As memories of the 2007-09 financial crisis fade, we worry that complacency is setting in. Recent news is not good. In the name of reducing the regulatory burden on small and some medium-sized firms, the Congress and the President enacted legislation that eased the requirements on some of the largest firms. Under the current Administration, several Treasury reports travel the same road, proposing ways to ease regulatory scrutiny of large entities without changing the law (see here, here and here). And, recently, the Federal Reserve Board altered its stress test in ways that make it more likely that poorly managed firms will pass. It also voted not to raise capital requirements on systemically risky banks over the next 12 months.
A few weeks ago, one of us (Steve) had the privilege to speak at the 20th Risk Convention of the Global Association of Risk Professionals (GARP). Founded in 1996, GARP engages in the education and certification of risk professionals and has several hundred thousand members worldwide. (Disclosure: Brandeis International Business School and NYU Stern are GARP Academic Partners.) The organizers allowed us to solicit the views of the 100-plus attendees on two issues that are central to financial resilience: Are bank capital requirements high enough? And, do central counterparties (CCPs) have sufficient loss-absorbing buffers? They answered both questions with a resounding “NO” …. Read More
Many features of our financial system—institutions like banks and insurance companies, as well as the configuration of securities markets—are a consequence of legal conventions (the rules about property rights and taxes) and the costs associated with obtaining and verifying information. When we teach money and banking, three concepts are key to understanding the structure of finance: adverse selection, moral hazard, and free riding. The first two arise from asymmetric information, either before (adverse selection) or after (moral hazard) making a financial arrangement (see our earlier primers here and here).
This primer is about the third concept: free riding. Free riding is tied to the concept of a public good, so we start there. Then, we offer three examples where free riding plays a key role in the organization of finance: credit ratings; schemes like the Madoff scandal; and efforts to secure financial stability more broadly.... Read More
Clean water and electric power are essential for modern life. In the same way, the financial infrastructure is the foundation for our economic system. Most of us take all three of these, water, electricity and finance, for granted, assuming they will operate through thick and thin.
As engineers know well, a system’s resilience depends critically on the design of its infrastructure. Recently, we discussed the chaos created by the October 1987 stock market crash, noting the problems associated with the mechanisms for trading and clearing of derivatives. Here, we take off where that discussion left off and elaborate on the challenge of designing a safe derivatives trading system―safe, that is, in the sense that it does not contribute to systemic risk.
Today’s infrastructure is significantly different from that of 1987. In the aftermath of the 2007-09 financial crisis, authorities in the advanced economies committed to overhaul over-the-counter (OTC) derivatives markets. The goal is to replace bilateral OTC trading with a central clearing party (CCP) that is the buyer to every seller and the seller to every buyer.... Read More
On Monday, October 19, 1987, the Dow Jones Industrial Average plunged 22.6 percent, nearly twice the next largest drop—the 12.8 percent Great Crash on October 28, 1929, that heralded the Great Depression.
What stands out is not the scale of the decline—it is far smaller than the 90 percent peak-to-trough drop of the early 1930s—but its extraordinary speed. A range of financial market and institutional dislocations accompanied this rapid plunge, threatening not just stocks and related instruments (domestically and globally), but also the U.S. supply of credit and the payments system. As a result, Black Monday has been labeled “the first contemporary global financial crisis.” And, a new book—A First-Class Catastrophe—narrates the tense human drama that it created for market and government officials. A movie seems sure to follow.
Our reading of history suggests that it was only with a great dose of serendipity that we escaped catastrophe in 1987. Knowing that fortune usually favors the well prepared, the near-collapse on Black Monday prompted market participants, regulators, the lender of last resort, and legislators to fortify the financial system.
In this post, we review key aspects of the 1987 crash and discuss subsequent steps taken to improve the resilience of the financial system. We also highlight a key lingering vulnerability: we still have no mechanism for managing the insolvency of critical payment, clearing and settlement (PCS) institutions.... Read More
The CCP Advantage: Incentive and Means to Control Counterparty Risks
The case of the insurance giant, AIG, highlights the information and incentives problems that CCPs can address. In the run-up to the financial crisis, AIG’s London-based Financial Products Group managed to sell enormous amounts of credit risk insurance without the liquid resources necessary to cover potential cash calls. By end-June 2008, AIG had taken on $446 billion in notional credit risk exposure as a seller of credit risk protection via credit default swaps (CDS). Read More
Experience Shows CCPs Safer than OTC Trading
Experience both before and after the crisis revealed that the system of bilateral OTC derivatives transactions was far more fragile than experience with CCPs. As a result, many people began to advocate a shift to central clearing. And, the G20 leaders agreed. Read More
G-20 Leaders Vote for CCPs: What are they?
In September 2009, as the financial crisis was starting to slowly recede, the leaders of the twenty largest economies of the world (the G-20) met in Pittsburgh. At the end of their summit, they issued a communiqué of nearly 9000 words. Somewhere in the middle of the statement, the following sentence appeared:
All standardized OTC [over-the-counter] derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. Read More