Market Risk: Systemic Risk A. Michael Spence
Market Risk: Systemic Risk A. Michael Spence
Market Risk: Systemic Risk A. Michael Spence
- 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