Systemic Financial Crisis: What Are the Odds of Another Collapse?

Categories: Systemic Risk
Preventing-Catastrophe.jpg

The 2008 financial crisis dealt the most serious threat to the world economy since the Great Depression. Fortunately officials, particularly those from the Federal Reserve, were able to avoid even greater fallout by applying the liquidity lessons learned decades earlier. Nonetheless, excessive trust in the large financial institutions and the resiliency of the financial system gave both regulators and the public a false sense of security and promoted complacency in the years leading up to the crisis.

Although we’ve made progress, has it been enough? What are the known and unknown risks that could lead to a financial system collapse? And is there an obvious “elephant in the room” that no one is willing to acknowledge?

CFA Institute and the New York Society of Securities Analysts recently held a half-day conference to consider these very issues. The event, titled “Systemic Risk Conference: What are the Odds of Financial Collapse?” brought together experts from around the financial world with expertise in analyzing and dealing with systemic risk. The speakers discussed the major risk factors in today’s financial system — what has been fixed and what still requires attention. (CFA Institute also co-sponsors with The Pew Charitable Trusts the Systemic Risk Council, a private-sector, nonpartisan body of former government officials and financial and legal experts committed to addressing regulatory and structural issues relating to systemic risk in the United States.)

Panelist Barbara Novick, co-founder and vice chair of BlackRock, discussed the reforms and safeguards that have been put in place since the financial crisis to make the financial system safer. Higher capital and liquidity requirements for financial institutions, together with the central clearing of derivatives, improved cash investing rules, and the registration of alternative investment funds (so there is at the very least someone to talk to in an emergency) have resulted in a safer financial system.

Firm Size and Systemic Risk: Is There a Correlation?

Novick noted that some of the concerns raised about certain aspects of the financial system are based on flawed reasoning, saying that the sheer size of some financial institutions has made them targets for concern and potential regulation, even though their contributions to potential systemic failure is low. Most mutual fund companies and large firms like BlackRock are indeed large, but she stressed that they invest on behalf of their clients in a diverse portfolio globally, and therefore rarely hold concentrated risks. Novick cited the example of the departure of Bill Gross, CFA, from PIMCO as a seismic event at a large firm that that firm, and the market, absorbed in an orderly fashion in a matter of days without any significant market disruption. (See related CFA Institute commentary on the designation of asset managers as significantly important financial institutions, or SIFIs.)

Novick also noted that policymakers need encouragement to identify the specific risks that need to be addressed, which she suggested requires greater focus on industrywide products and practices as well as market structure. Creative solutions will come with a better understanding of the complexities of markets.

What Role Does Moral Hazard Play?

Nick Gogerty, CAIA, is the author of The Nature of Value: How to Invest in the Adaptive Economy and is the founder of Thoughtful Capital Group. He spoke about moral hazard and the US residential credit process. He defined moral hazard broadly as any time someone gets paid today and someone else takes the risk later. Gogerty focused much of his commentary on the credit crisis brought about by the recent housing bubble in the United States. He focused on three main questions: 1) How to think about house price and value; 2) How the proper credit creation process works; and 3) How moral hazards can break it, and considered the effects of the crisis and the breakdown in the credit process in a historical context and where we are today.

Gogerty noted that we helped create a new financial machine leading up to the financial crisis that was accelerated with “creditization.” The leverage inherent in the creditization system, coupled with lax lending standards, should not have created a black swan event that no one saw coming, but was a rather obvious problem for those willing to take an honest accounting of the markets. Gogerty laments that we have made the system more complex with our reactions to the crisis — including regulation such as Dodd–Frank, when what is called for is a more simplified system where risks and systemic correlations can more readily be recognized.

How Can We Better Manage Risk?

Gogerty noted that the US housing market may be more fairly valued today than pre-crisis. At the same time, however, he suggested that the Canadian housing market is one that is potentially in a bubble, as well as possibly China, although the data from China is harder to get and difficult to confirm.

Rick Bookstaber took the podium to discuss Risk Management 3.0. Bookstaber holds a PhD in economics from MIT and is an expert in financial risk management, and is currently working in the Office of Financial Research of the US Treasury. He is the author of the book, A Demon of Our Own Design, which foresaw the vulnerability of the market arising from growing leverage and complexity.

Bookstaber noted that people would likely be more willing to buy assets and stop a cascading crisis (be willing to catch the proverbial “falling knife”) if they had better risk models. His contribution to the goal is an agent-based model for analyzing the vulnerability of the financial system to asset- and funding-based crises. Such a model views the dynamic interactions of agents in the financial system.

Bookstaber explained that it is the reaction to initial losses rather than the losses themselves that govern how pronounced a crisis becomes. Though such an exercise is complex, by understanding and modeling a map of the interactions of actors in the financial system, the agent-based model could provide a risk management tool that could help us better understand a future crisis resulting in fire sales and funding runs.

Emily Eisenlohr, CFA, author of Fairy Tale Capitalism: Fact and Fiction behind Too Big to Fail, spoke about systemic risk, credit, and derivatives. Eisenlohr, a former senior credit officer at Moody’s Investors Service, described the concentration of bank balance-sheet assets among the biggest six banks. At these same banks, the derivatives positions dwarf actual assets on the balance sheet.

In her slide presentation Eisenlohr offered a tongue-in-cheek, but documented recipe for brewing systemic risk:

  • Mix trading and the FDIC guarantee
  • Turn up the heat on competition
  • Add mergers
  • Season with financial engineering

Noting that, in general, $1 of bank capital supports about $7 in loans but many times that in derivatives notional amounts, Eisenlohr wondered about the impact of derivatives proliferation. She emphasized that derivatives are financial engineering products that do not support the economy in the same ways that loans do.

Finally, Lawrence Goodman, president of the Center for Financial Stability, spoke on global markets and global risks. He noted that the odds of a financial collapse or another financial crisis are small but not insignificant, and warrant active monitoring.

What Are the Unintended Consequences of Reform?

Goodman stated that unintended risks from recent policy measures may threaten the stability of the financial system and hinder growth — citing quantitative easing as an example. He said that despite ample monetary liquidity, there remained a shortage of financial market liquidity. Goodman was hopeful, however, feeling that solutions are in sight, including better international cooperation.

Goodman emphasized that we need to do a better job of understanding consequences of our actions and behaviors if they have an adverse effect on markets. To reduce risks, Goodman suggested three solutions:

  • Implement measures to partially restore financial market liquidity
  • Exit smoothly and resolutely from distortionary monetary policies
  • Embrace international cooperation

In sum, systemic market remains a complex matter that incorporates many different factors, from liquidity, leverage, concentration, and size, to how market participants and regulators interact with each other. Understanding one piece and responding to one aspect of a systemic threat is unlikely to answer every question and may even lead to different, but potentially more intractable problems down the road. Nevertheless, understanding how the relevant parts work is the only way to get to a workable solution. This conference provided a good start in that direction.


If you liked this post, consider subscribing to Market Integrity Insights.


Image credit: Paul Blow, 2014

 

Tags:

Leave a comment

Your email address will not be published. Required fields are marked *