New Directions for Understanding Systemic Risk A Report on a Conference Cosponsored by the Federal Reserve Bank of New York and the National Academy of Sciences (2007) / Chapter Skim
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2 Current Trends in Economic Research on Systemic Risk
2 Current Trends in Economic Research on Systemic Risk
Pages 20-28
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From page 20... ...
. Further, the conference organizers sought out analytical or theoretical papers that would show the conceptual underpinning of the literature on financial crises; empirical analyses of financial crises were not included.
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From page 21... ...
For instance, mark-to-market accounting is a risk management practice that makes trading performance transparent and prevents managers and traders from concealing losses while trying to gamble their way out of losing positions. Further, marking to market the value of trading positions combined with risk management loss limits that force a closeout of a losing position can prevent a loss from becoming large enough to bring down a firm. (Some bank failures and catastrophic investment fund losses are attributable to the failure to adhere to this basic risk management discipline.)
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From page 22... ...
The alleviation of the constraint short-circuits the wealth transfers that transmit the shock to others, reducing the likelihood of contagion. Risk and Liquidity in a System Context Hyun Song Shin of Princeton University examined how liquidity shocks can propagate through the linkages between balance sheets of financial institutions and securities prices.
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From page 23... ...
An equilibrium is a fixed point of these asset value equations. With the addition to the model of a target leverage ratio determined by, for instance, a risk management constraint, financial institutions will shrink or expand their balance sheets in response to shocks to their capital -- actions that will set off liquidity drains and lending booms.
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From page 24... ...
To examine endogenous illiquidity effects, the researchers assume that offsetting liquidity shocks exist: thus, in the initial period, a liquidity shock causes the price to deviate from fair value and, in the subsequent period, an offsetting shock occurs that restores the price to its initial fair value. In addition to liquidity shocks, a source of risk in the model is a fundamental shock that changes the fair value of the asset. Traders in the model buy and sell securities in an attempt to profit from the liquidity shocks and, in so doing, provide liquidity to the market.
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From page 25... ...
Discussion Herdlike Behavior and Incentives for Contrarian Trading Strategies The three presentations summarized in this chapter highlighted the positive feedback effects that produce herdlike behavior in markets, and the subsequent discussion focused in part on means of encouraging heterogeneous investment strategies to counter such behavior. Investors who sit on the sidelines during boom times will not be weakened by the inevitable downturn and will be well positioned to profit by entering the market to buy assets at distressed prices.
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From page 26... ...
In addition, the models can be either comparative static models or dynamic models: The former analyze Examples of such liquidity provision are the discount window lending facilities at central banks that provide emergency liquidity to banks, and the repo options that the Federal Reserve made available to nonbanks to address concerns about liquidity shocks associated with the Y2K vulnerability in computing systems.
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From page 27... ...
Adequacy of Buffers Against Systemic Shocks in the Financial System A third discussion topic that drew considerable interest was whether competitive pressures and risk management practices are undermining the robustness of the financial system. More sophisticated methods of assessing collateral and margin requirements in the financing of trading positions may be lowering the overall margin and collateral amounts held against these exposures.
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From page 28... ...
A critical risk management issue here is the treatment of correlation assumptions in determining margin amounts for a portfolio of diverse assets. Correlations among asset prices can change radically in a crisis.
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