discussion of financial innovation, macroeconomic stability and systemic crises
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Discussion of Financial Innovation, Macroeconomic Stability and Systemic Crises. Arvind Krishnamurthy Northwestern University. Questions: Effects of financial innovation on macroeconomic stability. Systemic risk/crises. Costs and benefits of innovation Relevant questions - PowerPoint PPT PresentationTRANSCRIPT
Discussion of Financial Innovation,
Macroeconomic Stability and Systemic Crises
Arvind KrishnamurthyNorthwestern University
Questions: Effects of financial innovation on macroeconomic
stability. Systemic risk/crises. Costs and benefits of innovation
Relevant questions Geithner quote about credit derivatives
Outline
Paper writes down a stylized model to help think about these questions
My discussion Explain the mechanics that drive the model
Externality/ policy application Non-monotonic effect of maximum loan to value/
leverage ratio ( ) on probability of crises How does the model shed light on the effect
of innovations, such as credit derivatives
Liquidity at date 1
In order to avoid liquidation at date 1, intermediaries/firms need to raise at least
( - xs + b1s ) i0xs < 0 is cash need for business operation
b1s > 0 is debt repayment Raise money in two ways:
Sell capital ( ) Borrow against capital ( )
Selling Capital: Fire Sales Raise ( - xs + b1s ) i0 by selling ks units at price q
ks = ( - xs + b1s ) i0 / q
qkD ()
Fire Sales and Financial Depth () Less financial depth: Demand curve not perfectly
elastic
Multiple equilibria / liquidation externality Policy: Role for the Fed LLR to rule out bad
equilibrium? Same downward sloping supply idea has been used
to discuss Bank Runs, 1987 market crash, 1997 Asian Crisis, 1998 LTCM episode …
Fire Sales and Financial Innovation ( ) Constraint on raising debt:
(at Date 0) b1s < q1s
(at Date 1) b2s < q2s
Raising loosens date 1 constraint, ks down Raising also allows for more borrowing at
date 0: b1s up and i0 up
Cash need is ( - xs + b1s ) i0
Non-monotonicity
Date 0
Agents don’t internalize liquidity externality in date 0 decisions Over-leveraging: too much i0 / too much b1s
Policy: Restrict ex-ante leverage
Financial Innovation: Raising Raises probability of crises over part of the
range Improvements in automobile safety:
Air bags Crumple zones Anti-lock brakes
People drive faster … Perhaps more accidents But we may on net be better off
Is Raising beneficial for Welfare? Something the paper should compute Unclear, for two reasons
On average beneficial (borrowing at date 1) Paper shows externality, but does not show
whether externality increases with My guess: In model, the Date 1 effect
dominates because it helps across all states of the world, whereas date 0 effects are only in the crisis/liquidation states.
Raising : Crisis costs vs. average benefits Conjecture: I think the model could say that
an LLR can solve the date 1 externality, so that LLR plus increase is beneficial
Possibly unambiguous in this case, which would give a different angle on the Fed’s role.
Model and Reality
Financial innovation in the model is about changing Reality: options, credit derivatives, MBS, etc.,
Problem model identifies is that agents over-leverage, not internalizing crisis costs Reality: Risk management of financial firms.
``Insufficient” risk management. Let us think about the risk management of a
new financial asset, i.e. credit derivatives
Financial Innovation is about the New Financial innovations are complex even to
sophisticated market participants Risk management of an unknown product
Learning Model risk Interpreting and acting on outcomes that the
model does not expect Examples
1987 Stock Market Crash 1997 Asian Crises 1998 LTCM Crisis
1987 Stock Market Crash
Insurance Strategies: Synthetic Puts/ Portfolio Insurance
Pre-1987: Compare implied volatilities on out-of-the-money put options to at-the money options (Bates 2000) Out-of-the moneys have 3% higher implied vols
Post-1987: Same comparison Out-of-the moneys have 10% higher implied vols
The crisis led agents to better understand the cost of crises
1997 Asian Crises Integration into world capital markets: Foreign
borrowing, capital inflows Pre-1997: Liability composition tilted towards
Dollar-denominated debt Short-term debt Portfolio inflows
Post-1997: Reserve accumulation Long-term debt FDI flows
Post-crises, countries adopted insurance strategies
1998 Hedge Fund Crisis
Hedge funds become the central liquidity providers in many specialized asset markets (MBS, sovereign debt, equity vol, …)
Pre-crisis risk management: Stress testing based on historical correlations
Crisis: Liquidity shortages cause unusual comovement.
Post-crisis risk management: Stress testing scenarios include liquidity events
Credit Derivatives
Geithner (2006) quote that begins this paper “…uncertainty about how exposures will evolve
and markets will function in less favorable circumstances”
Example: GM and Ford downgrades from last year
What are the true exposures and how will markets play out?
Average Benefits versus Crisis Costs
Model and My Take on Reality In the model, innovation is an increase in allowable leverage ()
Financial innovation is about the new
Realized events do not span the entire event space Uncertainty about outcomes What is the best crisis risk management strategy? Conjecture: Systemic risk is always in the new
assets, and not in the old assets (i.e. portfolio insurance is well understood at this point).
Average Benefits versus Crisis Costs
Model and My Take on Reality Date 1 policy in model: Eliminate liquidation equilibrium (role for an LLR)
I agree, but with a slightly different angle:
The liquidation externalities arise when bad outcomes are realized, and agents are not prepared
Perhaps also some “over-reaction” by agents As in this paper: Role for an LLR
Average Benefits versus Crisis Costs
Model and My Take on Reality Date 0 policy in model: Reduce over-leveraging
More generally, this translates to: Improve date 0 risk management What is date 0? Unclear if anyone (including the Fed) knows the
best strategy
Conclusion
The relevant calculation is average benefits versus crisis costs
There are liquidation externalities
Innovation is about the new…