitated by central banks has contributed to a spike in investor speculation, leverage, and hence unsustainable increases in asset prices, which eventually “burst.”
There have also been numerous historical financial crises brought on by the default by governments on both their external debt (e.g., default on payment to creditors under another country's jurisdiction) as well as domestic debt. There were at least 250 sovereign external defaults during 1800–2009 and at least 68 instances of default on domestic public debt. A couple of the most well-known examples of the former include Argentina's 2001 default on $95 billion of external debt and Mexico's 1994–1995 near default on local debt.10 The negative impact on a country that defaults on its debt can be significant and long lasting. For example, it took Russia decades to finally resolve its 1918 external default with creditors. In addition, because of Greece's default in 1826, the country's access to global capital markets was very limited for the next half century.
As one of the goals of this book is to identify tools that will help financial industry participants identify the early signs of a financial crisis, it is worth noting that episodes of sovereign default have exhibited some noticeable macroeconomic trends prior to the actual default event. The average total decline in domestic GDP during the three years prior to domestic debt defaults is 8%, compared to an average decline of 1.2% for external defaults.11
Banking crises, another frequent driver of systemic events, may be defined as either the failure, takeover, or forced merger of one of the largest banks in each nation or, absent such corporate events, a large-scale government bailout of a group of large banks in that nation. Using this definition, there have been a tremendous number of banking crises that have occurred globally throughout history. Dating back to the year 1800, 136 countries have experienced some form of banking crisis.12
An important point to note is that banking crises have historically been intertwined with other categories of financial crises. For example, many banking crises have been fueled, at least in part, by the bursting of asset bubbles in real estate and national stock markets. However, many of these same bubbles were enabled by the banking sector itself as banks are often the main provider of credit and liquidity for real estate financing. This point is supported by the following statement:
Interconnections among financial firms can also lead to systemic risk under crisis conditions. Financial institutions are interconnected in a variety of networks in bilateral and multilateral relationships and contracts, as well as through markets.13
Arguably the most important and practical benefit of studying the common drivers and details associated with previous systemic events is to learn from the past and the potential for using facts and statistics related to such events to help identify the buildup of emerging systemic threats.
WHY SYSTEMIC RISK MUST BE UNDERSTOOD, MONITORED, AND MANAGED
As previously mentioned, systemic events have been occurring for centuries and with devastating impact. Using events such as the Great Depression and the Credit Crisis as just two examples, both events led to the failure of hundreds of banks and other financial institutions in the United States and globally, deep and long-lasting global recessions, the seizing up of global credit markets, the need for massive government bailouts, and a tremendous loss of jobs in the private sector that in turn led to significant spikes in personal bankruptcies.
As we cover in more detail later in this book, there have been a multitude of causes for such events, many of which are extremely complex for several reasons. For example, what differentiates systemic risks from the more traditional forms of risk is that the former are typically classified by their impacts as opposed to their causes. Systemic risks can arise in many forms, can develop rapidly, and can be unpredictable. Another major difference is that systemic risk can involve interconnectedness of markets and industry participants, rather than a single, discrete source of risk. By its nature, systemic risk is also an extremely broad topic, subject to many different definitions, sources, and impacts. One of the reasons that systemic risk analysis has not yet evolved into a standard component of risk management practices in the financial industry is the lack of a roadmap that summarizes these many components and available tools to help support repeatable identification and monitoring processes.
Because of these significant challenges, and in consideration of the devastating effect systemic events have been shown to have on global economies, it is imperative that such risks become better understood and monitored so there is a greater likelihood they can be detected early to protect global financial institutions, the stability of financial markets, and individual taxpayers.
If history is any indicator, it is unlikely that all or even many future systemic events can be predicted ahead of time. That said, given the significant amount of data and other facts available concerning the root causes of the Credit Crisis and other financial events, this information has proven to be very helpful in the creation of models and other tools that may serve as early warning indictors in the future. In addition, as covered in detail in the second half of this book, new financial regulations have been enacted in the United States and internationally at a rate not seen since the Great Depression. Multiple new regulatory bodies and agencies have been created globally to oversee and enforce these new rules, most of which are aimed at the banking industry. In addition, financial institutions have vastly expanded their focus on systemic risk identification and mitigation.
While this clearly heightened global focus on systemic risk is certainly encouraging, the analysis and quantification of systemic risk remains a relatively nascent area. There is still a need for new and enhanced tools to assist the industry in its efforts to better understand, quantify, monitor, and mitigate systemic threats. While longstanding risk management disciplines such as credit risk, market risk, liquidity risk, and operational risk are all critically important pillars of the risk governance frameworks employed by nearly all large financial institutions, systemic risk warrants acceptance in the industry as a distinct risk discipline that can be monitored and managed in an organized fashion.
KEY POINTS
No single, universally accepted definition of
systemic risk
exists globally.
Although the Credit Crisis of 2007–2009 was one of the worst financial events in history, systemic risk events have been occurring for centuries, with currency crises representing one of the oldest categories of systemic risk.
Some of the more common causes of past financial crises include currency crashes, currency debasements, bursting of asset bubbles, banking crises, and sovereign defaults.
Even though systemic risk events have been taking place for centuries, the financial industry and regulatory bodies have only recently started to approach systemic risk identification, monitoring, and mitigation in a formal way.
Since systemic risk events typically involve a significant dislocation in securities markets and adversely affect the real economy (e.g., recession, unemployment, taxpayer-funded bailouts, personal bankruptcies, etc.), it is critical that systemic risk drivers be understood to increase the likelihood that early warning indicators anticipate future events to minimize these negative impacts.
KNOWLEDGE CHECK
Q1.1: What development differentiates a systemic risk event from other types of financial crisis?
Q1.2: Are systemic events only a phenomenon of modern history?
Q1.3: What are the six most common causes of systemic events throughout history?
Q1.4: Significant failures within which segment of the global financial sector have fueled several of the worst systemic events in history?
Q1.5: Why is it important that the level of understanding, monitoring, and managing of systemic risks improves globally?
NOTES
1
. Ben Bernanke in a letter to Senator Bob Corker, dated Oct. 30, 2009.
2
. Text of the Clare Distinguished Lecture in Economics and Public Policy by Mr. Jean-Claude Trichet, President of the European Central Bank, organized by Clare College, University of Cambridge, Cambridge, Dec. 10, 2009.
3
. Fouque, J.P., and Langsam J., 2013,
Handbook of Systemic Risk
. Cambridge University Press, 2013, p. xxi.
4
. Reinhart, Carmen M., and Rogoff, Kenneth S., 2009,
This Time Is Different: Eight Centuries of Financial Folly
. Princeton, NJ: Princeton University Press.
5
.
www.fsb.org/what-we-do/policy-development/systematically-important-financial-institutions-sifis/
.
6
. Acharya, V.V., Pedersen, L.H., Philippon, T., and Richardson, M., 2010, “Measuring Systemic Risk.” Working paper, New York University Stern School of Business.
7
. International Monetary Fund, 2000.
8
. Reinhart, Carmen M., and Rogoff, Kenneth S., 2009,
This Time Is Different: Eight Centuries of Financial Folly
. Princeton, NJ: Princeton University Press.
9
. Kindlelberger, C.P., and Aliber, R., 2005,
Manias, Panics and Crashes: A History of Financial Crisis
, 5th ed. Hoboken, NJ: Wiley.
10
. Reinhart, Carmen M., and Rogoff, Kenneth S., 2009,
This Time Is Different: Eight Centuries of Financial Folly
. Princeton, NJ: Princeton University Press, pp. 129–132.
11
. Ibid.
12
. Kindlelberger, C.P., and Aliber, R., 2005,
Manias, Panics and Crashes: A History of Financial Crisis,
5th ed. Hoboken, NJ: Wiley, p. 3.
13
. Acharya, V.V., Pedersen, L.H., Philippon, T., and Richardson, M., 2010, “Measuring Systemic Risk.” Working paper, New York University Stern School of Business.
CHAPTER 2How We Got Here: A History of Financial Crises
INTRODUCTION
Financial crises are far from a new phenomenon, having occurred as long as money and financial markets have been in existence. On the surface, it may appear that there is little to be learned from any event that occurred hundreds of years ago. Clearly the global financial services industry that exists today bears little resemblance to the one that existed even 50 years ago, due to changes in market structures, technological advances, the sophistication of risk analytical tools, and the highly developed nature of global financial regulatory frameworks.
It is outside the scope of this book to categorize every crisis throughout history, or to draw definitive conclusions about their primary causes. However, despite the vast differences in the way financial markets operate today, a brief review of key past events will reveal some common themes with respect to the nature and causes of such events. An understanding of these themes can assist the many actors involved in the study of systemic risk (e.g., risk managers, academics, policymakers, or regulators) to obtain a broader perspective on certain risks that have manifested themselves repeatedly throughout history and potentially identify the buildup of these risks before they become a full-fledged crisis. Consider the following remarks by well-known academics Carmen Reinhart and Kenneth Rogoff;
Until very recently, studies of banking crisis have focused either on episodes drawn from the history of advanced countries (mainly the banking panics before World War II) or on the experience of modern day emerging markets. This dichotomy has perhaps been shaped by the belief that for advanced economies, destabilizing, multi-country financial crises are a relic of the past. Of course, the Second Great Contraction, the global financial crisis that recently engulfed the United States and Europe, has dashed this misconception, albeit at a great social cost.1
After reading this chapter you will be able to:
Cite examples of some of the most noteworthy financial crises in history.
Explain some of the common themes behind prior systemic events.
Understand what is meant by an “asset bubble” and describe the economic conditions that typically lead to a bubble.
Describe which countries have been the source of most sovereign defaults in history.
Understand the ways in which international contagion either fueled or contributed to the severity of prior financial crises, including the Great Depression.
COMMON DRIVERS OF HISTORICAL CRISES
Table 2.1 presents a timeline of select historical crises. In nearly all cases, a close examination of each of the crises listed in Table 2.1 will result in a myriad of causes. Furthermore, in all cases the occurrence of just one of the underlying events likely wouldn't have led to the full-fledged crisis that ensued. Rather, it was often the simultaneous occurrence of multiple underlying events or the spillover and linkages among multiple countries or markets that ultimately caused these systemic events to take place. Given the multitude of underlying causes and the inherent complexity of every crisis, we attempt to group such causes into higher-level themes as a starting point for trying to understand, analyze, and identify tools that might help avoid similar events in the future.
Table 2.1 Timeline of Selected Historical Crises
Year
Event
County/Region
Broad Category
1636
Dutch Tulip Crisis
Europe
Asset Price Bubbles
1720
South Street Sea Bubble
Europe
Speculative Mania
1763
End of Seven Years War
Amsterdam
Asset Price Bubbles
1825
Crisis of 1825–1826
Europe/Latin America
Sovereign Default
1837
Crisis of 1836–1839
America/England
Price of Cotton
1857
Hamburg Crisis of 1857
Sweden/Hamburg
Expansion of Credit
1873
Panic of 1873
U.S., Austria, Germany
Global Contagion
1907
Panic of 1907
Global
Banking Crisis
1929
Great Depression
U.S./Europe
Banking Crisis
1977
“Big Five” Crisis
Spain
Real Estate Bubble/Banking Crisis
1980s
Debt Crisis of the 1980s
U.S.
Sovereign Default, Currency Crash
1987
“Big Five” Crisis
Norway
Real Estate Bubble/Banking Crisis
1990s
“Big Five” Crisis
Finland, Sweden, Japan
Real Estate Bubble/Banking Crisis
1990s
Junk Bond Market Crash
U.S.
Asset Price Bubbles
1994
Mexican Debt Crisis
Mexico
Currency/Banking Crisis
1997
Asian Financial Crisis
Asia
Currency Crash
1998
Long-Term Capital Mgt.
U.S.
Credit
1990s
Latin American Debt Crisis
Latin America
Sovereign Default
2000
Dot-Com Tech Bubble
U.S.
Asset Bubble
2008
Credit Crisis
U.S./Europe
Asset Bubble
Bursting of Asset Bubbles
Table 2.1 provides several examples of asset bubbles throughout history. One definition of an asset bubble is an upward price movement of an asset over an extended time period of 15–40 months, which then implodes. Economists use the term to mean any deviation in the price of an asset, security, or commodity that can't be explained solely by fundamentals. Asset price bubbles are most often fueled by a combination of a rapid growth in the availability of credit and the irrational behavior of investors and markets.
Although bubbles can theoretically take place with respect to any asset that has an observed value, most bubbles have tended to occur within a securities asset class, individual security, or real estate. In the past 30 years alone, major real estate bubbles have burst in Japan, non-Japan Asia, and most recently in the United States.
The following sequence of events are representative of a typical model of a financial crisis fueled by an asset bubble:
Economic expansion/boom
Euphoria and rapid increase in asset prices
Pause in asset-price increases
Distress/panic/crash
Asset price bubbles, at least the large ones, are almost always associated with economic euphoria. In contrast, the bursting of bubbles leads to a downturn in economic activity and is often associated with the failure of financial institutions, frequently on a large scale. The failure of these institutions disrupts the channels of credit, which in turn can lead to a slowdown in economic activity. As mentioned previously, bubbles in stock markets and real estate are often closely linked with three prominent examples of linkages and connections between these two asset markets:2
In many countries, and especially smaller nations and those in early stages of industrialization, a substantial amount of the stock market valuation consists of real estate companies and construction companies and firms in other industries that are closely associated with real estate, including banks.
Another connection is that individuals whose wealth has increased sharply because of the increase in real estate values want to keep their wealth diversified and so they buy stocks.
The third connection is the mirror-image of the second: the individual investors who have profited extensively tend to buy larger and more expensive homes.
Dutch Tulip Crisis: One of the earliest financial crises that was documented extensively is often referred to as the Dutch Tulip Crisis or Mania, when the prices of tulip bulbs increased by several hundred percent in the autumn of 1636. For more exotic and rare bulbs, price increases were even more dramatic.
In the mid-16th century tulips were introduced to Holland via the Ottoman Empire and quickly became a status symbol among its citizens, setting off a frenzy of speculative behavior across the country. The speculation became rampant in September 1636 as the bulbs were in their normal planting cycle and therefore could no longer be physically inspected by potential buyers who had to commit to purchases long before the spring bloom. This led to many investors purchasing bulbs at extraordinary prices that they had never seen.
Nobles, citizens, farmers, mechanics, footman, maid-servants, even chimney sweeps and old clothe woman dabbled in tulips.3
This frenzy was accompanied by the introduction of call options that further fueled speculative buying, resulting in a 20-fold increase in prices between November 1636 and February 1637.
As traditional bank financing was not fully developed at that time, most investors used in-kind down payments, which included things such as tracts of land, houses, furniture, silver and gold vessels, paintings, and so on. When the prices of tulip bulbs crashed, it led to the complete loss of savings of many citizens and fueled an overall decline in the European economy with the Dutch economy suffering into the 1640s.
Dot-Com Bubble of 2000: Another more recent example of the bursting of an asset bubble was the dramatic rise and fall of Internet stocks in the late 1990s. Per one index that tracked the performance of Internet stocks, prices of this sector rose 1,000% from October 1998 to February 2000.4 Prices started to drop in February 2000 and ultimately lost 80% of their peak value by the end of 2000, equating to approximately $8 trillion in lost market value. The Internet bubble exhibited similar characteristics of previous bubbles, including over-inflated prices driven by speculative buying, subsequent selling by insiders, short selling made easier by significant increases in asset float, and an eventual crash in prices.
Speculative Manias: Many crises throughout history can be traced to the rampant speculation by investors in any number of assets or investment opportunities. Herbert Simpson in a 1933 paper discusses the urban boom and collapse in the period 1921–30:
The economic history of this country is colorful with recurring speculative epochs and episodes, growing out of varying conditions and with varying effects upon our economic structure and welfare. We have had periods of gigantic speculation in western lands; periods of oil and mining speculation; periods of bank speculation; and of railroad speculation.5
The term mania implies that investors are behaving irrationally. This contrasts with the rational expectations assumption, which holds that investors behave rationally and react to changes to economic variables as if they are fully aware of the long-term implications of such changes. This is an example of the long-used axiom that all available information about a company is fully reflected in its security price, as investors theoretically react immediately to any new news about the company. Many theories exist as to why investment manias occur. One example is groupthink, when all investors in a market change their views simultaneously and act together.
The South Sea Company of 1720: An example of an event that can be categorized as a speculative mania, which in turn led to an asset bubble, occurred in Britain in 1720. The South Sea Company had been given special rights by the British government to trade with Spain's American colonies, which resulted in an effective monopolistic position. The price of the company's stock rose 330% in a five-month period to £550. Following its success, several other companies attempted to enter this market and trade in the same stock market. The South Sea Company successfully convinced Parliament to approve what was called the Bubble Act of 1720, which prevented such firms from becoming publicly traded, further boosting their stock price to over £1,000. Insiders of South Sea Company realized the company's business opportunities did not support a price so high and started to sell, fueling a dramatic decline in the share price to below £100 before end of the year. Consider the following comment by Adam Smith about the South Sea Company crisis:
The evils of reckless trading are always apt to spread beyond the persons immediately concerned. When rumors attached to a bank's credit they make a wild stampede to exchange any of its notes which they may hold; their trust has been ignorant, their distrust was ignorance and fierce. Such a rush often caused a bank to fail which might have paid them gradually. The failure of one caused distrust to rage around others and to bring down banks that were really solid.6
The Great Depression: The 1921–30 period of investment speculation in the United States was
