Systemic Risk Centre

SYSTEMIC RISK: WHAT RESEARCH TELLS US AND WHAT WE NEED TO FIND OUT Systemic Risk Centre

Published by Systemic Risk Centre The London School of Economics and Political Science Houghton Street London WC2A 2AE

All rights reserved. Requests for permission to reproduce the articles should be sent to the editor at the above address. The support of the Economic and Social © Systemic Risk Centre 2015 Research Council (ESRC) in funding the Designed by DesignRaphael Ltd SRC is gratefully acknowledged Illustrations pgs 9/11/20/26/28 by Judith Allan [grant number ES/K002309/1]. 1 SystemicSystemic RiskRisk CentreCentre Key messages

The global financial crisis Policy responses The autumn of 2008 was not the first time that the world Laws, rules and regulations drawn up ostensibly to bolster has faced systemic risk. The threat and, at times, its financial stability and limit the build-up of risk can often realisation have been present ever since the first financial become a channel for amplification mechanisms that system was created and they are an inevitable part of any have precisely the opposite effect. This occurs when market-based economy. multiple rules have inconsistent objectives and interact in unpredicted ways. Often these perverse consequences The challenge for can remain hidden until it is too late, and this can occur policy-makers in particular when policies are drafted hastily in response Society faces a difficult dilemma when it comes to to a crisis. systemic risk. We want financial institutions to participate in economic activity and that means taking risk. We also want Financial engineering financial institutions to be safe. These two objectives are The financial system is often compared to an engineered mutually exclusive. structure. Before the crisis, this led to a degree of complacency among policy authorities and private Endogenous risk market participants as advances in financial models The key insight from the emerging field of systemic risk is and regulations seemed to have reduced the problem that the threat comes not from outside the financial system of overseeing the financial system to a well-understood and the economic, social, political and legal setting in engineering exercise. Just as buildings, machinery and which it is embedded; rather, it comes from interactions other engineered structures can be made safe, so too can within the system, possibly amplified by the structure of the finance – or so it was thought. system and the ‘rules of the game’ established by the policy authorities at national and international level. Risk modelling Before the crisis, a common view was that risk forecasting Amplification mechanisms and risk management technologies had matured to such an Amplification mechanisms: Within the financial system, a extent that we could effectively prevent extreme outcomes small event can turn into a major crisis – a systemic event in financial markets. In other words, we had reached a level – while a much larger shock may whimper out into nothing. of permanent low volatility in financial markets. The crisis Behind those shocks that become systemic events is the demonstrated the folly of such thinking: just about every presence of mechanisms that amplify and/or accelerate the risk forecasting model failed miserably and the crisis caught impact through the rest of the financial system – ‘positive almost everybody by surprise. feedback loops’. Pro-cyclicality Financial networks Prior to the crisis, perceived risk – the risk reported by The nature and extent of the interrelationships of markets most risk models – was biased downwards, giving a too and market participants influence the manner by which optimistic view of the world; after the crisis, it became too positive feedback loops grip the entire system. Network high, making everyone too pessimistic and curtailing risk- theory can be used to understand the strategic interaction taking at exactly the wrong time. This is one manifestation of banks and the systemic implication of an individual bank’s of the ‘pro-cyclicality’ of endogenous risk – where the behaviour within a financial network: systemic risk is not behaviour of market participants and policy authorities necessarily driven by those that are the largest borrowers or amplifies the volatility of the financial system. most likely to default. 2 SystemicSystemic RiskRisk CentreCentre

Model diversity The legal dimension If banks are forced to have the same regulator-approved The legal system is one of the most important mechanisms standard risk models, they will all analyse shocks in the for exposing hidden endogenous risk. Financial contracts same way, and react in the same way, amplifying price are often very complicated, with untested legal terms. movements, all buying or all selling. In a worst-case In crisis times, this risk manifests itself through various scenario, this will cause extreme price movements. It will avenues. For example, while the financial system is also undermine market integrity by encouraging predatory global, the legal system is local; and court proceedings behaviour among other market participants not bound by that address the same financial contract can result in the models. conflicting decisions. Financial market regulation The political dimension Milton Friedman noted that ‘The great mistake everyone Systemic risk may arise from an unfortunate mix of special makes is to confuse what is true for the individual with what interest lobbying, regulatory capture, revolving doors, is true for society as a whole.’ This ‘fallacy of composition’ dysfunctional political institutions, and elite and mass has serious consequences for systemic risk: attempting public belief systems. Before a crisis, politicians are likely to to ensure the safety of each part of the financial system celebrate the build-up of excesses and attempt to prevent independently can lead perversely to the system as a any effective action by the regulators. After a crisis, they may whole becoming more unstable. Trying to make every want to demonstrate their toughness by clamping down market participant behave prudently destabilises the excessively on the financial system. This leads financial system. Instead, policies should explicitly take to pro-cyclicality. account of the interactions between individuals and of endogenous risk. The research agenda Macroprudential policy The SRC aims to develop a set of Since the crisis, the idea of designing ‘macroprudential’ tools for policy-makers to adjust policy to analyse interactions within the system and to reduce systemic risk has been a central focus of attention regulations to achieve the twin goals for regulators – the complement to ‘microprudential’ of ensuring the efficiency of the regulation, which seeks to improve the soundness of financial system and mitigating the individual institutions. But the dichotomy of pro-cyclical incidence and severity of financial microprudential and counter-cyclical macroprudential, together with the fuzziness of the macroprudential agenda crises. While it is not possible and the interplay of political pressures, may undermine the to eliminate systemic risk or the reputation of central banks and threaten the effectiveness incidence of crises entirely, the of monetary policy. objective should be a more resilient Financial transactions taxes financial system that is less prone to By curtailing ‘noise trading’, taxes on short-term disastrous crises while still delivering speculative trading can in principle reduce the excess benefits for the wider economy volatility of financial markets. But such taxes might actually and society. be counterproductive: by impeding the ability of the price to incorporate new information, they allow mispricing relative to fundamentals to last longer and when corrections eventually occur, these will be sudden and large. 3 Systemic Risk Centre Contents

4 Introduction 6 Engineering and the financial system 8 Systemic risk and the global financial crisis 10 Systemic risk and endogenous risk 11 Feedback loops and amplification mechanisms 13 Perceived risk and actual risk 15 Financial networks 16 Central counterparties 17 Computer-based trading 18 Systemic risk: dangers and policy responses 20 Identifying and forecasting risk 22 Model risk of risk models 23 Risk models: harmonisation or heterogeneity? 25 Policy initiatives to reduce systemic risk 27 Dangers for central banks 28 A financial transactions tax? 29 Systemic risk: what can data reveal? 30 Securities lending 31 Totem 31 Legal dimensions of systemic risk 34 Political dimensions of systemic risk

36 Further reading 38 Biographies 4 Systemic Risk Centre Introduction

‘Almost any interesting economic problem has the following characteristic: what is true for the individual is the opposite of what is true for everybody together.’ Milton Friedman, 1980 5 Systemic Risk Centre

n the wake of the global financial Several public sector institutions are economist is likely to become a crisis, the world’s central banks founding partners; and in the private nuisance if not a positive danger.’ and financial regulators are sector, Markit, a leading supplier of This view is echoed in a recent article focused on ‘systemic risk’ – the financial information services, is our by Julia Black who reasons that I danger that a serious disruption main data partner. we should go beyond economic to the financial system will lead to The unifying principle of the Centre’s frameworks and investigate social widespread economic distress. The agenda is endogenous risk – the idea conceptions of financial markets Systemic Risk Centre (SRC) has that financial risk is created by the (Black, 2013). been established at the heart of the interaction of market participants, world’s main financial centre to define In our view, it is essential to take a including the policy authorities. this emerging field, to investigate multidisciplinary approach to the What’s more, risk can be amplified the risks that may trigger the next analysis of systemic risk. through feedback loops within and financial crisis and to develop The SRC therefore brings together between the financial, economic, practical tools to help policy-makers experts from computer science, law, legal and political systems. We and private institutions become political science and the natural and therefore take to heart the words of better prepared. mathematical sciences, as well as the LSE professor and Nobel laureate from finance and economics. Based at the London School of Friedrich Hayek, writing in 1956: Economics and Political Science There are four key elements in ‘Nobody can be a great economist (LSE), the Centre is generously the Centre’s research programme who is only an economist – and funded by the Economic and Social that will contribute to a better I am even tempted to add that Research Council (ESRC) with an understanding of systemic risk and the economist who is only an annual budget of £1 million. inform future policy.

This report elaborates on these elements of the Centre’s research programme, describes some of the initial findings and policy recommendations, and outlines the research agenda.

Endogenous Amplification Crisis Policy risk mechanisms prevention responses

This is the risk that is created by The outbreak of systemic crises and mitigation Regulators need to focus and within the financial system is usually triggered by a small By building up theoretical and on policy initiatives that will itself rather than as a result of a event, the impact of which empirical knowledge of the way recognise and reduce systemic devastating event from outside is magnified by interlinkages that financial markets operate, risk. They also need to the system – what economists and feedback loops within the the SRC can help policy-makers avoid those that, even if well call an ‘exogenous shock’ and financial system, potentially to identify the build-up of risk intentioned, will actually others might call an ‘act of God’. leading to its failure and in time to respond. Ideally, this lead to the creation of new Endogenous risk can build widespread economic collapse. would help to prevent a crisis and larger risks. up over time and be released These amplification mechanisms from materialising. At the during an outburst or ‘systemic create much of the destruction very least, it would help to risk event’, such as the global during the unravelling of a mitigate its worst consequences financial crisis. systemic event. by cutting through the Furthermore, much like feedback loops and taming the a tightening coil, these amplification mechanisms. mechanisms often encourage the build-up of systemic risk in the first place. For example, a larger exposure may move prices in a certain direction, which attracts more money into the same trade, further increasing exposure until the coil is over-tightened and positions and prices are clearly unrealistic. At that point, just a small shock suffices for the event to unravel. 6 Systemic Risk Centre Engineering and the financial system

The financial system is often compared to an engineered structure. Indeed, there has long been a whole field of research and practical applications known as ‘financial engineering’. Before the crisis, this led to a degree of complacency among policy authorities and private market participants as advances in financial models and regulations seemed to have reduced the problem of overseeing the financial system to a well-understood engineering exercise. Just as buildings, machinery and other engineered structures can be made safe, so too can finance – or so it was thought.

hat was forgotten is was opened by Queen Elizabeth II, that finance is not really thousands of people used it to cross like engineering: it is the river. This should not have been a much more complex. problem, as the bridge was designed WWhen engineers design a structure, to cope easily with such large crowds. they mostly have to contend with But within moments of being opened well-understood forces of nature to the public, the bridge began to and can tailor the margin of safety to wobble violently, and it soon closed the problem at hand. Engineers can to the great embarrassment of generally rest safe knowing the bridge’s designers – Arup and that an intelligent oil rig or rocket Foster – and the authorities. In the will not conspire with nature to process, it earned the nickname the undermine their handiwork. That ‘wobbly bridge’. is not the case in finance, where Every bridge is designed to move market participants – the ‘forces of with the elements and the Millennium nature’ in the financial system – are Bridge was supposed to sway gently constantly seeking to find ways in response to the Thames breeze. around rules and regulations. But when a gust of wind hit the bridge, adjust stance But while engineering is an imperfect causing it to move sideways and model for financial regulatory policy, wobble, people’s natural reaction its interface with humans does help was to adjust their stance to regain to demonstrate ‘endogenous risk’ – balance. By doing so, the bridge was the guiding SRC principle that risk pushed back, making it sway even bridge moves push bridge is created by interactions of people more, causing people to adjust their within the system not by some stance yet again – more and more at outside force. The concept was first the same time – this time pushing the introduced by the SRC’s co-director bridge in the opposite direction. Jon Danielsson and Hyun Song Shin As an ever-increasing number of in 2003 and, to explain how it works, further pedestrians started to adjust their they generally use the analogy of adjust stance stance more or less simultaneously, London’s pedestrian Millennium the bridge moved more and soon Bridge, the first new bridge to span almost all the pedestrians joined the river Thames for a hundred years. in. This created a self-reinforcing Figure 1: On 10 June 2000, the day the bridge feedback loop between the The self-reinforcing feedback loop of the Millennium Bridge 7 Systemic Risk Centre

synchronised adjustments of the 2000 incident, experiments by the risk since all that was needed was pedestrians’ stance and the bridge’s engineers revealed that the critical for a small number of net additional wobble, as Figure 1 shows. number of pedestrians on the bridge pedestrians to go onto the bridge for that unleashed the wobble was 156. risk to materialise in the wobble. The financial system is replete with Below that number, no noticeable analogous processes in which an In engineering, this kind of calculation wobble occurred, while above it, there innocuous shock akin to the first gust can be determined by repeated was a wobble. It seems that beyond of wind has the potential to trigger experimentation in an environment 156, the idiosyncrasies of individual a systemic crisis. Financial markets that is largely constant. But finance is behaviour no longer cancelled each are examples of environments where more complex given the larger number other out and very rapidly interactions individuals not only react to events of interactions and forces, and the fact became mutually reinforcing. around them but also by their actions that the ‘financial Millennium Bridge’ directly affect market outcomes. The In that sense, an actual but latent is likely to change over time, making pedestrians on the Millennium Bridge build-up of risk occurred as more similar repeated experiments to were like traders reacting to price people populated the bridge. It is even determine the critical build-up largely changes and the movement of the possible that up to that critical number, impossible. n bridge was like price moves in markets. the steps of those pedestrians cancelled each other out and made The Millennium Bridge example also the perceived risk of the bridge illustrates the concepts of perceived ever lower. The lowest point on the risk and actual risk (explained in more perceived risk scale corresponded to detail on pages 13-14). After the June what was nearly the maximum actual 8 Systemic Risk Centre Systemic risk and the global financial crisis

The world economy was on the brink of collapse in the autumn of 2008 following the failure of the investment bank Lehman Brothers. Confidence, the lifeblood of the financial system, was evaporating at an alarming rate; financial institutions refused to do business with each other; people took their money out of banks; and it looked like the economy might be heading for a second Great Depression. Then, just as suddenly as the crisis materialised, it seemed like it was over: while the economic, social and political repercussions continue to this day, the immediate threat of disaster was gone.

hat happened global financial crisis. A full collapse financial system was created and they in 2008 was of the entire financial system was are an inevitable part of any market- a near-miss only averted thanks to the swift based economy (Danielsson, 2013a). systemic actions of the policy authorities – the So what led to the most recent build- crisis, generally central banks and finance ministries up of systemic risk and the resulting defined as of the leading economies – which global financial crisis, an outcome that a state in which interlinkages and stepped in to bridge some of the seemed to catch almost everybody Wfeedback loops within the financial defects in the system. by surprise? One explanation is system lead it to stop performing But this was not the first time that the that the relative absence of crises its essential roles. This event was world has faced systemic risk. The over the past few decades lulled followed by an economic recession threat and, at times, its realisation policy-makers, financial institutions and a sovereign debt crisis in the have been present ever since the first and researchers into complacency. eurozone, which in turn worsened the 9 Systemic Risk Centre

Central bankers mostly focused on With financial market regulation, the If all banks respond in this way, a fighting inflation while regulators fallacy of composition has serious downwards spiral of asset prices tended to neglect the system as a consequences: attempting to ensure is created, forcing banks into more whole, instead aiming to ensure that the safety of each part of the financial sales and further depressing prices, each individual financial institution was system independently can lead resulting in a crisis. well regulated – through so-called perversely to the system as a whole Attempts to reduce the risks related prudential regulations. becoming more unstable. Trying to to any one institution and to dampen make every market participant behave The latest crisis has demonstrated the the natural volatility of the markets prudently destabilises the financial folly of such thinking, which assumes over the short term lead to a ‘Great system. that as long as each component Moderation’ – a seemingly permanent of the system is safe, the whole One mechanism that allows this state of stability. But this false sense of system must be safe as well. This to happen is shown in Figure 2, security is itself the cause of a hidden assumption carries the danger of which illustrates how a regulatory build-up of systemic imbalances. policy authorities falling victim to the requirement for all banks to be run The outcome is a manifestation, ‘fallacy of composition’ prefigured by prudently can create systemic risk if perhaps in a novel manner, of Hyman the economist and Nobel laureate it prompts the sale of risky securities Minsky’s famous dictum ‘stability is Milton Friedman in 1980: in response to an external shock. destabilising’.

‘ The great mistake everyone makes is to EXTERNAL confuse what is true for the individual SHOCK with what is true for society as a whole. This is the most fascinating thing about economics. In a way, economics is the most trivial subject in the world, and yet it is so hard for people to understand. Prudent banks face ‘Why? I believe a major reason is because financial almost any interesting economic problem difficulties has the following characteristic: what is true for the individual is the opposite of what is true for everybody together.’ risk increases CRISIS forced to sell

prices fall

Figure 2: This is the key insight of the emerging When individual prudence leads field of systemic risk: the threat comes to a systemic crisis not from outside the financial system and the economic, social, political and legal setting in which it is embedded; rather, it comes from interactions within the system, possibly amplified by the structure of the system and the ‘rules of the game’ established by the policy authorities at national and international level.

This way of thinking – in terms of endogenous amplifying effects in both the build-up and unfolding of a systemic event – is applicable to real world situations, past, present and future, and forms the basis of systemic risk modelling. n 10 Systemic Risk Centre Systemic risk and endogenous risk The Financial Stability Board, the international body created in 2009 to oversee the global financial system, defines systemic risk as follows: ‘The disruption to the flow of financial services that is (i) caused by an impairment of all or parts of the financial system; and (ii) has the potential to have serious negative consequences for the real economy.’

here is broad acceptance extent that it evolves, that it keeps system is endogenous risk. In the of this as a descriptive its identity. extreme, the risk may be a risk to the definition but a more very central concept that guarantees Examples include a ‘banking system’ fundamental understanding the logical coherence of the system (with a central bank at the centre of Tof systemic risk requires a deeper in pursuit of the best use of scarce a network of interrelated banks) as sense of what constitutes a ‘system’. resources with multiple ends. opposed to a collection of banks; a After all, how can one think about ‘payment system’ as opposed to a set Instances during which the central systemic risk without having a clear of bilateral payment and settlement concept is itself incapacitated in the sense of what a system is in the arrangements; a ‘solar system’ as four systems outlined above could first place? opposed to a cluster of celestial involve the following. The inability or Analysis by the SRC’s co-director bodies; and a ‘nervous system’ as unwillingness of a central bank to Jean-Pierre Zigrand (2014) defines a opposed to a collection of unrelated act as a lender and market-maker of system as a functioning mechanism nervous cells. last resort removes the foundations governing a set of elements (i) that to a banking system. A failure of the The term systemic risk comprises the makes reference to something or real-time gross settlement processor risk to the proper functioning of the to a central concept in a coherent in a payment system brings the system as well as the risk created fashion (‘deductibility’), (ii) that implies system and all connected systems to by the system itself. The risk that meaningful relationships between its meltdown. A stroke incapacitates a is created or amplified within the elements (‘irreducibility’) and (iii) to the nervous system. And hyperinflation 11 Systemic Risk Centre

reduces a price system to a set of This is the SRC’s approach: to view primitive and inefficient bilateral systemic events as being mainly Feedback barter operations. In each case, the endogenous, with the trigger for a system stops being able to fulfil its crisis possibly being exogenous loops and function properly and consistently in a though not by itself extreme. On that systemic event. basis, systemic risk may be defined as the risk of a systemic event occurring, amplification Standard methodology for modelling where a systemic event is defined by risks treats systemic risks as the occurrence of positive feedback mechanisms being mainly extreme shocks from loops within the given system that outside the system drawn from adversely affect the proper functioning, some distribution – for example, the the stability and, in extreme cases, the payment system would grind to a structure of the overall system itself, halt in the event that an asteroid hit ithin the financial with resulting costs to the wider real the processor. But while the asteroid system, a small event economy of which the system is a would certainly constitute a risk to the can turn into a major subcomponent. system, it is more fruitful to crisis – a systemic focus on endogenous risk, where The idea is neatly captured in a Wevent – while a much larger shock the risk is both to the system and quotation from the science fiction film, may whimper out into nothing. amplified by the system. One example The Matrix Reloaded: Behind those shocks that become is from John Maynard Keynes in his systemic events is the presence Neo: ‘There are only two possible 1936 book: of mechanisms that amplify and/ explanations: either no one told or accelerate the impact through ‘By a cyclical movement we mean me or no one knows.’ the rest of the financial system. that as the system progresses The Architect: ‘Precisely. As you Amplification mechanisms are the in, e.g. the upward direction, the are undoubtedly gathering, the ways in which endogenous risk forces propelling it upwards at anomaly’s systemic, creating manifests itself in the financial system first gather force and have a fluctuations in even the most and translates into concrete events. cumulative effect on one another simplistic equations… an anomaly but gradually lose their strength There are a number of features that if left unchecked might until at a certain point they tend to inherent in the financial system that threaten the system itself.’ be replaced by forces operating can amplify a small event into a major in the opposite direction; which crisis. They include balance sheet in turn gather force for a time issues, such as levels of leverage and and accentuate one another, until liquidity; constraints on the way that they too, having reached their institutions behave that are imposed maximum development, wane and either by regulators or the institutions give place to their opposite.’ themselves; and the way in which 12 Systemic Risk Centre market participants react to each In the run-up to the global financial builds up during stable periods. other in times of both relative calm crisis, AIG – the US-based Banks tend to have surplus capital and stress. international insurance company – when the economy is booming, while became through its AIG Financials capital levels drop during recessions. For example, it has been estimated subsidiary the world’s largest seller Likewise, economic agents have a that the losses in the US subprime of credit protection in the form of tendency to borrow too much during mortgage market, which triggered credit default swaps, helped by its good times and borrow too little the global financial crisis, were AAA rating. In the summer of 2008, in downturns. roughly equivalent to an equities AIG’s credit rating was downgraded, market fall of 2%. The vast majority As Figure 3 illustrates, pro-cyclicality obliging it to raise capital to post of equities market losses of 2% do is often created by the various additional collateral at the height not lead to any major instabilities, amplification mechanisms built of the crisis. This triggered a vicious while the subprime losses led to into the financial system, and feedback loop that ultimately led huge downwards spirals given the is encouraged by risk weighted AIG to seek a bailout by the US distribution of losses, the balance capital, mark-to-market accounting Federal Reserve. sheets, liquidity holdings and and the fact that the strength of interconnections of the market Analyses based on the idea of financial regulations tends to erode participants, and the lack of common endogenous risk show how small in boom times and come back knowledge about who held what and shocks like this can snowball into with a vengeance during and right how they were interconnected. extreme outcomes, which are after crises. Amplifying pro-cyclical more destructive than is warranted feedback loops can also comprise Both regulators and institutions by the fundamentals of the loss and margin spirals, in which fire place constraints on how market problem (a phenomenon known as sales destroy capital and increase participants are supposed to behave. ‘overshooting’). This happens purely risk, which in turn forces further sales, Those rules are often motivated because of reinforcing feedback loops closing the loop. by ‘microprudential’ or internal originating within the system, without considerations, such as moral hazard These feedback loops can operate the need for extreme exogenous or adverse selection. For example, both in the build-up phase of a crisis shocks, provided latent imbalances there is a wide range of constraints on (years 1-4) and in the crisis phase have been allowed to build up. The the amount of risk an institution can (years 4-6). In practice, the loops tend outcome for risk in the system as a hold, how it can refinance itself and to build up slowly over long periods whole can therefore be fundamentally on the collateral it must hold. and to accelerate when reversing in different from that resulting from a crisis. Unfortunately, in the spirit of the the risk management decisions of fallacy of composition, while these individual institutions. The SRC’s co-director Jean-Pierre rules are meant to guarantee sound Zigrand (2015) has just published We have seen that feedback loops are microprudential behaviour, they can a comprehensive survey of such directly affected by the nature of the create dangerous positive (reinforcing) feedback loops, documenting how regulatory policy environment, which feedback loops. One example would the acceleration mechanisms work can encourage ‘pro-cyclicality’, a be cases where a fall in asset prices and how policy can either amplify or process that is positively correlated triggers an obligation to raise cash reduce these effects. n with the economic cycle. Bank capital by selling more assets, which pushes and leverage are two examples of a prices down further. pro-cyclical process in which risks

Figure 3: Amplification mechanisms lead to pro-cyclicality

top of cycle risk-sensitive capital

non-risk-sensitive capital

YEARS 1 2 3 4 5 6

bottom of cycle 13 Systemic Risk Centre Perceived risk and actual risk

Most financial models are implicitly based on the assumption that risk is generally created by an outside natural or man-made disaster – what many would call an ‘act of God’ and which economists call an ‘exogenous shock’. In reality, risk within the financial system is primarily created by people interacting with each other – endogenous risk.

n this kind of analysis, much of what takes place in a financial system is caused by the interaction of all the players in the market, Iwhether they are financial institutions, traders, regulators or policy-makers, all of which are pursuing their own objectives. These players continually study and react to the financial system, changing its nature in the process. In other words, the financial system is not invariant under observation.

Most of the time, individual economic players behave in a way that cancels out shocks: for example, the same event may prompt some to buy an asset and others to sell it. Systemic risk is realised when this no longer happens because the players start behaving in a harmonious way; the distress of one player triggers behaviour that causes distress in other players, who then further spread trouble.

In other words, individual economic players react to some particular event, and their actions in turn affect 14 Systemic Risk Centre

their environment through a network The red line shows perceived risk: lead to violent market reversals. of feedback loops and amplification how market participants view risk The green line shows what happens mechanisms. Endogenous feedback when using the industry’s typical risk to actual risk, which builds up before between the behaviour of market forecast models. Prices increase market prices shoot up, eventually participants can suddenly and when perceived risk – such as indicating a constant high probability unexpectedly create a vicious cycle, forecast volatility – falls. When market of a crash in the near future. Eventually, causing a crisis. participants observe increasing prices as the market collapses, so does and falling risk, they are encouraged Incorporating endogenous risk in actual risk. to continue buying, an example of a the analysis of financial systems ‘momentum strategy’. In the short run, This means that perceived risk sends leads to situations where the system this becomes a virtuous circle of ever the wrong signals in all states of the cycles between virtuous and vicious increasing prices and lower risk. world. Before the crisis, it is biased feedbacks. When things are good, downwards, giving a too optimistic market participants are optimistic and Eventually, when traders realise that view of the world; after the main buy, which endogenously increases there is nothing fundamental behind crisis event, it becomes too high, prices, with a bubble feeding on itself. these high prices, they all sell at the making everyone too pessimistic and This eventually goes into reverse, same time, causing prices to collapse. curtailing risk-taking at exactly the and negative news feeds on falling Because the fall in prices leads to wrong time. This is one manifestation prices, with the markets spiralling an increase in perceived volatility, of the phenomenon of ‘pro-cyclicality’ downwards. risk forecast models report sharply – where the behaviour of market increasing risk. This manifests itself in the difference participants and policy authorities between the risk reported by most Figure 4 illustrates a further challenge amplifies the volatility of the financial risk forecast models – ‘perceived in the existence of non-linearities, system – rather than the more risk’ – and the actual underlying risk namely that small changes in a risk desirable phenomenon of ‘counter- that is hidden but ever present. As a driver that determines actual risk can cyclicality’. bubble is building up, perceived risk Figure 4: is low and falling, while actual risk is EndogenousEndogenous bubble bubble increasing. After the bubble has burst prices and prices have snapped back close perceived risk to fundamental values, the actual risk falls, but because the observed volatility increases, so does perceived risk (Danielsson et al, 2012a). actual risk

We can illustrate this phenomenon with the Millennium Bridge where after the opening, engineers established that the swaying caused by positive feedback loops arose when there were more than 156 pedestrians on the bridge. The build-up of risk with the Millennium Bridge happened under the radar screen. The bridge 1 2 3 4 5 6 7 8 was very stable with 156, but adding just a few more pedestrians would The relationship between perceived produce the wobble. In other words, and actual risk is the subject of perceived risk was very low at 156 several SRC research projects. For while the actual risk of a wobble was example, one study analyses the highest since all it took was a few benefits of trading strategies that go more pedestrians stepping onto the against the perceived risk of bubble bridge than stepping off. momentum (Ergun and Stork, 2013). The results suggest that such Figure 4 illustrates this phenomenon counter-cyclical trading strategies graphically in a financial context: the can mitigate large negative shocks blue line shows the evolution of to investors in financial markets. prices, starting low and increasing at an ever more rapid rate, peaking A comprehensive analysis of and then collapsing and remaining the nature of financial risk and constant thereafter. This is typical of a implications for risk management bubble, where it is said that ‘prices go and policy-making is the subject of a up by the escalator and come down new study by the SRC’s co-director by the elevator’. Jon Danielsson (2015b). n 15 Systemic Risk Centre

through a networked financial system is again greatly determined by the structure of the network, irrespective of the size of the exposures accumulated beforehand. Jason Financial Donaldson and Eva Micheler model how negotiable instruments can help to absorb shocks to the financial system (Donaldson and Micheler, 2014). networks It can be challenging to draw practical recommendations for policy-makers by studying the network structure of the financial system, especially when using publicly available data. Furthermore, without a deeper understanding of the economics etworks can also be formed Networks can accelerate and amplify of the market situation and the through trading patterns. commercial and legal nature of the the way that shocks reverberate through One example is the ex post N relationships, such analysis often just the financial system. They can arise, for realisation that fund managers hold seems to suggest that everybody is very similar – and often narrow and example, from balance sheet links across connected to everybody, with some illiquid – portfolios or have exposures financial institutions, such as counterparty of the links stronger than others, and to undiversified risk factors, such as risk. This can happen within as well as with links sometimes coming and in the quant crisis of 2007. Another across countries, as the global financial going quickly. example consists of the inter- crisis has made clear. market connections established A study by SRC researchers Christian in modern fragmented markets Julliard and Kathy Yuan, conducted by high frequency traders, which with colleagues at the Bank of transmit price changes to hundreds England, bypasses this problem with of markets and products, such as a unique state-of-the-art model for exchange-traded funds and financial capturing the dynamic evolution of options. the UK’s banking network (Denbee et al, 2014). The analysis uses network The nature and extent of the theory to understand the strategic interrelationships of markets and interaction of banks and the systemic market participants influence the implication of an individual bank’s manner by which the positive behaviour over the period 2006-10. feedback loops grip the entire system. Just like risky holdings, The researchers find that most interrelationships also build systemic risk is driven by a small up over time, often under number of banks, but not necessarily the radar. The network by the ones that are the largest matters in at least two borrowers or those most likely to respects. default. Their study generates a tool for evaluating ‘shock multipliers’ in First, the structure of the the financial system to which more network determines how careful supervision or more stringent large the build-up of risky regulation could be applied. exposures is in the first place. For example, if This research models the banks’ a financial institution liquidity holding decision as a can easily pass on simultaneous game on the interbank some risks to other borrowing network. In equilibrium, parts of its network, the contributions of each bank to the it is encouraged network liquidity level and liquidity risk to take on larger are distinct functions of its centrality positions. in the system. Moreover, a wedge between the equilibrium that a Second, ex benevolent planner would choose and post, the way the market equilibrium arises because a local shock individual banks do not internalise is transmitted 16 Systemic Risk Centre

the effect of their liquidity choice on Network structures are not themselves exogenous. other banks’ liquidity benefit and risk Some bilateral connections are freely chosen while others exposure. The authors show that the network can act as an absorbent or a are mandated. For example, the push towards clearing multiplier of individual bank shocks. through central counterparties (CCPs) significantly alters the network structure, not least with CCPs becoming Bringing their model to real UK interbank data provided by the Bank of some banks’ largest counterparty risk. Little academic England, the authors find evidence for research has gone into the modelling of CCPs, and less a substantial and time varying network still on their effect on systemic risk once the interactions risk over the period 2006-10. In the pre- with clearing members, traders, central banks and the crisis period, until August 2007, there is general public have been considered. This is an area of a large network liquidity shock multiplier. analysis on which the SRC is working. This implies a tendency for the network to amplify shocks through the system. Essentially firms are borrowing to lend, and their decisions are self-reinforcing: the system is overheating and liable to Central exogenous shocks. The network multiplier drops sharply counterparties at the outset of the crisis following the run on Northern Rock in August 2007, and the network becomes more diffuse, The difficulties of CCP modelling stem as banks try to limit their exposure from the fact that the essence of a to the most risky nodes. While there CCP is the interconnectivity of the is a temporary reversion back to the agents and that, as a result, network previous trend, from the collapse of US modelling takes on a crucial role. It investment bank Bear Stearns on 11 is known that CCPs affect netting March 2008 until well into 2009, the efficiency in markets, and the SRC is multiplier is more or less zero – there is studying the further implication of this basically no additional risk coming from in terms of endogenous risk. Indeed, if the network structure. The risk of the collateral needs across securities and system as a whole behaves as if it were CCPs is not netted out, then the loss a collection of separate individuals. on one contract that would normally be netted out by a gain on another After the crisis, when the Bank of one will now create a margin call. England was implementing its programme of ‘quantitative easing’, A 2010 study by the SRC’s co-director the network liquidity multiplier Jean-Pierre Zigrand looks at the becomes smaller than one, implying a impact of moving trading onto CCPs. lower network potential for generating He considers the potential of CCPs liquidity, but also a lower level of to alter the network structure of the volatility of aggregate liquidity. The financial system by changing the network structure is acting to reduce interconnections between financial risk, as bank behaviour has moved institutions, and thereby potentially from self-reinforcing to reserve increasing systemic risk. substituting. The network has become Over and above the relevant question highly directed towards one node – of the quantity of collateral needed the central bank itself. in a world with multiple CCPs and This research makes an important compulsory central clearing, CCPs contribution to so-called may reduce counterparty risk or at ‘macroprudential’ policy-making, which least push it into the open. But they aims to improve the soundness of may also create stronger feedback the financial system as a whole. By loops if CCPs are not interoperable simultaneously exploiting the most across products. Those stronger direct network connections in the feedback loops can represent a financial system – the payment system systemic fragility. Further modelling – coupled with an economic model efforts need to be undertaken to of strategic bank behaviour, policy- gauge the strength of this effect and makers can identify the specific points to provide indications as to the extent of vulnerability in the system and test to which CCPs reduce systemic risk policy prescriptions. n ‘net-net’. n 17 Systemic Risk Centre Computer-based trading FigureFlash 5: Crash, May 6, 2010. DJIA One area that can be viewed as a Flash crash, 6 May 2010 laboratory for endogenous risk and DOW JONES INDEX feedback loops is computer-based trading (CBT) – and in particular the 10600 special category of high frequency trading (HFT) – which is taking over 10500 much of the trading in liquid financial markets. These trading activities 10400 can alter the characteristics and the dynamics that, in turn, feed into the values and price signals guiding 10300 investment behaviour. 10200

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his phenomenon has raised concerns among investors and market commentators. Some highlight the Talgorithms that follow simple rules at lightning speed, which means that human traders are bound to lag behind. Another concern is that robot computers follow these rules mechanically, without any sense of discretion or common sense.

An example of the potential dangers of CBT is the May 2010 ‘flash crash’ of the US stock market, when it fell almost 10% in a matter of minutes and recovered just as quickly (see Figure 5). A joint report by two US regulatory authorities – the Securities and Exchange Commission and the Commodity Futures Trading Commission – identified a single institution selling a large number of E-Mini futures contracts on the S&P 500, prompting HFT programmes to start trading aggressively, which in turn encouraged the selling institution to sell even more given the impression of an active and liquid market.

The stress then spiked further when the crash contaminated the markets 18 Systemic Risk Centre for shares and exchange-traded funds (ETFs). The slide was eventually halted when algorithms were switched off and bargain-hunters Systemic started flooding into the market. Further uncertainty is created for future events by the arbitrary fashion by which the regulator decided to risk: cancel some of the trades, meaning that next time around traders may be more cautious about stepping back in. dangers The work of the SRC’s co-director Jean-Pierre Zigrand and SRC research associate Charles Goodhart has played a significant role in shaping and policy thinking in Europe about CBT, notably through the recommendations of a UK government report (Government Office for Science, 2012). responses In particular, the report cast doubt on a number of widely held views on how HFT works and formed the basis Society faces a difficult dilemma when it for rethinking the nature of policy comes to systemic risk. We want financial interventions, notably the Markets institutions to participate in economic in Financial Instruments Directive, activity and that means taking risk. We the EU legislation that governs how financial service markets operate. also want financial institutions to be The original European Commission safe. These two objectives are mutually proposal for trading halts in volatile exclusive and that gives rise to a difficult markets – ‘minimum resting times’ – policy challenge. to regulate HFT was dropped, and the report’s proposal of time stamps based on synchronised atomic clocks across trading venues was adopted.

This work is currently being extended by four SRC researchers, who are studying liquidity shocks in HFT environments by modelling their life cycle with a survival model (Danielsson et al, 2015b). n 19 Systemic Risk Centre

in continental Europe, where banks One possible avenue for identifying are by far their most important the build-up of systemic risk is if funding source. SRC researcher Katja perceived risk is unusually low, leading Neugebauer is taking a closer look to ‘Great Moderation’-type economic at firms’ financing constraints in two environments. This motivates the current projects. work of the SRC’s co-director Jon Danielsson and two SRC research The first is examining the impact of the associates in a 2015c paper, where decline in cross-border banking on they consider the long-run historical firms’ financing constraints, using the connection between volatility, the European Central Bank’s Survey on incidence of serious types of crisis and Access to Finance of Enterprises in economic performance. combination with data from the Bank for International Settlements (Bremus Two key policy objectives and Neugebauer, 2014). The key question for policy-makers is The second is investigating the how to limit the build-up of systemic appropriateness of currently used risk and contain crisis events when measures of firms’ dependence on they happen, balancing the need for external finance, which are usually an efficient financial system with the drawn from cash flow statements. desire to avoid disastrous systemic Using a unique survey conducted outcomes. The SRC is addressing this in seven European countries during question by focusing on two objectives. well-functioning and the financial crisis, this allows for appropriately regulated The first objective is improving the checking the validity of these measures financial market makes an functioning of financial markets so at the industry level (Eppinger and essential contribution to that they better serve the needs of the Neugebauer, 2014). overallA economic wellbeing. economy as a whole. Some market In a perfect world, it might be thought activities and regulations contribute Financial crises have serious desirable for any build-up of systemic positively to financial stability and consequences for both the functioning risk to be identified early enough to to the quality of markets. Other of the financial system and the enable policy-makers and market market activities and regulations do wider economy, not least the need participants to respond and avert a the opposite, even if they may be to mobilise substantial resources crisis. But while a safer financial system perceived individually as helping to to stabilise and mend the system, has many benefits, it is also vital for the reduce risk. SRC research is studying including resources directly or system to deliver its role of financing these mechanisms and identifying indirectly financed by taxpayers. risky economic activity, perhaps ways to reduce the trade-off as much Ultimately, problems in the financial providing mortgages to households or as possible. system can spread to the real sector, lending to SMEs. The two objectives posing a danger to economic growth The second objective is raising of stability and risk cannot be fully (Buch and Neugebauer, 2011). awareness of the potential risks to the satisfied at the same time, opening up financial system as a whole. Policy- One example is the lack of financing the need for intelligent interventions making that focuses on individual opportunities for small and medium- and ex post resolutions based on institutions while ignoring their sized enterprises (SMEs), especially careful research into systemic events. interactions (based on the assumption that shocks arrive from outside the system) may fail to meet its objectives. Indeed, narrowly focused measures may even perversely increase systemic risk.

SRC research aims to develop a set of tools for policy-makers to adjust regulations to achieve the twin goals of ensuring the efficiency of the financial system and mitigating the incidence and severity of financial crises. While it is not possible to eliminate systemic risk or the incidence of crises entirely, the objective should be a more resilient financial system that is less prone to disastrous crises while still delivering benefits for the wider economy and society. n 20 Systemic Risk Centre

Models of financial risk are at the heart of supervision as well as the financial sector’s self-monitoring. These models are essential for the functioning of financial markets and it would be impossible to manage risk without them. But there is a tendency by both financial institutions and supervisors to overstate their reliability and underplay their dangers. Identifying and forecasting risk 21 Systemic Risk Centre

inancial regulations and the methodology in current use is that in terms of evaluating current tools, internal operations of banks they fail to treat financial risk as but also in reducing resistance to increasingly make use of endogenous. While (largely backward- endogenous risk methodologies. While risk forecasting in areas looking perceived risk) statistical they rely on views of the build-up of F such as investment decisions, risk models are easy to implement, they risk and its violent emergence through management and the determination also require less analysis and less data, feedback loops, with different views of bank capital. Behind this increased and – crucially – it is easier to reach yielding different risk assessments, dependence on risk forecasting lie agreement among disparate decision- similar discordance appears even rapid developments in statistical makers as to which model to prescribe within exogenous risk models, and methodologies and computer or to use. therefore the perceived advantage of software and hardware, as well as exogenous risk models may in fact be the wider availability of data. To capture actual risk, the hidden mistaken. build-ups of imbalances need to be Before the crisis, a common view gauged subjectively, the feedback The Basel committee has made was that risk forecasting and risk loops and interconnections between important changes to the way it management technologies had players presumed and a set of wants market risk forecasting to be matured to such an extent that we plausible scenarios determined. There done. SRC researchers have been could effectively prevent extreme is currently no authority that would be analysing the proposals, first in a outcomes in financial markets. In able to elucidate agreement among policy commentary by Jon Danielsson other words, we had reached a level diverse regulators – and exogenous (2013b) and since developed into a of permanent low volatility in financial risk methodologies are continuing to working paper (Danielsson and Zhou, markets. The crisis demonstrated the be the workhorses precisely because 2015). The results indicate that market folly of such thinking: just about every they do not allow as inputs the risk under Basel III would be less risk forecasting model failed miserably unverified and subjective ways in which accurately measured and forecast than and the crisis caught almost everybody endogenous risk actually builds up. in the previous Basel II regime. Jon by surprise. Danielsson in a 2015a commentary The study of risk forecasting and the After the crisis, risk forecasting is even studied the impact of the the Swiss development of risk testing methods more important, given the fundamental central bank abandonment of its euro is a significant focus of the SRC, and role it plays in reforms to financial exchange rate ceiling, finding the fallout the hope is that some endogenous risk regulations and in macroprudential from the decision demonstrates the methodologies will find acceptance policy. So it is not surprising that inherent weaknesses of the regulator- among policy-makers. For example, there have been many proposals for approved standard risk models SRC researchers have been working better risk forecast methodologies. used in financial institutions. These on analysing the robustness of risk Yet despite widespread criticism of models under-forecast risk before forecast models on which new risk models for both theoretical and the announcement and over-forecast macroprudential regulations and practical failures, especially during the risk after the announcement, getting it market risk regulations are based financial crisis, it is puzzling that most wrong in all states of the world. (Danielsson et al, 2014a). policy authorities are still determined to This issue is also discussed by SRC ground regulation heavily in risk models The study provides empirical evidence researcher Lerby Ergun in a 2015 based mainly on exogenous shocks. that even within the set of accepted working paper, and in his joint work exogenous risk methodologies, In particular, a fundamental problem with Jon Danielsson in 2015a working predictions can be hugely disparate. of almost every risk forecasting paper on the pitfalls with worst case This finding may be significant not only analysis. n 22 Systemic Risk Centre Model risk of risk models

Systemic risk analysis, financial regulations and the internal operations of financial institutions heavily depend on statistical risk models. In spite of that, little is known about the reliability of such models.

he greatest need for models generally accepted risk forecast is in the forecasting of methods disagree. Two SRC reports extreme risk or ‘tail risk’, (Danielsson et al, 2014a, 2014b) find especially during periods that model risk is usually quite low, Tof financial crisis and extreme but it sharply increases in periods of market turmoil. But this is the area turmoil and crisis, suggesting that where risk models are least reliable the models provide poor guidance statistically because the effective to risk during crisis, a finding that is sample size of comparable events is consistent with the perceived risk/ very small. At worst, there might be actual risk view of the world. This can one observation or even zero when be seen in Figure 6, which shows considering events not yet seen. the level of model risk in risk forecast Furthermore, since the build-up to a models for US equities over the past critical level is not observable, timing three decades. is difficult also. Over the past half-century, there have Several SRC researchers have been been fewer than ten episodes of looking at the question of model extreme international market turmoil. risk – the degree to which competing Each of these events is essentially

Figure 6: unique, and apparently driven by The level of model risk in risk forecast models for US equities different underlying causes. Trying to get an overall idea of the statistical process of events during those average model risk episodes with fewer than ten episodes 95% confidence interval of turmoil, all with different underlying 15 causes is virtually impossible. While it might be possible to construct a model fitting nine crisis events in a row, there is no guarantee that it will 10 perform well during the tenth.

Nor does it seem likely that much information about price dynamics 5 during turmoil can be obtained by using the non-crisis data that makes up the bulk of available information. There is ample evidence that market 0 dynamics are very different in times 1980 1990 2000 2010 of crisis. 23 Systemic Risk Centre

Market lore suggests that in a crisis, Every model is wrong, some models are useful. When traders rely more on simple rules of it comes to regulation by models, should we aim to use thumb – such as ‘all stocks have a beta of one’ (they all move with the the same models across the entire financial system or market as a whole) or even ‘cash is encourage model diversity? king’ – than in more nuanced normal times, and that such rules can be self- fulfilling in the short term, leading to a Risk models: lack of diversity in decision rules. This is supported by research showing that correlations go to one during crises harmonisation because of incentives to trade out of risky assets into safe assets when risk constraints are binding, causing or feedback between ever higher risk and sharper constraints (Danielsson et al, 2012b). heterogeneity? Such considerations provide the fundamental limit to what existing risk forecast methodologies can be expected to achieve, since such models are likely to perform the worst when they are needed the most, both when it comes to forecasting a crisis and how markets behave during a crisis. But this only applies to risk forecasting as implemented in the state-of-the-art models of today. Considerable work, at the SRC and elsewhere, is focused on improving risk forecast methodologies at a more fundamental level, aiming to capture the hidden build-up of endogenous risk that only materialises at the worst times, during a crisis. t is standard and fruitful practice that the observed price or other A potentially fruitful avenue is to in economics to rely on the ‘rational variable is so and so, I can infer that identify the hidden feedback loops expectations hypothesis’. But the unobservable variables driving the and latent triggers that ultimately this approach seems to offer economy – and generating the price result in a systemic crisis. Among Igreater insights in normal times or in the first place – must have been the SRC research projects directed in stationary settings when rational such and such.’ The agent will then towards this objective are studies of expectations can be viewed as act on this new-found information. the long-run connection between being the limiting outcome of a The mapping is rational if, after having volatility and crisis (Danielsson et al, learning process. It is less useful in acted on the information, market 2015c) and work with the securities non-stationary market environments variables behave just as the true lending and Totem databases (see suffering from a variety of externalities model would have predicted. and inefficiencies where exceptional pages 29-31). A further SRC study In terms of risk modelling, if agents and unique stressed times can occur proposes a model in which the risk do possess this true mapping, and if that have never been observed in this forecast method learns from its they agree on the prior probabilities form before. historical performance, adapting the governing the underlying states of model in real time to rectify historical A ‘rational expectations equilibrium’ the world, then they unambiguously n mistakes (Boucher et al, 2014). is a market clearing equilibrium in know the probabilities of various which agents possess the ‘true market events happening in the model’ – that is, the true mapping future. If agents have had different from a realised but unobservable experiences and have accumulated state of the world to a set of observed different information sets over time, variables, chiefly prices. Since then they may still be able to add to agents are assumed to know the true their information by inverting the price model, they can rationally learn from mapping. If not, then prices are not observed variables by going through informative for this particular agent. the following mental exercise: ‘given It can also happen that even though 24 Systemic Risk Centre agents have learned over time from their own experience, prices are so informative that they would have had the same information set simply by observing prices: this case is the one of a fully revealing rational expectations equilibrium.

One notable danger of basing financial regulations on the outputs of statistical risk forecast models is the logical implication of such an approach: that there is one knowable and ‘correct’ model and that regulators should therefore be concerned when different banks’ risk models do not give the same risk assessments for the same assets. Both the Basel Committee and the European Banking Authority have indicated that they are troubled by such model heterogeneity and horse, a model that is less accurate But there is a further and potentially are seeking to rectify the problem, or that leads to larger pro-cyclicality more damaging issue: moving as discussed in a policy commentary if implemented, affording financial towards model homogeneity leads by the SRC’s co-director, Jon institutions and the financial system to excessive pro-cyclicality. If each Danielsson (2013c). less protection in the future. These bank develops its own models, and Requiring all actors to have the same predictions do emanate from formal models are different across the risk assessments may well be the models that have been studied at industry, when the next shock arises wrong conclusion in such unique the SRC. some banks may view it positively and buy the underlying asset, while other situations. There are a number of For this reason, it is generally better banks take the opposite view and reasons for this. First, even in a for financial institutions to develop sell. In aggregate their actions would rational expectations equilibrium, their own models internally, subject cancel out, resulting in more stable prices may not be fully revealing to regulatory scrutiny. This is more markets where extreme movements and therefore different agents have likely to lead to a healthy competition are less likely than in markets where different rational risk models. In fact, in model design and more protection regulations themselves contribute to some agents may be sitting nearer for the financial system, because pro-cyclicality. the market events and have a strictly model quality will improve over time. better risk model because they have A supervisory-mandated model is But if the banks are forced to have strictly finer information. much more likely to stagnate and the same models, they will all analyse Second, let us move away from the become ossified, leading to less the shock in the same way, and react assumption that agents have been model development and ultimately in the same way, amplifying price able to learn over time the true market less protection. movements, all buying or all selling. In a worst-case scenario it causes mapping – as is required in rational If the authorities end up backing a extreme price movements. It also expectations equilibrium models. If the given risk model, and some years undermines market integrity because economy is also subject to frictions down the road when the next crisis it encourages predatory behaviour by or pecuniary externalities, then happens, analysts may find that a key other market participants not bound moving towards model harmonisation contributor to the crisis was the wrong by the models. could in such circumstances further model promoted by the authorities. destabilise the financial system by This means that responsibility has Even if the supervisor is fortunate making it more pro-cyclical. This is been transferred to the governments, enough to pick the best model, an issue of model accuracy, since in making a stronger case for bailouts. it will still harmonise bank reactions practice it would seem that all models unless the financial institutions’ Regulatory involvement in model are simplifications of the real world, policy functions can be decoupled design directly affects the probability which means that they are wrong from the risk models during periods of bailouts and if it is not carefully by definition – that is, ‘not rational’ in of stress. Otherwise, model thought through, it may increase the sense of rational expectations homogeneity is pro-cyclical and moral hazard. This means that it may equilibrium. undermines market integrity. n be better to leave model development If the authorities pick one modelling to the financial institutions, letting approach over another, they may them take responsibility while just as easily be backing the wrong encouraging innovations in modelling. 25 Systemic Risk Centre

To deliver their objectives of maintaining financial stability and preventing and mitigating the impact of financial crises, policy-makers in central banks, egulatoryr authorities and finance ministries strive to design laws, rules, egulationsr and other devices, especially in reaction to a costly event. Since the global financial crisis, they have launched a large number of policy initiatives, some of which may yield real benefits in terms of controlling the build-up of systemic risk.

Policy initiatives to reduce systemic risk

thers, however, may it is hard to predict how participants’ actually holding excessively small and perversely increase individual motives will come together decreasing levels of effective capital. systemic risk. Laws, rules to produce overall behaviour in They also include poorly conceived and regulations that the market. In particular, so-called banking regulations that can lead to wereO drawn up ostensibly to bolster ‘representative agent’ models used the emergence of a ‘parallel banking financial stability and limit the build-up widely by economists are by design system’ that itself can come with of risk can often become a channel unable to guide policy-makers in its own vulnerabilities – what former for amplification mechanisms that this regard. US Federal Reserve chairman Ben have precisely the opposite effect. Unfortunately, many policy rules may Bernanke in 2012 called the ‘diverse This occurs when multiple rules have be effective in preventing some types set of institutions and markets that, inconsistent objectives and interact of risk while at the same time creating collectively, carry out traditional in unpredicted ways. Often these new, perhaps hidden, sources of banking functions – but do so outside, perverse consequences can remain risk. These include capital regulations or in ways only loosely linked to, hidden until it is too late, and this can that enable financial institutions to the traditional system of regulated occur in particular when policies are report healthy capital levels while depository institutions’. drafted hastily in response to a crisis.

Policy-makers operate under specific mandates and with incomplete information. The new financial regulations they design can often contain embedded ‘constraints’ and devices that can coordinate actions of otherwise seemingly unconnected agents. Such rules often look to be a sensible step in the right direction, but which lead to unintended consequences in more stressed situations and contribute to amplification mechanisms once all indirect effects are taken into account.

Such indirect effects can lead to feedback loops, undesirable coordination and a lack of diversity within the market. Designing a robust regulatory regime is difficult because 26 Systemic Risk Centre

None of this implies that no remedial The new agenda of Furthermore, systemic risk arises from actions ought to be undertaken macroprudential policy – and is worsened by – a series of for fear of the potential unintended externalities. Each player disregards consequences. Rather, it suggests Since the global financial crisis, the the effects of its risky choices on that research into policy effects idea of designing macroprudential others, both when taking on risk as ought to incorporate – even if only policy to reduce the systemic risk well as when implementing mitigating tentatively – the system as a whole, within the financial system as a whole actions. Externalities arise even within with all its imperfections, to capture has been a central focus of attention the international context. its indirect and feedback effects for regulators and central banks. One current example is the bank- and minimise the occurrence of While not yet clearly defined, the sovereign-main street loop in the unintended consequences. Even the macroprudential agenda captures eurozone, where bank weaknesses ambiguity under which policy-makers the desire of society for robust rules called for sovereign bail-outs, which operate – the fact of not being sure to prevent crises and to cope with in turn weakened the sovereigns and which model is the right one – can them when they do happen, acting main street, further weakening state be coherently modelled and taken as a countervailing force to the guarantees and national product, into account in the first place. The natural decline in measured risks which fed back on banks, and so on. modelling and estimation of ambiguity in a boom and the subsequent rise The lack of international coordination is a fascinating task on which the SRC in measured risks in the following and fiscal union means that any is working. one country disregards the adverse consequences of underproviding for ‘The effect of the people’s agreeing financial soundness and resilience which that country’s actions have on that there must be central planning, its neighbours. Macroprudential policy – ideally implemented at a global without agreeing on the ends, will level – is required to internalise the be rather as if a group of people externalities and improve efficiency and systemic resilience. were to commit themselves to take Political scientists see the a journey together without agreeing weakness of the ‘counter-cyclical political constituency’ as one of where they want to go; with the the key obstacles to sustaining macroprudential policy in the result that they may all have to face of political resistance from make a journey which most of them those benefitting from asset price appreciation. As part of this agenda, do not want at all.’ Friedrich Hayek, 1944 the SRC is investigating the impact of various communication strategies that central bankers and regulators collapse. Macroprudential regulation can use to provide greater public is the complement to ‘microprudential’ legitimacy to macroprudential regulation, which seeks to improve intervention. SRC researchers the soundness of individual financial are developing various survey institutions. experiments to assess the impact The development of the of these communication strategies macroprudential agenda is very much on public opinion in the UK n in the early stages, and the SRC sees and elsewhere. its involvement with that discussion as a fundamental objective. Particular focuses for research include the systemic importance of individual institutions (in terms of their size, leverage and interconnectedness with the rest of the system), whether macroprudential tools are sufficient enough to have much of an impact, and whether they can withstand the political pressure for pro-cyclicality and are genuinely counter-cyclical or only create the appearance of counter-cyclicality. 27 Systemic Risk Centre

One particular concern is that it is the world’s central banks that have political support in a more positive been given the task of developing and deploying tools to limit the environment, where memories of the last crisis have faded and people are build-up of systemic risk and its potentially disastrous consequences enjoying the short-term benefits of the of financial instability and economic distress. The hope is that the bubble. Political support then is likely credibility acquired from conquering inflation in the 1980s and 1990s to be much weaker than now. will rub off on the new agenda of macroprudential policy. As a practical matter, the macroprudential agenda seems set up for failure in many countries. The technical uncertainties and institutional designs give sufficient room for significant political objections to gain traction. Since Dangers for any implementation is likely to run into strong political objections, anything that gives credence to those central banks objections is problematic. Having the central banks take the RC researchers fear the policy-makers, the more scope there lead in implementing macroprudential opposite: that the fuzziness of is to inhibit policy implementation. policy might seem sensible. But the the macroprudential agenda success of the agenda depends S The politicisation of macroprudential and the interplay of political pressures on maintaining political consensus policy leads to countervailing may undermine the reputation of as well as the existence of a robust pressures. Financial regulators may central banks and threaten the toolkit. Central bankers have be biased towards non-intervention effectiveness of monetary policy. fine-tuned the art of economic because they would face political In assuming responsibility for communication to steer inflation pressure against tightening during a macroprudential policy, central banks expectations. They must now become boom. It is often politically difficult to risk their hard-earned reputations for better political communicators, and take measures that reduce short-term effective monetary policy (Chwieroth sharpen their macroprudential tools, economic growth in the interests of and Danielsson, 2013). to maintain consensus for managing fending off a bust that many think systemic risk. If they fail in either task, In fighting inflation, central banks will not happen. This is a common all the sound and fury around the have one explicit tool at their problem in financial regulation, macroprudential agenda could signify disposal – interest rates – and an creating the widespread phenomenon nothing, risking both financial and unambiguous and easily measured of ‘pro-cyclicality’ – when the price instability. n objective – inflation. There are no behaviour of market participants and equivalents in macroprudential policy authorities amplifies the volatility policy. Instead, policy-makers have of the financial system. a wide-ranging collection of often- On the other hand, especially after a conflicting tools and an even more crisis, regulators may lean towards baffling set of measures designed to premature intervention because they capture systemic risk and financial fear being criticised for failing to spot instability. This ambiguity makes a bubble. But the desire to prevent it difficult to build the necessary future crises at all costs could put political consensus for employing the severe constraints on investment and macroprudential toolkit. the capacity for growth. The implementation of The macroprudential agenda is hard macroprudential policy, especially in to disagree with: who can object to times of crisis, inevitably involves a measures that prevent the build-up of wide array of institutions, including imbalances that will cause significant the fiscal authority. This increases economic harm? No wonder then that both the politicisation and access for the macroprudential agenda currently divergent viewpoints, which permits enjoys significant political support, any critic to use macroprudential especially as memories of the crisis ambiguity to argue that a different are fresh and policies have only been measure or different tool is more implemented sparingly. appropriate. The direct involvement of the fiscal authority gives critics even But at some point in the future, more leverage. The more avenues that macroprudential policy will have to be divergent interests have for influencing implemented more widely and receive 28 Systemic Risk Centre A financial transactions tax? ‘It is generally agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of Stock Exchanges.’ ‘Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes the by- product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism – which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.’

John Maynard Keynes, 1936

he global financial crisis has financial transaction tax for the EU, revived an idea that goes for the purpose of stabilising financial back to John Maynard markets and raising additional tax Keynes: using transaction revenue from financial institutions. The Ttaxes to discourage short-term proposal is being implemented by 11 speculative trades. Such trading is EU member states, whereas other often blamed for causing excess member states do not share the belief volatility in financial markets. The that the tax is beneficial. Nobel laureate James Tobin gave SRC researchers are actively engaged his name to the tax more than 40 in developing a deeper understanding years ago, when he proposed it as a of the economic trade-offs involved in measure to ‘throw some sand in the the taxation of financial transactions. wheels of speculation’, specifically for By curtailing ‘noise trading’, Tobin currency trading. The idea has been taxes can in principle reduce the extended to all forms of financial excess volatility of financial markets. transactions. But by reducing the amount of In September 2011, the European informed trading, such taxes might Commission proposed a harmonised also harm market quality. 29 Systemic Risk Centre

A 2014 study by SRC researchers In economic policy-making circles around the world, Albina Danilova and Christian Julliard significant effort is currently being invested in empirical finds that if the goal is to dampen market volatility, a tax on financial techniques to identify systemic risk. Yet much of this transactions might actually be work, which is based on studying directly observable counterproductive. By impeding outcomes in financial markets, may not be able to the ability of the price to incorporate identify systemic risk until it is too late to take action. new information, it allows mispricing relative to fundamentals to last longer and when corrections eventually occur, these will be sudden and large. Systemic risk: Market participants will seek to recover the costs incurred by the tax, and therefore will require larger what can departures of prices from fundamental values as a precondition for trading. Consequently, only relatively larger data reveal? information shocks will induce trading. This means that price volatility is reduced in calm times and raised in hectic times. Hence, a Tobin tax would increase the fragility of financial markets.

An empirical study involving SRC arket prices have two reactive. Some of the work done at researcher Andreas Uthemann fundamental roles: the SRC incorporating insights from measures the impact that a Tobin they reflect the current endogenous risk suggests that simple tax would have on the price volatility, valuation of assets but and widely available market-based volume and informational efficiency Mthey are also imperatives to action. indicators – such as the so-called of stocks traded on the New York Much of the data used for the VIX volatility index, spreads on credit Stock Exchange (Cipriani et al, 2014). empirical modelling of systemic risk default swaps and off-the-shelf In particular, the authors construct a is generated by financial markets, market risk methods like ‘value-at-risk’ market microstructure model of asset and therefore reflects the opinions – react only after a crisis is underway. of market participants as to future trading and estimate it using intraday This suggests the importance of profitability and risk. transaction data. looking deeper for data that are useful They find that a Tobin tax should be While such data capture the current for the identification and forecasting of responsive to the liquidity situation state of the financial system, they systemic risk. Looking at a simple and of the affected markets. A flat tax may not provide good guidance as commonly available market-based in particular, if applied to all traded to the future. One reason is that to indicator extracted from a restricted stocks irrespective of their individual the extent market participants fit number of financial security prices is characteristics, can be potentially backward-looking statistical models not sufficient to capture the build-up quite damaging to the proper for forecasting risk to such data, so of imbalances. n these outcomes reflect perceived risk functioning of the price mechanism. One avenue that the SRC is exploring and not actual risk. is to analyse confidential data sets Observed outcomes in collected by policy authorities, such financial markets may as the joint work by SRC researchers reflect the reality on the Christian Julliard and Kathy Yuan with ground, but may not be colleagues at the Bank of England very useful when it comes (Denbee et al, 2014). Another is to forecasting systemic risk work with Markit, a leading supplier – before a crisis happens of financial information services, to – thereby enabling the explore the build-up of potential authorities to take fragilities in a few sub-markets that corrective action. may create instability in the financial system. Ultimately, this perverts empirical SRC research in collaboration with work on forecasting Markit is underway using two large- systemic risk. If scale proprietary datasets – one available data reflect covering the securities lending market; the market consensus, it and one covering the ‘over-the- is almost by definition counter’ (OTC) derivatives market. n 30 Systemic Risk Centre

One of the main ways that financial institutions obtain liquidity is by means of securities lending, where financial assets are lent out or used as a pledge for borrowing. The market for securities lending has grown rapidly in recent years, with more than $2 trillion worth of securities estimated to be on loan at any given time. Securities lending

ecurities lending can securities transactions over the past facilitate access to liquidity 12 years, enabling SRC researchers through several means. For to understand the evolution of example, securities can global liquidity, especially at the Sbe used as collateral to gain liquidity height of the crisis in the fall of 2008. in the form of cash or highly rated Furthermore, the database can be bonds, thus allowing the holder to used to identify how global liquidity avoid having to liquidate securities provision is affected by central bank in a fire sale. This also reduces the announcements and policies. The cost of trading and promotes price successful conclusion of this research discovery by providing liquidity to will enable macroprudential regulators market-making operations in the to tailor liquidity provision more capital markets. effectively, both during crises and in more routine stimulus, reducing At the same time, securities lending the cost to the taxpayer while can be a source of systemic risk. One simultaneously increasing way is via the excessive reinvestment the efficiency of macroprudential of cash collateral associated with policies. n securities lending transactions, which can lead to maturity mismatches and eventual runs. An example is the case of US insurance company AIG, which caused such extreme liquidity risk that not only was its own survival threatened but also the health of the entire financial system.

The Markit securities finance data set covers over 13 trillion of global 31 Systemic Risk Centre

When financial institutions want to know if their derivatives pricing models Legal are reliable they use Totem. Academic analysis of totem data promises dimensions to answer fundamental questions about information cascades, of systemic model risk and the nature of liquidity. risk

The financial system is underpinned and shaped by Totem law, which makes it difficult to think about systemic risk without considering the legal system. Indeed, law otem is a service that and finance are so inseparably linked that it is next to Markit provides to impossible to imagine a financial system that operates banks to validate their without law. Law supports the financial system in a proprietary derivative number of ways, including issues around contracts, Tpricing models, identifying and quantifying risks that originate ownership rights and regulation. from mis-specified models. A large source of market irst, law enables market crisis means that the enforceability of uncertainty during the crisis from participants to shape the contracts only becomes visible at 2007 was the inability to value their relationship through that time. derivative securities. This lack of contracts. The content of robustness leads to substantial One example is the ownership Fthese contracts is determined by the uncertainty concerning the treatment of assets by custodians parties who will each aim to shape correct prices for products such (see below). Another is how the ‘flip the outcome in their respective as collateralised debt obligations clause’ in a trust deed in the Lehman interest. In some areas of the financial (CDOs). In turn, this has systemic Brothers insolvency proceedings system, there are standard forms for consequences. against investors were treated contracts that market participants differently by two court systems (see SRC researchers are using the either adopt outright or modify to page 33). Just a handful of words Totem database to develop a suit their requirements. Contracts in the contracts might determine better understanding of systemic are mechanisms that help to balance whether assets fell into the Lehman risk in several different ways. One interests between parties by setting Brothers estate or were available to example is a study of whether up a framework that can be enforced counterparties (Braithwaite, 2014). quantitative analysts know when by courts or forums of the parties’ they don’t know: in other words, choosing. Contracts can be private While each standard financial do analysts have an idea of how or regulated. instrument may have a small face well their models are able to price value, the use of standard terms The legal system is one of the most complicated derivative contracts? n multiple times over internationally important mechanisms for exposing means that they can have a very real hidden endogenous risk. Financial impact on the global economy. When contracts are often very complicated, there is considerable uncertainty as with untested legal terms. In crisis to how a court system might address times, this risk manifests itself through terms and resolve conflicting claims, various avenues. For example, while judicial expertise is required. the financial system is global, the Very few judges have experience legal system is local; and court with complex financial contracts. proceedings that address the same This can lead to significant legal risk, financial contract can result in which manifests itself in the worst conflicting decisions. Furthermore, the state of the world during a crisis. complexity of contracts on financial In other words, how courts treat risk that tends to materialise during a complicated financial instruments 32 Systemic Risk Centre represents yet another form of hidden connected with each other through law. The thesis of the study is that endogenous risk. contract law. There is also legislation structural reform is required to reduce determining the relationship between the number of intermediaries that Similarly, financial institutions might custodians and their clients. operate between issuers and investors. get into a situation in which they are A central, direct and transparent unable to comply fully with authorities The research shows that custody mechanism should be created through in different countries. If they satisfy chains have become independent which investors hold securities. The one authority, they consequently from investors and issuers. Neither research observes that in the past violate the rules of another. issuers nor investors are able to incumbent market participants have control the length of the chain or the lobbied intensively to preserve the content of the legal arrangements that existing structure and predicts that Ownership and govern the custody chain. Custodians they are likely to oppose any proposed custody chains are connected through a series of changes. The law makes it possible for investors bilateral links that are independent of to acquire and exercise ownership each other. This erodes the rights of rights in financial assets. Investors are investors. The study illustrates this by allocated rights to interest payments reference to the liability of custodians or dividends, voting rights and other for their services and by reference to governance rights through legislation, the ability of custodians to contract regulator policy or the terms of a with sub-custodians on terms that are financial instrument contract. Law also independent from the terms that they enables investors to enforce those have entered into with their customers. rights against issuers. Property rights Custody chains affect securities can help to protect investors when a markets at a very fundamental level. counterparty becomes insolvent. Securities are a bundle of rights that investors have against issuers. Market In recent years, a market structure A further study by Eva Micheler (2014b) participants assume that these has evolved that leads to securities shows that holding securities through rights are enforceable against the being held indirectly through chains of chains of intermediaries compromises issuer. There is always a risk that an custodians. These chains yield many the ability of investors to exercise issuer defaults and becomes unable benefits to the financial intermediaries their rights, a problem that is not to meet claims. Otherwise, however, who have embedded themselves remedied by the Geneva Securities the market is entitled to expect that in them. But many investors do not Convention. She argues that research its infrastructure will make it possible understand the risks associated with should be carried out to determine to enforce claims where an investor custodians holding assets. if a mechanism can be created that takes the view that the issuer does not enables ultimate investors to hold Custody agreements often allow comply with the terms of an issue. custodians to use investors’ assets securities directly. If the enforcement of claims is for their own business purposes. In Further work on creating a harmonised significantly compromised this can times of crisis, when counterparties set of rules at a functional level will affect the value of securities. Investors fail, securing assets back for investors not improve legal certainty, reduce will only enforce claims if the cost of is difficult. After all, the legal framework systemic risk or enhance market enforcement is outweighed by the made up of bilateral custody contracts efficiency. The problems associated benefits. If the market infrastructure is a fragile one. A domino exercise is with the current framework are is set up in a way that makes required to retrace steps of assets a function of the process of enforcement systematically very before investors can get them back. intermediation itself. Legal risk, expensive, investors will refrain So investors must carefully monitor systemic risk and market efficiency are from enforcing claims and that has their assets and the terms of their all adversely affected by the number of implications for the value of those agreements. intermediaries operating in this context. claims. This can have systemic This is an area where law cannot help Work by SRC researcher Eva Micheler implications. considers how custody chains can but structural reform can. It is worth operate as a source and amplifier of Custody chains not only affect security investigating if a framework can be risk affecting the value of securities with values in the portfolios of investors. created that allows for securities to be potentially systemic implications. One They also cause problems for issuers. held directly by ultimate investors. of her studies shows that the current They pose a significant hurdle preventing individual and institutional market infrastructure systemically Law as a tool of prevents investors, both shareholders investors from exercising rights against and bondholders, from exercising issuers when they wish to do so and financial regulation their rights against issuers (Micheler, as a result deprive issuers of oversight In the context of systemic risk, law 2014a). Equity and debt securities are from the shareholders. is used as a tool to regulate financial now normally held through a chain This problem cannot be overcome by institutions. The aim is to set up a of custodians. These custodians are contract law, corporate law or property framework that renders financial 33 Systemic Risk Centre

institutions robust against risk. seen whether these instruments a way that reaches far beyond that Financial regulation puts in place live up to their expectations or if the particular insolvency, to worldwide mechanisms that are designed to terms of the bonds align in a way that users of standard form documents, discourage excessive risk-taking. Law amplifies risk within the system. the global financial markets and the can help to contain and manage risk. common law itself. Seen in this light, the case law around Lehman Brothers Law, however, can also be a source Domestic and is a significant, but under-appreciated, of risk. Unregulated activities of high international law side effect of the global financial crisis volume and interconnectedness – The national – as opposed to cross- (Braithwaite, 2014). such as shadow banking – can lead border – nature of legal systems can to systemic risk. Legal rules can also Are court systems able to cope with be significant amplifiers of systemic have unintended consequences the complexity of financial contracts? risk. The bankruptcy of Lehman for the parties of a contract or the The English court’s ability to deal Brothers in 2008 highlighted the legislature and the market as a whole. with complex financial contracts was challenges faced by litigants in The regulators can overlook the fact highlighted in the Lehman Brothers recouping their property. There is no that certain contracts allocate risk in cases. Perpetual Trustee [2011] UKSC single international insolvency law. a systemically problematic way. But 38 in particular showed the power Each jurisdiction has its own laws in following the global financial crisis, and flexibility of the UK common relation to bankruptcy and insolvency. regulators have been more keen to law system in comprehending and provide guidelines. The complexity of the Lehman accommodating new and complex Brothers operations, products and contracts with existing common Contracts can also be a source of risk network of international litigants law. The common law system with potentially systemic implications. made the litigation unprecedented. enabled many proceedings to be For example, the Basel Committee The bank was ‘international in life heard or case managed by the has endorsed the use of new and national in death’. A powerful same judge (Mr Justice Briggs), who financial products called ‘contingent example of the differences in meaning, brought expertise, consistency and convertible bonds’ – known as effect and outcome when particular expediency to the entire process. CoCos – as a cushion for market structures are tested against the shocks. CoCos are private and public It is essential that future financial insolvency laws of different countries contracts outlining the terms for which regulation reduces the different can be found in the 2011 parallel an investor’s money will be used treatment of assets, taxation and Lehman Brothers proceedings in the to fund an issuer’s capital in times property rights. Only when a known US and UK courts. of distress. Regulators, banks and or uniform approach exists will investors alike have welcomed their The collapse of Lehman Brothers also systemic risk be curbed. Clear use since they were first introduced demonstrated that precedents that and internationally coordinated laws on a large scale by Lloyds Banking are set in the aftermath of catastrophic will remove uncertainty from the Group in 2009. But it remains to be events affect the financial system in financial system.n 34 Systemic Risk Centre Political dimensions of systemic risk

A key question for policy-makers is how to limit the build-up of systemic risk and contain crisis events when they do happen. But the interaction between the political system, financial regulators and market participants can itself create endogenous feedback loops.

efore a crisis, politicians are leading states. More likely to celebrate the build- critically, some view its up of excesses and attempt fundamental origin to lie to prevent any effective in an Anglo-American Baction by the regulators. After a project towards market- crisis, they may want to demonstrate friendly regulation. One their toughness by clamping down need not adopt this more excessively on the financial system. critical view to accept the This leads to pro-cyclicality. proposition that leading states and their regulators may use SRC research is seeking a better international coordination to avoid the understanding of the policy-making competitiveness of unilateral action process that encourages laws that and to create an attractive market for may not have been fully thought their financial industry. through. One potential reason for that been the most likely to lose their hold lies in politicians’ short-term electoral Thus, systemic risk may arise on political power. horizons. Another is the horse-trading from an unfortunate mix of special that imposes many rules on a single interest lobbying, regulatory capture, Yet these ‘great expectations’ of law, which ends up being approved revolving doors, dysfunctional governments may provide a without any detailed debate about political institutions, and elite and socio-political origin for systemic their precise intended consequences. mass public belief systems. For risk. Societies expect crisis SRC researchers are studying the example, SRC researchers are mitigation politics and in response, political origins of risk, specifically investigating the consequence of governments intervene to avoid how rules of decision-making rising social expectations about crisis political punishment. The problem influence the distribution of risk prevention and mitigation. As citizens is that they do so with increasingly among different parties. have become more demanding of large distributional consequences, governments since 1945, those that potentially producing moral hazard In many instances, political scientists are perceived to be unresponsive and undermining long-run financial see the global governance of systemic to the consequences of crises for stability (Chwieroth and Walter, 2013, risk as reflecting the interests of income, employment and wealth have 2014, 2015). 35 Systemic Risk Centre

The political nominal interest rate by the European performance between different embeddedness of Central Bank (ECB), produced a economies within the monetary union. pro-cyclical monetary policy, and Different political systems also seem systemic risk institutional traps that make it very to be related to different ways of difficult to get out of that pro-cyclical The political embeddedness of producing financial risk. For example, policy (Hancké, 2013). systemic risk invites questions about the collapse of the so-called Keynesian how that happens and why. One thing Imagine a monetary union, like the welfare state, which guaranteed that seems clear is that capitalism eurozone, consisting of two economies stable, slowly rising incomes for the has many organisational faces and of roughly equal size (call them DE and vast majority of the population, has takes many institutional forms, in RE, for Germany and its satellites and imposed constraints on governments which finance plays different roles. As the rest of Europe). Both economies to provide other means through which a result, some capitalist systems are evolve on their own in interaction, but the bottom two-thirds of the income more prone to producing crises than are subject to a single interest rate that distribution can see their incomes rise others. What is interesting is that when reflects, to keep things simple, the in real terms. different financial systems integrate, ECB’s inflation target. banks in the more careful systems Access to credit in a burgeoning suddenly develop two faces: one high- For a variety of endogenous and housing market has become one of risk, often oriented towards finance historical reasons, DE’s inflation rate those means. But that also implied outside the domestic economy; and is slightly lower than RE’s – say, 1.5% that housing prices became a crucial one retaining much of the low-risk as opposed to 2.5%. The perverse parameter in a country’s economic profile it had before. effect is that the real interest rate, the wellbeing, regardless of the underlying difference between the single nominal economic fundamentals. Financial integration in Europe, interest rate set by the ECB and the This preoccupation with access to together with deregulation and inflation rate in the country, now will credit, mortgage policies by the banks liberalisation of the financial sector, be too low in RE, thus fuelling inflation and housing prices has become have made the once very sharp in RE and pushing economic activity far more important in the highly boundaries between different sub- down in DE. types of banks considerably more deregulated Anglo-Saxon economies permeable. During the eurozone crisis, In the second period, the inflation with a strong financial sector, it became abundantly clear that even differential between DE and RE will where the safety net and welfare the once ‘conservative’ German banks therefore increase – and the pro- arrangements have been hollowed out. had exposed themselves to risky US cyclical difference in real interest rates It is considerably less of a destabilising financial instruments and to sovereign in the two countries will increase with factor in continental European debt in weaker eurozone member that. This process repeats itself until economies, where the broad social states. The latter risk was facilitated the monetary union breaks – unless RE compact that has governed since the by EU rules stipulating that for the can do what it needs to bring inflation Second World War has remained more purpose of bank capital calculation, down, for example, by imposing wage intact. moderation, while DE slowly increases sovereign debt is risk-free. In addition, the electoral system may its inflation rate in parallel. While the purpose of such a rule is to have an impact. It is probably not a subsidise government borrowing, it The sad irony is that in the real world, coincidence that economies such as has the unfortunate consequence of the two economies are endowed with the United States and the UK, where making banks look safer than they exactly the opposite institutions to growth is credit-led, were at the core actually are. This meant that European what they need: DE has the institutions of the financial crisis, while export-led banks had to be rescued – directly to keep inflation low or bring it down economies such as Germany and through a bank bailout or indirectly when it is rising – strong labour unions other continental countries, were through a bailout of the governments and central wage coordination – often lagging far behind. Credit-led whose bonds they held. while RE lacks them. DE is, in fact, economies have a majoritarian constrained to keep inflation rates electoral system, in which narrow This tension between national low since economic growth depends interest lobbies, be they homeowners regulation (and therefore national disproportionately on a competitive or financial institutions, can have a profiles of financial risk) and the real exchange rate rather than disproportionate impact on policy in internationalisation of finance beyond allowing them to rise in a symmetric their favour. regulatory frameworks is a central adjustment process across the entire Export-led economies, in contrast, part of the political economy of monetary union. systemic risk. often have an electoral system based Despite its origins in a volatile financial on proportional representation, in A second key issue is how the ‘real’ sector abroad, much of the eurozone which many different interests in an economy (as opposed to the money crisis was precipitated by these economy are balanced through the economy on its own) produces risks. dynamics between pro-cyclical political system. To some extent, this SRC researchers have worked on how monetary policy and divergent suggests, endogenous risk is also different labour market institutions, domestic institutions that exacerbated politically endogenous. n against the background of a single small differences in economic 36 Systemic Risk Centre Further reading

Bernanke, Ben (2012) ‘Some Chwieroth, Jeffrey and Andrew Walter Danielsson, Jon, Kevin James, Marcela Reflections on the Crisis and the Policy (2014) ‘Financial Crises and Political Valenzuela and Ilknur Zer (2014b) Response’, Fed chairman’s speech Turnover: A Long Run Panoramic View’. ‘Model risk and the implications for risk at the Russell Sage Foundation and http://personal.lse.ac.uk/chwierot/ management, macroprudential policy, Century Foundation Conference on images/Panoramic.pdf and financial regulations’. ‘Rethinking Finance’, New York. www.voxeu.org/article/model- Chwieroth, Jeffrey and Andrew Walter http://www.federalreserve. risk-risk-measures-when-models- (2015) ‘Great Expectations, gov/newsevents/speech/ may-be-wrong Veto Players, and the Changing bernanke20120413a.htm Politics of Banking Crises’, Danielsson, Jon, Stathi Panayi, Gareth Black, Julia (2013) ‘Seeing, Knowing, SRC Discussion Paper No. 28. Peters and Jean-Pierre Zigrand (2015b) and Regulating Financial Markets: http://www.systemicrisk.ac.uk/ ‘Liquidity Resilience’, mimeo. Moving the Cognitive Framework from publications/discussion-papers/ Danielsson, Jon and Hyun Song Shin the Economic to the Social’, LSE Law, great-expectations-veto- (2003) ‘Endogenous Risk’, in Modern Society and Economy Working Paper players-and-changing-politics- Risk Management: A History edited by No. 24/2013. banking-crises Peter Field, Risk Books. http://www.lse.ac.uk/collections/ Cipriani, Marco, Antonio Guarino and law/wps/WPS2013-24_Black.pdf Danielsson, Jon, Hyun Song Shin Andreas Uthemann (2014) ‘Tobin and Jean-Pierre Zigrand (2012a) Boucher, Christophe, Jon Danielsson, Taxes and the Informational Efficiency ‘Endogenous Extreme Events and the Patrick Kouontchou and Bertrand Maillet of Financial Markets: A Structural Dual Role of Prices’, Annual Review of (2014) ‘Risk Models-at-Risk’, SRC Estimation’, mimeo. Economics 4: 111-29. Discussion Paper No. 6. Danielsson, Jon (2013a) Global Financial http://www.systemicrisk.ac.uk/ Danielsson, Jon, Hyun Song Shin Systems: Stability and Risk, Pearson. publications/discussion-papers/ and Jean-Pierre Zigrand (2012b) risk-models-risk Danielsson, Jon (2013b) ‘The new ‘Procyclical Leverage and market-risk regulations’. Endogenous Risk’, available at: Braithwaite, Jo (2014) ‘Law after http://www.voxeu.org/article/new- www.riskresearch.org/ Lehmans’, LSE Law, Society and market-risk-regulations ?paperid=39#papercontent Economy Working Paper No. 11/2014. http://eprints.lse.ac.uk/55834/ Danielsson, Jon (2013c) ‘Towards a Danielsson, Jon, Marcela Valenzuela more pro-cyclical financial system’. and Ilknur Zer (2015c) ‘Volatility, Crises Bremus, Franziska and Katja http://www.voxeu.org/article/ and Economic Growth’, mimeo. Neugebauer (2014) ‘Don’t Stop Me towards-more-procyclical- Now: The Impact of International financial-system Danielsson, Jon and Chen Zhou (2015) Banking on Firm Financing’, mimeo. ‘Why Risk is So Hard to Measure’, SRC Danielsson, Jon (2015a) ‘What the Discussion Paper No. 36. Buch, Claudia and Katja Neugebauer Swiss FX shock says about risk models’. http://www.systemicrisk.ac.uk/ (2011) ‘Bank-specific Shocks and the http://www.voxeu.org/article/ publications/discussion-papers/ Real Economy’, Journal of Banking and what-swiss-fx-shock-says-about- why-risk-so-hard-measure Finance 35 (8): 2179-87. risk-models Danielsson, Jon and Jean-Pierre Chwieroth, Jeffrey and Jon Danielsson Danielsson, Jon (2015b) ‘The Nature Zigrand (2008) ‘Equilibrium Asset Pricing (2013) ‘Political challenges of the of Risk’, mimeo. with Systemic Risk’, Economic Theory macroprudential agenda’. 35: 293-319; earlier version available http://www.voxeu.org/ Danielsson Jon, Lerby Ergun and as Financial Markets Group Discussion article/political-challenges- Casper de Vries (2015a) ‘Pitfalls in Worst Paper No. 561. macroprudential-agenda Case Analysis’, mimeo. http://www.lse.ac.uk/ Chwieroth, Jeffrey and Andrew Walter Danielsson, Jon, Kevin James, Marcela fmg/workingPapers/ (2013) ‘From low to great expectations: Valenzuela and Ilknur Zer (2014a) ‘Model discussionPapers/2006.aspx banking crises and partisan survival over Risk of Risk Models’, SRC Discussion Danilova, Albina and Christian Julliard the long run’. Paper No. 11. (2014) ‘Information Asymmetries, http://www.voxeu.org/article/ http://www.systemicrisk.ac.uk/ Volatility, Liquidity, and the Tobin Tax’, banking-crises-and-political- publications/discussion-papers/ SRC Discussion Paper No. 24. survival-over-long-run model-risk-risk-models http://www.systemicrisk.ac.uk/ publications/discussion-papers/ information-asymmetries-volatility- liquidity-and-tobin-tax 37 Systemic Risk Centre

Denbee, Edward, Christian Julliard, Ye Micheler, Eva (2014a) ‘Custody Chains Li and Kathy Yuan (2014) ‘Network Risk and Remoteness – Disconnecting and Key Players: A Structural Analysis Investors from Issuers’, SRC Discussion of Interbank Liquidity’, Financial Markets Paper No. 14. Group Discussion Paper No. 734. http://www.systemicrisk.ac.uk/ http://www.lse.ac.uk/fmg/ publications/discussion-papers/ workingPapers/discussionPapers/ custody-chains-and-remoteness- home.aspx disconnecting-investors-issuers

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Hayek, Friedrich (1956) ‘The Dilemma of Specialization’, in The State of the Social Sciences edited by Leonard D. White, University of Chicago Press.

Keynes, John Maynard (1936) The General Theory of Employment, Interest and Money, Macmillan and Co. 38 Systemic Risk Centre Biographies

Tomaso Aste Jeffrey Chwieroth Co-Investigator Research Associate Tomaso Aste is Reader in Jeffrey Chwieroth is Professor of Computational Finance and Head International Political Economy, of the Financial Computing & Department of International Relations, Analytics Group at University College LSE. His research interests are in Jean-Pierre Zigrand London. His research interests the international political economy of Co-Director concern the investigation of complex money and finance, specifically the Jean-Pierre Zigrand holds a PhD systems and complex materials political consequences of financial in economics from the University by combining network theory and crises, sovereign wealth funds, of Chicago and is Associate statistical methods to decode the financial globalisation, the International Professor of Finance at the LSE. properties of these systems and to Monetary Fund, emerging markets, His research interests cover general extract information concerning their and economic norms and ideas. equilibrium asset pricing, financial organisation. intermediation and delegation, continuous time asset pricing, market crashes and foundations of arbitrage.

Lerby Ergun Julia Black Research Officer Co-Investigator Lerby Ergun works on the empirical Julia Black is Pro Director for Research aspect of systemic risk in the financial at the LSE. She completed her first system. His PhD thesis mainly degree in Jurisprudence and her focuses on, but is not exclusive to, DPhil at Oxford University. Her primary studying the extreme behaviour of research interest is regulation. financial markets. She has written extensively on regulatory issues in a number of areas, Jon Danielsson and has advised policy-makers, Co-Director consumer bodies and regulators Jon Danielsson holds a PhD in on issues of institutional design and economics from Duke University and regulatory policy. is Associate Professor of Finance at the LSE. His research interests Bob Hancké cover systemic risk, financialrisk, Co-Investigator econometrics, economic theory and Bob Hancké is Associate Professor financial crisis. of Political Economy at the LSE. Previous appointments were at the Wissenschaftszentrum Berlin, and as a PhD candidate at the J.F. Kennedy School and Center for European Studies at Harvard University, and at MIT. His research interests are political economy of advanced capitalist societies; the political economy of transition economies; institutions and macroeconomic policy; and labour relations. 39 Systemic Risk Centre

Christian Julliard Kyle Moore Andreas Uthemann Co-Investigator Research Officer Research Officer Christian Julliard is an Associate Kyle Moore completed his PhD at the Andreas Uthemann’s research Professor in the Department of Erasmus School of Economics. His interests include financial economics, Finance and a senior research research interests include extreme market design, and regulation. He associate of the Financial Markets value theory and asset pricing. The did his undergraduate studies at Group (FMG), LSE. He is also a aim of his SRC work is to apply novel Humboldt University, Berlin, and his research affiliate of the International ideas along with unique datasets doctoral studies at University College Macroeconomics and Financial to analyse potential sources and London, both in economics. Economics programmes of the channels of systemic risk in the Centre for Economic Policy Research financial sector. (CEPR), and an associated editor of Economica. His research interests are in macroeconomics, asset pricing, applied econometrics, international economics, networks, and market microstructure. Romesh Vaitilingam Editor Katja Neugebauer Romesh Vaitilingam is a writer and Research Officer media consultant, and is the author Katja Neugebauer is interested in of numerous articles and several all aspects of international banking, successful books in economics, with a special focus on bank risk and finance, business and public policy, contagion. She is also interested in including The Financial Times Guide Eva Micheler firms’ financing constraints and the to Using the Financial Pages Co-Investigator real effects of international banking. (FT-Prentice Hall), now in its sixth Eva Micheler is Reader in Law at She holds a PhD in Economics from edition (2011). In 2003, he was the LSE and a Universitätsprofessor the University of Tübingen. awarded an MBE for services to at the University of Economics in economic and social science. Vienna. Before joining LSE, she was also a TMR fellow at the Faculty of Law at the University of Oxford. Her research interests are the law of investment securities in England, Germany, Austria and Russia, the law of corporate finance, in particular the Philip Treleaven law of equity finance. Co-Investigator Kathy Yuan Philip Treleaven is Professor of Co-Investigator Computing at University College Kathy Yuan received her PhD in London. He is also Director of the UK economics from MIT. Prior to this, PhD Centre for Financial Computing. she worked briefly in the Emerging His research and teaching interests Markets Trading Desk at J. P. Morgan cover financial services (e.g. (now JPMorgan-Chase). She is computational finance and algorithmic Professor of Finance at the LSE and trading) and the creative industries a member of the Financial Markets (e.g. anthropometrics surveys using Group (FMG), the Centre for Economic 3D body scanners). Policy Research (CEPR) and has recently received a Houblon-Norman Fellowship at the Bank of England. 40 Systemic Risk Centre 103 Systemic Risk Centre Systemic Risk Centre SYSTEMIC RISK: WHAT RESEARCH TELLS US AND WHAT WE NEED TO FIND OUT

Dimitri Vayanos Professor of Finance, Tim Frost Head of Director and Founder, Department of Cairn Capital, Finance, LSE and Governor of LSE “Systemic risk has emerged as one of the “The world expects LSE to apply itself to most important areas of study for anybody understanding the causes of society’s biggest interested in and concerned with the financial problems. Few problems are bigger or require system. Therefore, the Department of more understanding than the risk inherent Finance at the London School of Economics in our financial system, so the world will be is delighted to have the opportunity to host delighted but not surprised that Danielsson the Systemic Risk Centre (SRC). and Zigrand have incubated and delivered the Systemic Risk Centre at the LSE. We now “The two directors of the Centre, Jon look forward to the SRC’s insights, intuition Danielsson and Jean-Pierre Zigrand, in their and innovation as we prepare for more capacity as Associate Professors in our financial instability ahead.” Department, were among the first academic researchers to study systemic risk, long before the global financial crisis that started in 2007. Since establishing the Centre two years ago, they have continued their academic work, and this magazine clearly demonstrates the excellent research being done on the question of systemic risk, in the SRC and LSE.”

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