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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1 Introduction
1 Introduction
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Accordingly, in May 2006 a conference cosponsored by the National Academy of Sciences and the Federal Reserve Bank of New York was convened in New York to promote a better understanding of systemic risk. The sessions brought together a broad group of scientists, engineers, economists, and financial market practitioners to engage in a cross-disciplinary examination of systemic risk that could yield insights from the natural and physical sciences useful to researchers in economics and
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Transitioning from a Bank-Based to a Market-Based Financial System Financial market practitioners began the conference by highlighting various aspects of systemic risk and systemic events in the financial system. The topics of the presentations ranged from historical systemic episodes, such as the liquidity crisis of 1998 and the failure of LTCM, to risk assessment techniques, such as value-at-risk (VaR)
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Crises in this more market-based financial system, such as the stock market crash of October 1987 and the market liquidity crisis of 1998, fit a general pattern of rapid decline in the price of some asset or class of assets, leading to a drop in liquidity. The result is contagion, in the form of further sympathetic price declines and a shift in market conditions marked by severely reduced financial market activity and potential negative effects on the real economy.
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As the relative importance of banks as financial intermediaries has declined with the growth of market-based financial intermediation, market-based systemic events such as the stock market crash of 1987 and the failure of LTCM have shifted the emphasis from funding liquidity to market liquidity. Moreover, as Federal Reserve Board Governor Donald L
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In aggregate, the firms' actions combine to reduce financial market activity severely as asset prices fall, possibly harming the real economy in the process as the provision of financial services to otherwise creditworthy entities is curtailed and declines in asset prices impact firms' balance sheets. As Governor Kohn explained, the stock market crash of 1987 followed this pattern: simultaneous efforts to reduce equity market exposures were followed by a broad pullback in all risk taking.
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nonlinearities in expectations and investment decisions can lead to sharp changes in the volatility and covariation of asset prices in an apparent regime shift, as discussed by risk managers below in this introduction. This commonality between financial and other complex adaptive systems points to the broad social importance of the study of systemic events.
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Somewhat analogously, in financial markets, an exogenous change in the economic environment can lead to new profit opportunities in certain assets that attract capital and, if investment in the assets is excessive, to an asset price bubble vulnerable to a change in investor confidence. If a shock triggers a collapse of asset prices, there is a risk of a broader contraction if the normal self-correcting features of markets fail to work.
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For example, Thomas Daula of Morgan Stanley described systemic events as regime shifts in which periods of extreme volatility combine with losses of liquidity to produce solvency risk. These crisis periods, according to Daula, "are characterized by very sharp increases in correlations and, therefore, they look and feel a lot like a regime shift -- and a regime shift where you are moving from a normal regime, where there are relatively low correlations amongst financial markets, to a different regime, where you have extremely high volatility and a sharp spike in correlation." Under such regime shifts, the normal assumptions culled from historical experience that guide day-to-day trading break down.
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Thus, the notion of systemic risk, which financial market participants are at least viscerally acquainted with, can be worked into the framework of complex systems research from other fields. While conference participants from the financial industry agreed on the "look" and "feel" of systemic episodes, there was some diversity of opinion on the more academic question of what actually constitutes systemic risk or a systemic event.
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As Governor Kohn stated: "The natural inclination is to take more intrusive actions that minimize the risks of immediate disruption, and this inclination is probably exacerbated by ignorance and uncertainty." He explained that too much regulation could harm efficiency or generate moral hazard as market participants begin to take regulators' corrective measures for granted and increase risk taking. For example, they may fail to engage in adequate due diligence when extending credit or fail to maintain adequate capital for the risks they undertake.
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In their role as providers and conduits of liquidity, healthy banks can be bulwarks against the propagation of financial turmoil. As a crisis manager, the Federal Reserve can avert many problems by monitoring conditions and identifying risks as they arise. Indeed, as Governor Kohn explained, a common element in the Federal Reserve's response to both the 1987 stock market crisis and the 1998 liquidity crisis Federal Open Market Committee Statement, September 29, 1998 ( |
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First, both began with sharp movements in asset prices that were exacerbated by market conditions -- portfolio insurance in 1987 and the closing out of positions in 1998. Second, market participants became highly uncertain about the dynamics of the market, the true value of assets, and the future movement of asset prices.
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The goal was to capture a small yield differential in relative asset prices, allowing LTCM to earn steady returns as relative prices converged to fair values while the fund avoided directional risk. At the time at least, this strategy was considered somewhat state-of-the-art, and many financial entities attempted to emulate it, if not to mirror LTCM's positions outright.
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The process also illustrates the importance of linkages and nonlinearities in systemic events: Even though Russian instruments were a small proportion of LTCM's overall portfolio, market participants began to question their own rationale for holding other, non-Russian positions that LTCM also held. Thus, they
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According to Governor Kohn, this points to a crucial role for policymakers: Heightened uncertainty is the key characteristic of episodes of financial instability. The central bank may not have any more information than market participants do.
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Governor Kohn added that, in a market-based system, sound risk management by all market participants is essential to protect against the risk of a low-probability -- or "tail" -- event causing a financial crisis. For example, the bringing together of practitioners in risk management policy groups can potentially lead to improved reporting of risk information to
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The presentations by financial market participants addressed these issues in discussions of scenario analysis. Scenario analysis, as Daula explained, is the primary tool that market participants use to examine the risks posed by systemic events.
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Needless to say, any such analysis must be very careful in its assumptions of probability distributions.10 Researchers and policymakers face many challenges in arriving at a better understanding of systemic risk in our evolving securities-marketdominated financial system. Market participants and regulators face a dual problem: They must determine the factors that can trigger contagion, the prospect for sudden regime shifts, and the potential for hysteresis; they must also craft policies that strengthen resilience to the threat of systemic events in a way that neither predisposes the system to even larger disruptions nor imposes unjustifiable costs on market participants.
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" Federal Reserve Bank of New York Current Issues in Economics and Finance 5, no. 12 (August)
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