Streetwise Professor

August 5, 2011

Idiosyncratic Shocks and Systemic Crises? I Think Not

Filed under: Clearing,Derivatives,Financial crisis,Politics,Regulation — The Professor @ 8:11 pm

Zero Hedge provides a reminder of the approaching automatic triggering of an increased haircut on Spanish and Italian government bonds in RepoClear.  Earlier this year LCH indicated that it would increase margins on Irish bonds when the spread hit 450 bp, and Italian and Spanish debt is reaching that level.

This is the kind of action that is individually rational for a clearer to take, but which can be destabilizing, pace my earlier posts on the hike in silver margins earlier in the year.

The haircut spiral plays a central role in a recent paper by BOE Financial Stability Executive Director Andrew Haldane and two co-authors.  The paper is nicely done, and the use of numerical methods to study the highly non-linear dynamics of complicated financial networks is the right way to go.

I am not persuaded that the paper focuses on the real sources of financial crises, however.  The reason is directly related to my post earlier in the week on clearing and systematic risk.  Haldane et al study how an idiosyncratic shock to the bank-specific haircut of a particular bank can propagate through a complex, densely connected network.  In some cases, such a shock can lead to a systemic crisis resulting from a cascade of banks deciding to hoard liquidity.  Not surprisingly, they find that the likelihood and intensity of such a contagion depends on the connectedness of the network, the skewness of the sizes of firms in the network, and the size and connectedness of the bank hit by the shock.

But I remained unconvinced as an empirical matter that major financial crises, at least in recent years, have developed in this fashion.  For this story to work, a single bank–and in the Haldane et al results, that bank would likely have to be a very big, highly connected one–is hit by an idiosyncratic shock that results in it having to pay higher haircuts on its secured lending.  In the real world, this could happen as the result of a rogue trader risk or some other major operational failing.

Perhaps the canonical example of such an episode would be the Kervial debacle at SocGen.  But even though that occurred when the markets were already stressed (in January, 2008), it didn’t lead to contagion.  I would be interested to hear of other examples, but I can’t think of any that have led to the cascade of failures like that that plays the central role in the Haldane et al analysis.

Instead, the major financial crises, most notably that of 2007-2008, the one that may be impending,  1998, etc., have been marked by an adverse shock hitting virtually all major financial institutions due to the similarity of their balance sheets.  European banks today are on the brink because they are all–all–heavily exposed to Eurozone government debt, and in particular to PIIGS debt.  This is a system-wide shock–a systematic shock, not a diversifiable, idiosyncratic one that is magnified through the web of interconnections among banks.  Such interconnections, margin spirals, liquidity hoarding, and so is a real possibility and could exacerbate the effects of the shock, but the point is that what is going on now, and what went on in 2007-2008, and what went on in 1998 is very different than the mechanism studied in the Haldane et al paper.

Perhaps many of the recommendations that Haldane and his coauthors make based on their analysis of the propagation of an idiosyncratic shock carry over to the case of a common shock hitting virtually all banks.  For instance, bigger liquidity cushions might be stabilizing in this situation as they are in the Haldane et al setup.

But maybe not.  Especially when one considers that for a variety of reasons–financial repression among them–sovereign debt is, and likely will remain a major component of any liquidity buffer.

That doesn’t work so well when the collapse of the creditworthiness of the governments issuing the debt is the root of the crisis, as is the case today.

I recommend the Haldane paper, but I think that it,  and many other papers that are based on tracing out the implications of idiosyncratic shocks to individual banks in a dense network, aim well wide of the mark.  I would like to see empirical work–hell, a case study, or even an anecdote–showing this mechanism working in practice.  If it is instead the case, as I am highly confident that it is, that financial crises are typically the result of an economy-wide, non-idiosyncratic, shock, the mechanism will be different and the policy implications will almost certainly be different.

A conjecture: in such a world, the greatest crisis accelerant is the similarity of balance sheets across major financial institutions.  To some degree, this cannot be avoided.  But there is no doubt in my mind that uniform regulations–and the Basel standards and other coordinated risk-based capital requirements–encourage even greater similarities in balance sheets.  This is a real danger, and if my conjecture is correct, many of the efforts currently underway to harmonize capital and liquidity requirements could make crises more rather than less likely . Basel Faulty and all that

The self-interested role of governments in cramming down more of their burgeoning debt will only exacerbate this problem, as regulators have an incentive to tilt capital and liquidity requirements in favor of holding government debt.  As dodgy as that debt is these days, it’s hard to imagine a better way to create the next crisis.

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  1. Linking to ZeroHedge SWP? You’re ending up on somebody’s bad list, you evil tea party ‘t#rrorist’, you.

    The third anniversary of Misha the Tie Eater’s ill-fated offensive is almost upon us. I’m not participating in the annual SWP commenter Baghdad Bob parody denying reality and Beltway embarassment over a U.S. ally running amuck and shelling a city full of civilians.

    Comment by Mr. X — August 5, 2011 @ 8:32 pm

  2. @x-man. I link to zh from time to time. It’s name is accurate: it is very high variance. Some of the stuff is good. Some of it delusional. Frequently it reports interesting stories and then has a delusional take on them.

    The ProfessorComment by The Professor — August 5, 2011 @ 9:48 pm

  3. 7 percent – that is the magic number. I saw a recent piece by Merrill that indicated that if Italian yields hit seven percent, then Italian debt dynamics become unstable. Italy isn’t quite there yet. The ten-year benchmark bond is trading at just over six, depending on the day in question.

    Nevertheless, Italian spreads have been on an upward trajectory for about two years. Italy is getting there.

    Comment by Leslie — August 6, 2011 @ 7:08 pm

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