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Financial Catastrophe Research & Stress Test Scenarios

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Financial Catastrophe Research & Stress Test Scenarios Cambridge Judge Business School Centre for Risk Studies 7th Risk Summit Research Showcase Financial Catastrophe Research & Stress Test Scenarios Dr Andy Skelton Research Associate, Cambridge Centre for Risk Studies 20 June 2016 Cambridge, UK Financial Catastrophe Research 1. Catalogue of historical financial events 2. Development of stress test scenarios 3. Understanding contagion processes in financial networks (eg, interbank loans) - Network models & visualisations - Role of central banks in financial crises - Practitioner model – scoping exercise 2 Learning from History Financial systems and transaction technologies have changed But principles of credit cycles, human trust and financial interrelationships that trigger crises remain relevant 12 Historical Financial Crisis Crises occur periodically – Different causes and severities – Every 8 years on average – $0.5 Tn of lost annual economic output – 1% of global economic output Without FinCat global growth could be 4% a year instead of 3% Financial catastrophes are the single greatest economic risk for society – We need to understand them better 3 Historical Severities of Crashes – Past 200 Years US Stock Market Crashes UK Stock Market Crashes 1845 Railway Mania… 1845 Railway Mania… 1997 Asian Crisis 1997 Asian Crisis 1866 Collapse of Overend… 1866 Collapse of Overend… 1825 Latin American Crisis 1825 Latin American Crisis 1983 Latin American Debt… 1983 Latin American Debt… 1837 Cotton Crisis 1837 Cotton Crisis 1857 Railroad Mania… 1857 Railroad Mania… 1907 Knickerbocker 1907 Knickerbocker 1987 Black Monday 1987 Black Monday 2001 Dotcom 2001 Dotcom 1893 Baring Bank Crisis 1893 Baring Bank Crisis 1973 Oil Crisis 1973 Oil Crisis 1873 Long Depression 1873 Long Depression 2008 Great Financial Crisis 2008 Great Financial Crisis 1929 Wall Street Crash 1929 Wall Street Crash 0% 20% 40% 60% 80% 100% 0% 20% 40% 60% 80% 100% Stock Market Crash Peak to Trough Stock Market Crash Peak to Trough Observed, last 200 years Observed, last 200 years Crashes Number of Average Crashes Number of Average Greater Than Crises Interval (Yrs) Greater Than Crises Interval (Yrs) 10% 12 16 10% 11 17 20% 9 21 20% 8 24 40% 6 32 40% 5 38 50% 1 190 50% 2 95 4 Modelling Historical Financial Crises 100 95 90 1893 Baring Bank Crisis 85 1873 Long Depression 2008 Great Financial Crisis 80 75 70 1929 Wall St Crash GDP (US$ 2010, 2010, Tn)(US$ GDP 1907 US ‘Bankers’ Panic’ 65 60 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2015 2016 2017 2018 2019 2020 2021 2022 2023 5 Estimating GDP@Risk 70 Trillion Crisis GDP US$ Trajectory 65 Global GDP 60 GDP@Risk Impact 55 Recovery 50 2012 2013 2014 2015 2016 2017 2018 2019 2020 GDP@Risk: Cumulative first five year loss of global GDP, relative to expected, resulting from a catastrophe or crisis 6 GDP@Risk from Historical Events GDP@Risk US$ Trillion, 2010 prices GDP@Risk 1893 Baring Bank Crisis 5 1873 Long Depression 7 1907 US ‘Bankers’ Panic’ 14 2008 Great Financial Crisis 20 1929 Wall Street Crash 30 7 Taxonomy of Financial Crisis Complex / Technological Flash crash Inflation Black box trading Cost-push inflation Complex derivatives Demand-pull inflation Cyber crash Deflation Banking Crisis Systemic failure Bank run Currency Crisis Credit crunch Reserve currency FX shock Asset Bubble Stock market crash Commodity price bubble Debt Property price bubble Sovereign Debt Private Debt Illegal Activity Fraud Financial irregularity 8 What is a Stress Test Scenario? . Use narratives that pose ‘what if’ questions and explore views about alternative futures. Help deal with complexity and uncertainty . Release us from conditioning and existing habits that may inhibit new actions and insight . Bring together creativity and analytics . Not predictions, or forecasts . A coherent, ‘severe yet plausible’ expectation about the future - Sufficiently impactful to reveal vulnerabilities in a portfolio/system - Realistic enough to justify managerial attention or remediation . Used to improve business resilience to shocks 9 Cambridge Stress Test Scenarios Context A justification and context for a 1% annual probability of occurrence worldwide based on historical precedents and expert opinion Timeline & Footprint Sequencing of events in time and space in hypothetical scenario Narrative Detailed description of events 3-4 variants of key assumptions for sensitivity testing Loss Assessment Metrics of underwriting loss across many different lines of insurance business Macroeconomic Consequences Quantification of effects on many variables in the global economy Investment Portfolio Impact Returns and performance over time of a range of investment assets 10 Cambridge Financial Stress Test Scenarios Global Property Crash Sudden collapse of property prices in the inflated property markets and this triggers a cascading crisis throughout the global financial system Eurozone Meltdown The default of Italy is followed by a number of other European countries, leading to multiple cession from the European Union and causing an extensive financial crisis for investors High-Inflation World A series of world events puts pressure on energy prices and food prices in a price increasing spiral, which becomes structural and takes many years to unwind Dollar Deposed US dollar loses its dominance as the default trading currency as it becomes supplanted by the Chinese Renminbi, with rapid unwinding of US Treasury positions and economic chaos 11 Global Property Crash: Narrative 1. Shake-up 2. Bubble Bursts 3. Rock Bottom Emerging market Contagion flows IMF declares a property prices & through global global recession rental returns begin financial system Global cycle of to slip Bubble bursts in negative growth – Triggers sell-off by Australia, followed by austerity measures shrewd investors NZ & Canada (all have little effect for that gains with highly inflated several years momentum property markets) Low consumer Chinese & Indian Labelled a “global confidence property markets collapse” & dampens low begin to plummet worldwide property interest rate International prices plummet stimulus measures property market Mortgage equity Triggers destabilised – most markets shrink, deflationary spirals inflated markets hit several large in major economies first European banks for next 3 years, allowed to fail with 2 more years till recovery 12 Global Property Crash Stress Test Scenario Minimum Credit Rating 300 Location Baseline S1 S2 250 ) Baseline P D China AA BBB BBB G S1 f 200 o S2 % Canada AAA AA AA , x a 150 M ( Sweden t AAA AAA AAA b e D . 100 t United Kingdom AAA BB B v o G Eurozone AA BBB BBB 50 United States AAA AA BBB 0 Tier 1: China Tier 2: Tier 3: Tier 4: UK Tier 7: US Tier 8: Tier 9: Japan Germany AAA AAA AAA Canada Sweden Germany Figure 12: Maximum government debts (% of GDP) Japan AA BBB BB comparison, change from baseline Table 9: Minimum credit ratings comparison across affected countries and regions As expected, China is observed to suffer one of the greatest incremental losses, shaving 8% of its quarterly China suffers a downgrade from AA to BBB primarily growth rate (from 5.3% to -2.8%) in scenario variant S2. due to a reduction in foreign direct investment and All other economiesa suffer significnt losses and a reduced confidence in the market after the property global recession develops in this scenario, regardless crash, although its proportion of government debt of the variants. Canada, Sweden, UK and the Eurozone remains the same. are all particularly affected with growth rates dropping Other major economiesa that suffer significnt below -8%. downgrades are: the UK (AAA to B), Eurozone (AA to BBB), the US (AAA to BBB), and Japan (AA to BBB). GDP@Risk The downgrades could be attributed to endogenous The macroeconomic consequences of this scenario weak market fundamentals,t inflaed housing are modelled, using the Oxford GEM. The output markets, and higher cumulative government debts as from the model is a five-year projection of the global a proportion to their GDP (Figure 12). economy. The impacts on each scenario variant are Countries such as Sweden and Germany both have compared with the baseline projection of the global their credit ratings remain the same throughout economy under the condition of no crises occurring. the variants, indicating relatively higher credit The difference in economic output over the five-year worthiness and lower overall debt-to-GDP ratios. period between the baseline and each model variant represents the GDP@Risk. Impact on economic growth rates The total GDP loss over five years, beginning in thes The technical definition of a recession is two firt quarter of Year 1 during which the shock of consecutive quarters of negative economic growth. the global property crash is applied and sustained Table 8 represents the minimum GDP growth rates through to the last quartere of Year 5, defins the (quarter-on-quarter) across the affected regions. GDP@Risk for this scenario. Table Global10: Global GDP@Risk Property for the Global Crash Property Crash: Macroeconomic Scenario variants losses Baseline S1 S2 5-yr GDP GDP@Risk GDP@Risk GDP@Risk GDP@Risk Location (US$ Tn) (US$ Tn) (%) (US$ Tn) (%) Tier 1: China 48.4 0.8 1.6% 1.1 2.2% Tier 2: Canada 9.5 0.4 4.3% 0.6 5.9% Tier 3: Sweden 2.8 0.1 3.0% 0.1 4.4% Tier 4: UK 14.0 1.1 8.0% 1.3 9.6% Tier 5 & 6: Eurozone 67.1 2.9 4.4% 3.7 5.6% Tier 7: US 88.9 3.0 3.3% 6.1 6.9% Tier 8: Germany 19.1 0.5 2.8% 0.8 4.1% Tier 9: Japan 29.3 0.7 2.3% 1.2 4.2% Cambridge Centre for Risk Studies World 395.0 13.2 3.3% 19.6 5.0% 90 The result is a global recession with growth rates ranging between -3% and -5% across S1 and S2.
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