Market Risk: Systemic Risk A. Michael Spence

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Market risk

- The risk of this collapse (“systemic risk”) is, more generally, regarded as 
the risk that an economic shock — in the present case, the subprime 
mortgage crisis — can trigger a chain of market and/or financial 
institution failures, resulting in increases in the cost of capital or 
decreases in its availability. Because systemic risk is positively 
correlated with markets, investors cannot diversify it away. 
 
- systemic risk: The aggregate effect of these and other risks has recently been called
systemic risk​. According to Nobel laureate Dr. ​A. Michael Spence​, "systemic risk escalates in
the financial system when formerly uncorrelated risks shift and become highly correlated.
When that happens, then insurance and diversification models fail. There are two striking
aspects of the current crisis and its origins. One is that systemic risk built steadily in the
system. The second is that this buildup went either unnoticed or was not acted upon. That
means that it was not perceived by the majority of participants until it was too late. Financial
innovation, intended to redistribute and reduce risk, appears mainly to have hidden it from
view. An important challenge going forward is to better understand these dynamics as the
analytical underpinning of an early warning system with respect to financial instability."​[60] 
 
Two elements of systemic risk  
1.) There was excessive maturity transformation through conduits and 
structured-investment vehicles (SIVs).  
- When this broke down, the overhang of asset-backed securities that had 
been held by these vehicles put significant additional downward 
pressure on securities prices. 
- The extent of leverage and of maturity transformation in real-estate 
finance on the basis of mortgage-backed securities. 
- :The leverage of hedge funds. On the order of 50% on average, was 
dwarfed by the leverage of the conduits and SIVs that had been set up 
by the banking industry for the purpose of investing in asset-backed 
securities. 
- Moreover, while these institutions were investing in long-term securities, 
they refinanced themselves by issuing asset-backed commercial paper - 
very short-term debt, and were in constant need of refinancing. 
- When there is a shock to the availability of funds for refinancing, the 
individual institution is in trouble because it needs funds to repay its 
short-term debt. 
2.) As the financial system adjusted to the recognition of delinquencies and 
defaults in US mortgages and to the breakdown of maturity transformation of 
conduits and SIVs, the interplay of market malfunctioning or even breakdown, 
fair value accounting and the insufficiency of equity capital at financial 
institutions and finally systemic effects of prudential regulation created a 
detrimental downward spiral in the overall financial system. 
 
 
https://link.springer.com/content/pdf/10.1007%2Fs10645-009-9110-0.pdf 
1.) There was excessive maturity transformation through conduits and 
structured-investment vehicles (SIVs).  
- Banks and other financial institutions had a market risk because of 
leverage. 
- They are highly leveraged by issuing debt more than selling equity. 
- During the housing boom, many banks and hedge funds invested heavily 
invested in mortgage that related securities finance with their holdings 
by borrowing heavily in debt markets. 
- Before crisis, investment banks highly leverage with debt-to-equity 
ratios of 25 to 1. 
 
 
1. systemic risk is leverage. Compared with most nonfinancial firms, 
banks and other financial institutions are highly lever- aged—that is, they 
fund a substantial portion of their assets by issuing debt rather than 
selling equity. During the housing boom, many banks, hedge funds, and 
other firms that invested heav- ily in mortgage-related securities 
financed their holdings by borrowing heavily in debt markets. 
Investment banks were especially highly lever- aged before the crisis, 
with debt-to-equity ratios of approximately 25 to 1. That is, for every 
dollar of equity, investment banks issued an average of $25 of debt. 
2. Bank had a systemic risk because they finance their holdings of 
relatively illiquid long-term asset with short-term debt.  
- the mismatch in the maturities of their assets and liabilities can cause 
the risk to the interest rate or liquidity shocks. 
- Most financial intermediaries borrow short and lend long but they fund 
long-term illiquid investments with short-term debt.  
- Many investment banks and securities firms rely heavily on commercial 
paper (repurchase agreements: repos), and other short-term funding 
sources to finance long-term investments. 
- So, when the lender cannot purchase a repos, the bank could be forced 
to bankruptcy. 
- Many firms 
- Many investment banks and securities firms rely heavily on com- 
mercial paper, repurchase agreements (repos),15 and other short-term 
funding sources to finance long-term investments. If depositors 
suddenly pull their funds from a commercial bank or lenders refuse to 
purchase a securities firm’s commercial paper or repos, the bank or 
securities firm could be forced into bankruptcy. Bear Stearns collapsed 
when investors refused to purchase the firm’s short-term debt. Other 
firms faced sharply higher funding costs in 2007-08 as markets 
reevaluated the creditworthiness of borrowers. The speed with which 
the markets can “turn off the tap” makes financial institutions especially 
vulnerable to temporary disruptions of liquidity in financial markets.16 
 
3. A third reason why the financial sector is especially vulnerable to 
systemic risk is the ten- dency of financial firms to finance their 
holdings of relatively illiquid long-term assets with short- term debt. Not 
only are financial institutions typi- cally highly leveraged, but the nature 
of their business entails an inherent mismatch in the maturities of their 
assets and liabilities that can make them vulnerable to interest rate or 
liquidity shocks. Most financial intermediaries borrow short and lend 
long—that is, they fund long-term, relatively illiquid investments with 
short-term debt. For example, commercial banks tradition- ally have 
used demand deposits, which deposi- tors can withdraw at any time, to 
fund loans and other long-term investments. Many investment banks 
and securities firms rely heavily on com- mercial paper, repurchase 
agreements (repos),15 and other short-term funding sources to finance 
long-term investments. If depositors suddenly pull their funds from a 
commercial bank or lenders refuse to purchase a securities firm’s 
commercial paper or repos, the bank or securities firm could be forced 
into bankruptcy. Bear Stearns collapsed when investors refused to 
purchase the firm’s short-term debt. Other firms faced sharply higher 
funding costs in 2007-08 as markets reevaluated the creditworthiness 
of borrowers. The speed with which the markets can “turn off the tap” 
makes financial institutions especially vulnerable to temporary 
disruptions of liquidity in financial markets.16 
4. http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.211.7022&re
p=rep1&type=pdf 
 

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