8 December 2015 Market Risk: Understanding and Managing Tail Events
Exploring Tail Risk in Financial Catastrophe
Dr Scott Kelly Senior Research Associate Centre for Risk Studies Session Agenda
Exploring tail risk in financial catastrophe – Dr Scott Kelly, Senior Research Associate Four Cambridge Financial Catastrophe Scenarios
Asset Bubble Eurozone Meltdown Collapse Dr Ali Shaghagi Dr Olaf Bochmann Research Assistant Research Associate
Dollar Deposed High Inflation World Dr Jay Jung Jaclyn Zhiyi Yeo Risk Researcher Research Assistant
2 Cambridge Financial Stress Test Scenarios Global Property Crash Sudden collapse of property prices in the inflated property markets and this triggers a cascading crisis throughout the global financial system
Eurozone Meltdown The default of Italy is followed by a number of other European countries, leading to multiple cession from the European Union and causing an extensive financial crisis for investors
High-Inflation World A series of world events puts pressure on energy prices and food prices in a price increasing spiral, which becomes structural and takes many years to unwind
Dollar Deposed US dollar loses its dominance as the default trading currency as it becomes supplanted by the Chinese Renminbi, with rapid unwinding of US Treasury positions and economic chaos
3 Cambridge Stress Test Scenarios Context A justification and context for a 1% annual probability of occurrence worldwide based on historical precedents and expert opinion
Timeline & Footprint Sequencing of events in time and space in hypothetical scenario Narrative Detailed description of events 3-4 variants of key assumptions for sensitivity testing Loss Assessment Metrics of underwriting loss across many different lines of insurance business
Macroeconomic Consequences Quantification of effects on many variables in the global economy
Investment Portfolio Impact Returns and performance over time of a range of investment assets
4 The Baseline Outlook is Positive 90
80 Trillion US$ 70 60
50
40
30
20
10
0 1980 1990 2000 2010 2020 Global GDP 1980: $22.5 Trillion Historical Average Annual Growth Rate 1980-2006: 3.0% Global GDP 2013: $55.6 Trillion OE Economic Forecast Global GDP 2025 (US$ 2015): $80.5 Trillion Forecast Size of Global Economy in 2025, relative to today: 130% Forecast Average Annual Growth Rate 2014-2025: 3.1% 5 South Sea Bubble 1720 But the Road to Growth is Rocky World War II 1939
10,000
American Revolution 1,000 1775-1783
100 Credit Crunch 2008
10
Spanish Flu Pandemic 1918
1
Source: Jay (2010) http://fintrend.com/tag/bear-market/
1700 1750 1800 1850 1900 1950 2000
6 Stock Market Contagion: 24 Aug 2015 Shanghai New York London
FTSE DOW SHCOMP -10% -27% -11%
Kuala Lumpur Frankfurt Mumbai
BSE KLI DAX -6% -4% -5%
7 2007-12 Great Financial Crisis
90 80
Trillion 70 60 50 40 30
20 Historical GDP Levels Predicted (after crisis) Global GDP ($US, 2005) Global GDP 10 Predicted GDP Levels (Prior to Financial Crisis) 0 2000 2005 2010 2015 2020 2025
GDP@Risk: 20 Trillion ($US, 2010) GDP@RR: 6.82% The Economic Burden of Financial Catastrophes 70 The Great Financial Crisis of 2008 Great Financial Crisis of 2008 destroyed an estimated $20 Trillion of Trillion world economic output 60 – It was the most recent crisis, and the most severe, for some time Financial crises occur periodically, with 50 Historical GDP Levels different causes, and different severities Predicted (after crisis) Predicted GDP Levels (Prior to Financial Crisis) – In the past generation, we have had a financial 40 GlobalGDP ($US, 2005) crisis every 8 years on average 2000 2005 2010 2015 We estimate that the financial burden of crises averages $0.5 Trillion of lost economic output per year – This is around 1 percentage point of global economic output – Without financial catastrophes global growth could be 4% a year instead of 3% Financial catastrophes are the single greatest economic risk for society – Why don’t we understand them better?
9 What is Tail Risk?
Classical Definition
Type 1 tails… Short term tail risk
Catastronomics Definition
100
Type 2 tails… 80 Long term tail risk 60
40
20
0 2000 2005 2010 2015 2020 2025
10 Estimating GDP@Risk
70 Trillion Crisis GDP US$ Trajectory 65 Global GDP
60 GDP@Risk Impact
55
Recovery 50 2012 2013 2014 2015 2016 2017 2018 2019 2020
GDP@Risk: Cumulative first five year loss of global GDP, relative to expected, resulting from a catastrophe or crisis
11 Learning from History
A key component of understanding financial crises is the study of past events What happened, and what drove them? What-If… they were to happen today? Technologies have changed, but human behaviour remains – crowd behaviour What does it tell us about the past frequency and severity of crises? What might the future frequency and severity of crises be? 12 Historical Financial Crisis
Publication in preparation
12 Historical Catalogue of Financial Crises
1. 1720s Crises (South Sea, Mississippi Scheme, Windhandel) 2. 1825 UK Country Bank Crisis 3. 1857 Panic (USA) 4. 1866 Collapse of Overend and Gurney 5. 1873 Crisis (USA) 6. 1890 Baring Crisis 7. 1907 US ‘Bankers’ Panic’ 8. 1914 Financial Crisis 9. 1931-33 and the Great Depression 10. Early 1980s Latin American Debt Crisis 11. 1997-99 Asia crisis, 12. 2008 Global Financial Crisis
13 Data Sources
Collected data over period 1800 - 2015 Data is problematic – sparse, inconsistent, unconnected, incomplete and sometimes dubious….
Source Period Data Collected: Hills, Thomas, and Dimsdale (2015) Website: • GDP http://www.centerforfinancialstability.org/hfs.php 1830-2010 • Inflation Janssen et al (2002), Mitchell (1988). 1703-1755 • Unemployment Bank of England and ONS. 1800-2012 Schumpeter-Gilboy index from Mitchell(1988), 1750-1975 from ONS • Government Debt (O'Donoghue et al (2004)), 1975-2009 CPI (ONS and Bank of England) 1688-1750 • Bond interest rates Mitchell (1988) and ONS (series code BKQK) 1800-2010 • Exchange rates Feinstein (1972), ONS (code BCJE) 1855-2010 Mitchell(1988), Chapter XVI, Table 5 pages 831 to 8350 Sefton and • HH consumption Weale (1995), Table A2ONS: Series Code IKBI 1830-2008 • Exports / Imports Capie and Webber (1985) and Bank of England/ONS 1870-2009 • Balance of payments BP Statistical Review of World Energy 2010 1861-2013 • Money Supply Reinhart, Camen M. and Kenneth S. Rogoff, “From Financial Crash to Debt Crisis,” NBER Working Paper 15795, March 2010. Forthcoming in • Equity Index American Economic Review. 1800-2009 • Population www.measuringworth.com 1800-2012 Three Centuries of Data, Bank of England (2012) 1700-2012 • Oil Price
14 US and UK Equity Index (1800-2015)
14 US Equity Index
12 UK Equity Index
10
8
6
4 Equity 1800= (Log ScaleEquity Index 1) 2
0 1801 1821 1841 1861 1881 1901 1921 1941 1961 1981 2001 2015 1914 Financial Crisis Asian Crisis Country Banking Crisis The Great Depression 2008 GFC
15 Two Centuries of Financial Crisis
Annual Crisis Count (1800 - 2015) 0 20 40 60 80 100 120 140 160
Currency Crisis United States United Kingdom Inflation Crisis
Asset Bubble
Sovereign Crisis
Banking Crisis
Total
Currency: 15% devaluation Sovereign crisis: Failure to make payment Inflation: 20% Increase in prices Banking crisis: One significant bank fails Asset bubble: 25% drop in returns
Source: Reinhart, Camen M. and Kenneth S. Rogoff, “From Financial Crash to Debt Crisis,” NBER Working Paper 15795, March 2010. Forthcoming in American Economic Review. 16 GDP Growth Rates
2008 Subprime
1997 Asian Crisis
1983 Latin American Debt Crisis
1929 Wall Street Crash
1907 Knickerbocker
1893 Baring Bank Crisis
1873 Long Depression
1866 Collapse of Overend and Gurney
1857 Railroad Mania Bubble US
United States 1845 Railway Mania Bubble UK
United Kingdom 1825 Latin American Crisis
-25.0% -20.0% -15.0% -10.0% -5.0% 0.0% 5.0% 10.0%
17 Duration of Stock Market Impact from Crises
6 years (UK) 14.25 years (UK) 22.6 years (UK) 2008 GFC 1825 UK Country Bank Crisis 1873 Long Depression 12.8 years (UK) 25 years (USA) 1907 US ‘Bankers’ Panic’ 19.6 years (US) 1890 Baring Crisis 1929 Great Depression
0%
-20%
-40%
-60%
-80%
-100% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Years
18 Multiple Crisis Occur Simultaneously
Peak to Crisis Type Trough Loss Year Crisis UK US Asset Sovereign Currency Inflation Banking Bubble Crisis Crisis Crisis Crisis
1720 South Sea Bubble 80% - x x 1825 The Country Banking Crisis 43% 3% x x x 1845 Railway Mania Bubble UK 9% 5% x x 1857 Railroad Mania Bubble US 13% 23% x x 1866 Collapse of Overend and Gurney 7% 6% x 1873 Long Depression 33% 47% x x 1890 Baring Bank Crisis 9% 42% x x x 1907 US ‘Bankers’ Panic’ 19% 26% x x 1929 Wall Street Crash 52% 85% x x x 1983 Latin American Debt Crisis 5% 20% x x x x 1987 Black Monday 31% 30% x 1997 Asian Crisis 12% 6% x x x x x 2008 Great Financial Crisis 44% 48% x x x
19 Taxonomy of Financial Crisis
Complex / Technological Flash crash Inflation Black box trading Cost-push inflation Complex derivatives Demand-pull inflation Cyber crash Deflation
Banking Crisis Systemic failure Bank run Currency Crisis Credit crunch Reserve currency FX shock
Asset Bubble Stock market crash Commodity price bubble Debt Property price bubble Sovereign Debt Private Debt Illegal Activity Fraud Financial irregularity 20 Equity and GDP at Risk
Equity Value at Risk (1800 - 2010)
1% 5% Mean US Equity VaR 35.7% 23.6% 5.7%
UK Equity VaR 19.9% 12.8% 4.6%
GDP Value at Risk (1800 - 2010) 1% 5% Mean
US GDP at Risk 12.7% 7.4% 5.3%
UK GDP at Risk 5.1% 3.0% 2.0% US Distribution of Returns
21 Historical Severities of Crashes – Past 200 Years
US Stock Market Crashes UK Stock Market Crashes
1845 Railway Mania… 1845 Railway Mania… 1997 Asian Crisis 1997 Asian Crisis 1866 Collapse of Overend… 1866 Collapse of Overend… 1825 Latin American Crisis 1825 Latin American Crisis 1983 Latin American Debt… 1983 Latin American Debt… 1837 Cotton Crisis 1837 Cotton Crisis 1857 Railroad Mania… 1857 Railroad Mania… 1907 Knickerbocker 1907 Knickerbocker 1987 Black Monday 1987 Black Monday 2001 Dotcom 2001 Dotcom 1893 Baring Bank Crisis 1893 Baring Bank Crisis 1973 Oil Crisis 1973 Oil Crisis 1873 Long Depression 1873 Long Depression 2008 Great Financial Crisis 2008 Great Financial Crisis 1929 Wall Street Crash 1929 Wall Street Crash
0% 20% 40% 60% 80% 100% 0% 20% 40% 60% 80% 100% Stock Market Crash Peak to Trough Stock Market Crash Peak to Trough
Observed, last 200 years Observed, last 200 years Crashes Number of Average Crashes Number of Average Greater Than Crises Interval (Yrs) Greater Than Crises Interval (Yrs) 10% 12 16 10% 11 17 20% 9 21 20% 8 24 40% 6 32 40% 5 38 50% 1 190 50% 2 95
22 Modelling Historical Financial Crises
100
95
90
1893 Baring Bank Crisis 85 1873 Long Depression 2008 Great Financial Crisis 80
75
70 1929 Wall St Crash
GDP (US$ 2010,GDP Tn) 1907 US ‘Bankers’ Panic’ 65
60 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2015 2016 2017 2018 2019 2020 2021 2022 2023
23 What is a scenario stress test?
. Scenarios use narratives that pose ‘what if’ questions and explore views about alternative futures. . Help deal with complexity and uncertainty . Release us from conditioning and existing habits that may inhibit new actions and insight . Bring together creativity and analytics . Not predictions, or forecasts . Coherent and plausible expectations about the future . Used to improve business resilience to shocks
24 Seven Critical Characteristics of Stress Tests
Improbable Coherent
Quantifiable Relevant Plausible
Includes Challenging Variation
25 Historical & Scenarios: GDP@Risk
GDP@Risk US$ Trillion, 2010 prices GDP@Risk 1893 Baring Bank Crisis 5 1873 Long Depression 7 1907 US ‘Bankers’ Panic’ 14 2007 Great Financial Crisis 20 1929 Wall Street Crash 30 CRS Dollar Deposed 2-3 CRS High Inflation World 5-11 CRS Eurozone Meltdown 6-20 CRS Global Property Crash 11-33
26 Cambridge Scenarios: GDP@Risk GDP@Risk US$ Trillion S1 S2 X1 Geopolitical Conflict China-Japan Conflict 17 27 32 Asset Bubble Shock Global Property Crash 13 20 30 Pandemic Sao Paolo Virus 7 10 23 Sovereign Default Shock Eurozone Meltdown 11 16 23 Food and energy price spiral High Inflation World 5 8 11 Cyber Catastrophe Sybil Logic Bomb 5 7 15
Social Unrest Millennial Uprising 2 5 8
De-Americanisation of Financial System Dollar Deposed 2 2 -2 2007-2012 Great Financial Crisis 18 Great Financial Crisis at 2014 20 27 Without financial catastrophes the world’s economy would grow a third faster than it does today – Financial crises impose burden of 1 percentage point on economic growth per year
Financial catastrophes are the single greatest risk to economic output in our threat universe – Everyone should care about them, not just banks and regulators
The tools for practitioners to understand and manage financial catastrophes are currently inadequate – The Centre for Risk Studies is assisting in the development of better analytics for financial catastrophe risk management
‘Contagion’ is the key unknown in understanding financial catastrophe risk – Maps of the financial universe need to be combined with laws of human behaviour 28