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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Appendix B: Background Paper
Appendix B: Background Paper
Pages 82-106
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From page 82... ...
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 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.
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From page 83... ...
A recent report by the Group of Ten (2001) on financial sector consolidation defined systemic 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 episodes 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.
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From page 84... ...
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 wholesale 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 derivatives markets; providing asset management services; providing payments, settlement, and custodial services; and taking deposits.
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From page 85... ...
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 central bank and obtain cash on a short-term basis.
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From page 86... ...
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.
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From page 87... ...
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.
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From page 88... ...
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.
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From page 89... ...
At the same time, however, disintermediation has increased the importance 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)
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From page 90... ...
When asset prices drop sharply, there are generally some participants willing to "swoop in" and buy assets that have 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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From page 91... ...
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 failure 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)
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From page 92... ...
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.
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From page 93... ...
Although the extent to which such activity was responsible for stock price declines in October 1987 is heavily debated, there is little doubt that such strategies -- if widespread -- could create self-reinforcing market movements. Importance of Clearance and Settlement Arrangements Clearance and settlement mechanisms contributed greatly to the liquidity strains created by the large price declines across cash, futures, and options markets, and the resulting margin calls in the 1987 stock market crash.
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From page 94... ...
dollar payments were completed in the United States. This created a shortterm gridlock in the foreign exchange market that remained a source of systemic concern until the mid-1990s, when central banks made clear that the amounts of such "payment versus payment mismatch" were too large to be tolerated indefinitely and the large commercial banks invested in
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From page 95... ...
The Role of Central Banks Central banks have historically played a key role in ensuring that financial markets have sufficient liquidity to function effectively. They have several tools that can be used in this regard.
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From page 96... ...
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.
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From page 97... ...
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, contagion figured very prominently in the Asian crisis.
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From page 98... ...
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.
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From page 99... ...
While analysts differ in their views on whether the disorderly collapse 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?
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From page 100... ...
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.
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From page 101... ...
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.
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From page 102... ...
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 activities 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 relatively small number of organizations.
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From page 103... ...
Indeed, in the wake of 9/11, the Federal Reserve extended the operating 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 operations and to the system generally through open market operations.
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From page 104... ...
Not surprisingly, the potential systemic risk associated 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.
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From page 105... ...
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 securitization and derivatives as well as the increasing use of central counterparties and other specialist financial institutions that fill specific roles in the financial market infrastructure.
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From page 106... ...
1983. "Bank Runs, Deposit Insurance, and Liquidity." Journal of Political Economy 91, no.
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