Within financial systems, the biggest risk factors are illiquidity, insolvency from high leverage, concentration of market share in too-big-to-fail institutions, and policy shocks. These risk factors are exacerbated by feedback loops and herding behavior, where actions by some market participants influence others in ways that create imbalances. For example, in the 1990s, US policy aimed to expand homeownership led to risky subprime lending and securitization of those loans, inflating a housing bubble. When housing prices stopped rising, many homeowners owed more than their homes were worth.
2. “A financial crisis is a situation in which the
value of financial institutions or assets drops
rapidly. A financial crisis is often associated
with a panic or a run on the banks, in which
investors sell off assets or withdraw money
from savings accounts with the expectation
that the value of those assets will drop if they
remain at a financial institution.”
(Investopedia)
4. Within a financial system, the biggest risk factors
often include but are not limited to:
Illiquidity
Insolvency/High leverage
High concentration of market share (TBTF)
Policy shocks
Network effects and feedback loops drive many
of these risk factors.
6. Financial systems are highly sensitive to
feedback loops.
Herding behavior within financial markets
creates imbalances in the markets, creating a
positive feedback loop.
Event-driven architecture has a tendency to
promote feedback loops, due to the multilevel
nature of financial market transactions.
https://youtu.be/Cz75_p2IVl4?t=54s (0:54-
9:47)
7. Success in finance requires knowledge of how
other actors behave.
Individual behavior is not necessarily
independent of that of the whole.
Such tendencies often lead to market
overheating and overcorrection.
Markets never reach static equilibrium, and
very rarely reach dynamic equilibria because of
this.
10. In the 1990s in the US, it was determined that
every citizen should have the opportunity to
own a home.
Public policymakers passed legislation to
expand access to credit markets, and the
economy soared.
However, when combined with a liberalization
regime, this planted the seeds for crisis.
11. “High-risk” loans as a proportion of financial
institution portfolios soared.
Lack of creditworthiness checking lead to an
increase in subprime lending.
Profit motives of financial institutions
encouraged such behavior.
Financial institutions packaged the loans into
securities and sold them as investment
vehicles, due to high growth rates.
12. Financial Institutions were trapped in a cycle
that incentivized and encouraged ever-riskier
behaviors in mortgage lending.
They were also trapped by the consumers, who
demonstrated a greater appetite for high
returns than safer investments.
They could do this because they believed that
they would be bailed out.
13. Politicians could not effectively stop the wave
of mortgages without risking losing their seats
in congress to politicians who would not stop
them.
Policies were put into place that allowed the
housing markets to further overheat,
worsening the eventual crisis.
14. Consumers took out loans and made other
investments and purchases using equity from
their homes, which had inflated value from the
influx of new homebuyers who were not
previously on the market.
The assumption that housing prices would
keep rising factored into the decision making of
these homeowners.
As a result, late market entrants ended up
underwater (owing more than the value of the
home).
15. Financial Globalization has created conditions
in which markets are linked across the globe,
allowing investments to be made quickly
anywhere in the world.
This leads to partial decoupling of local
markets from local economic factors, exposing
them to a wider array of economic conditions.
16.
17. Fintech (financial technology) is changing the
ways in which people interact with money,
whether through P2P lending, electronic
payment systems, personal finance, and even
investment banking.
Because Fintech is a new and growing industry
in a policy environment that has not yet been
fully adapted for its uses, it will be some time
before we understand its effects on financial
markets.
18. Policymakers should work to ensure that other
markets with high debt volumes (auto, student
loans, etc.) do not follow a similar trajectory as
the US housing market.
Credit rating agencies should reduce their
conflicts of interest by capping investments in
any particular line item at a certain percentage
of their total investment portfolio.
19. In all likelihood, people will continue the
patterns of socially maladaptive “herding”
behavior.
The increased linkage of these markets may
increase the risk of a particularly “hot” market
to overheat.
Conversely, a crash in one market is more
likely to be a drag on another market.
These effects will increase in magnitude with
lower market friction and democratization of
access to the markets.
Editor's Notes
Many different kinds of financial markets exist – the housing market, auto market, and stock market being the biggest 3 financial markets. Other markets include the higher education market, and any other market for which loans may be given or taken.
This is important because it lays out the way that seemingly disparate systems can combine together to produce an outcome through an event structure. In the world of finance, this becomes important due to the various kinds of debt which exist in the world. In the next slides, I will present various different ways through which financial systems experience vulnerabilities.
Event-driven architecture lays out the multilevel way in which financial markets are often constructed, which structurally encourages feedback loops.
Or some combination of all of these. These are the factors that are most likely to increase systemic risks to the financial system, which the economy depends on their efficient running. Illiquidity is having enough assets to cover liabilities, but not enough liquid assets to do so. Insolvency is the inability to cover liabilities even counting illiquid assets. Too big to fail introduces an element of moral hazard to the financial decisions made by the firm. Policy shocks, especially contractionary policy shocks, can put institutions that were highly-leveraged before into illiquidity or insolvency. This does not mean that expansionary policy can not do so – as we will explore in the next section.
Chart from the Federal Reserve website outlining many of the possible vulnerabilities and “pressure points” within a financial system (example: USA). Also worthy of note is that for most nations, Foreign Exchange and Liability Dollarization are significant financial risks to the system. This is because most countries cannot borrow from abroad in their own currencies. Current models do not account for all of these factors when factoring in economic risk, nor is it possible to determine from where the risk comes most of the time.
Feedback loops can either lead to bull markets and growth, or they can lead to financial crisis. Even dynamic equilibria are difficult to achieve and maintain because of these feedback loops. These will always be a source of risk in financial markets. Individual boom-bust cycles in individual assets/securities are caused by the same phenomenon (e.g. sell-offs, risk-off trading behavior, etc.). Being able to guess/predict where a feedback loop will start/end can make investors a lot of money.
Investors and asset-buyers who do not know the expectations of other investors well will often act more independently of the masses. Individual small investors with little power to alter the market prices individually rarely set off the avalanche, rather large institutions and secular changes in the collective financial well-being of small individual investors have more of a tendency to do so, since these are the most likely scenarios in which major price changes occur. Stock trading today is not independent of how stocks traded yesterday, and this is possibly one of the major reasons exchanges have remained closed on weekends – to break those effects.
This video explains the event-driven architecture and the network effects which propelled the vicious cycle leading to the housing crisis.
Fannie and Freddie are rooted in the desire of HUD to ensure that all Americans could own a home. Coupled with these organizations are the mandates to increase lending and homeownership rates. However, when combined with other financial liberalization policies, such as the repeal of Glass-Steagall, short-term growth took off, which betrayed the fact that a crash was inevitable.
More people began buying houses, which helped to create a virtuous cycle in which housing prices continued to rise. While this lead to many years of sustained economic growth, the lower appetite for housing eventually created the environmental upper bound on housing prices.
Employees of financial institutions had a personal profit motive to make subprime loans in the short term (profitability and commissions) as well as a reputational reason to do so (if housing prices continued to rise, greater long-term profit would reasonably follow). Furthermore, when these mortgages were transformed into securities, they became fodder for people who wanted to speculate against the value of those loans.
This was brought into being by the democratization of high-yield investments, which often tend to be the most risky. Furthermore, there was a lot of market concentration by the most well-capitalized and highly-leveraged banks, which tended to dominate the market shares of any industry they invested in. Knowing this, they knew that as their fates went, so did that of the economy.
Furthermore, credit rating agencies rated securities with these subprime mortgages mixed into them as ‘AAA’, which gave investors the false sense of security that they were buying a safe asset, further feeding into the feedback loops.
Nobody wants to hear politicians saying that the economy is in a risky place and is going to crash. Despite prophetic testimonies by congressmen such as Bernie Sanders and Ron Paul about the risks of the policies that allowed the housing boom to maximize, there was…more deregulation and risk added to the economy.
Individual consumers leveraging themselves against the value of their homes created a situation in which many homebuyers simply walked away from their mortgages after ending up underwater, or could no longer afford them due to the economic cooldown costing asset values, salary, and jobs.
Decoupling is usually a good hedging strategy – however, when a market is overheated, events in other parts of the world can have an outsized effect on when and by how much the market corrects.
Moral hazard and conflicts of interest must be reduced for markets to work more efficiently – these are inherently inimical to well-functioning markets, as they allow for rent-seeking behavior to be pursued without any major consequence, in addition to various forms of “insider trading”.
There may not be an effective way to mitigate the network effects of herding behavior – it consists of individual investors and institutions doing what they believe is in their best self-interest, given their beliefs about the future. However, it remains to be seen whether the post-crisis markets have become better in keeping risk levels and market temperature in check.
