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1914

What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Global Financial Systems


Chapter 1
Systemic Risk
Jon Danielsson
London School of Economics
2013
To accompany
Global Financial Systems: Stability and Risk
http://www.globalfinancialsystems.org/
Published by Pearson 2013
Global Financial Systems 2013 Jon Danielsson, page 1 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Book and slides

The tables and graphs are

the same as in the book


See the book for
references to original data
sources
Updated versions of the
slides can be downloaded
from the book web page
www.globalfinancialsystems.org

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

1914

Global Financial Systems 2013 Jon Danielsson, page 3 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

1914 is perhaps the closest we ever got to


a systemic crisis
Globalism was at its peak in 1914
The worlds financial system was highly integrated
The assassination of Archduke Franz Ferdinand on June

28 changed all of that


The important observation is that the financial crisis did
not happen because of World War I But in anticipation of
it
In other words, confidence, and hence liquidity,
disappeared
It is the mechanism that matters
Global Financial Systems 2013 Jon Danielsson, page 4 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Mechanism
Expectations of war built up
Crossborder creditors repatriated
sterling and franc appreciated, rouble and dollar
depreciated gold standard unravels
Expectation of crisis in London run on gold at the

Bank of England (BoE)


Stock markets around the world closed for months
Gold standard destabilizing. Some central banks (e.g.
BoE) raised interest rates in trying to hold on to it
Doubts about adequacy of gold reserves

Global Financial Systems 2013 Jon Danielsson, page 5 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Reaction in London
Widespread bankruptcies in City
Suspension of fixed relationship between gold and money
Quantitative easing (literally massively printing money)
Market closures
Moratoria on debt
Bailouts
Authorities went much farther than in previous and

subsequent crises
May have prevented extreme firesales (firesale
externalities, see below)

Global Financial Systems 2013 Jon Danielsson, page 6 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Systemic Risk

Global Financial Systems 2013 Jon Danielsson, page 7 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Systemic vs. systematic

Systematic risk relates to nondiversifiable risk factors that


affect everybody, perhaps the stock market
Systemic risk relates to the danger of the entire financial
system collapsing

Global Financial Systems 2013 Jon Danielsson, page 8 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

What is systemic risk?


IMF, BIS and FSB (2009)

the disruption to the flow of financial services that is (i)


caused by an impairment of all or parts of the financial system;
and (ii) has the potential to have serious negative
consequences for the real economy.

Global Financial Systems 2013 Jon Danielsson, page 9 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

My definition
The risk that the entire financial system may fail causing
significant economic distress.

Systemic risk arises from the interlinkages present in the


financial system, where the failure of an individual institution
may cause spillovers and even cascading failures, amplified by
the inherent procyclicality of banking and regulations.

The conditions for systemic risk tend to be created when all


outward signs point to stability and low risk.
Global Financial Systems 2013 Jon Danielsson, page 10 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Differing views on systemic risk

Some look at extreme events, those that never happen


Others call bad crises systemic events
Policy response depends on ones notion of systemic risk

Global Financial Systems 2013 Jon Danielsson, page 11 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Worries about systemic risk

Depends on size of financial system


And how well a country is insulated
See next slide which shows the EU bankingsystem, total

assets/GDP before the crisis in 2007, and then in 2011


Note distinction between domestic and all assets

Global Financial Systems 2013 Jon Danielsson, page 12 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

EU banking system
Romania
Poland
Bulgaria
Slovakia
Lithuania
Czech Republic
Hungary
Slovenia
Latvia
Finland
Italy
Greece
Estonia
Portugal
Germany
Spain
Sweden
France
Denmark
Austria
United Kingdom
Belgium
Netherlands
Cyprus
Ireland
Malta
Luxembourg

All
Domestic
upper column 2007
lower column June 2011

0%

500%

1000%

1500%

2000%

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Importance of financial system to the UK


Finance
Whole economy
Manufacturing

200

150

100
1995

1997

1999

2001

2003

2005

2007

2009

UK Output Index, 1995 Q1=100


Global Financial Systems 2013 Jon Danielsson, page 14 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Banks, bank size and politics


Structure of financial sector matters
Two countries have same sized banking systems
first has one bank
second has 10 equally sized banks

First country is much more vulnerable


failure of the single bank more damaging than a few, but
not all, of the 10
the single large bank is likely to have more political
power than the 10 smaller banks combined

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Should we eliminate systemic risk?


Extreme measures are needed to fully eliminate systemic

risk
It would come at too high a cost
We want banks to take risk
lending to risky small and medium size enterprises

(SMEs) and the like


With risk comes occasional failure
So only way to eliminate systemic risk is to eliminate the

financial system
And that will severely hold back growth
Instead, it is better to try to develop policies that
mitigate the frequency and severity of systemic crises
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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Who creates systemic risk?

Global Financial Systems 2013 Jon Danielsson, page 17 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

When systemic risk is created

Former head of the BIS, Andrew Crockett in 2000:


The received wisdom is that risk increases in recessions and
falls in booms. In contrast, it may be more helpful to think of
risk as increasing during upswings, as financial imbalances
build up, and materialising in recessions.

Global Financial Systems 2013 Jon Danielsson, page 18 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Role of the market


Profitmaximizing behavior can cause financial

institutions to take on considerable risk.


Former Yale professor Hyman Minsky (1992) argued that
economies have either stable or unstable financial
regimes. Even if the economy starts out stable, continued
prosperity paves the way for an unstable system
Stability is destabilizing because financial institutions
have a tendency to extrapolate stability into infinity,
investing in ever more risky debt structures, followed by
an abrupt correction
Like the crises from 2007, where all were blind to the
hidden risk during the great moderation
Global Financial Systems 2013 Jon Danielsson, page 19 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Role of the government

Systemic risk can be greatly increased by some

government policies adopted in the name of preventing


such systemic risk
Analogy: Governments provide flood insurance and hence
encourage home owners to build in flood plains
Is the EU creating systemic risk?

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Fisher Black (1995)


Fisher Black had even a stronger view in 1995:
When you hear the government talking about systemic risk,
hold on to your wallet!
It means that they want you to pay more taxes for more
regulations, which are likely to create systemic risk by
interfering with private contracting ...
In sum, when you think about systemic risks, youll be close to
the truth if you think of the government as causing them
rather than protecting us from them.

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Fundamental Origins of
Systemic Risk

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Who creates systemic risk?

Origins of systemic risk

Monetary aggregates
M0 Monetary base, this is sum of currency in
circulation and reserves
M1 Narrow money, monetary base plus checkable
accounts
M2 M1 plus saving accounts
M3 Broadest measure of money. M2 + large time
deposits, institutional money market funds, short
term repurchase and other larger liquid assets
M2 and M3 are a good indication of inflation and credit

expansion.
They increase in booms and fall in recessions
Global Financial Systems 2013 Jon Danielsson, page 23 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

David Humes pricespecie flow model


Fisher equation
Quantity theory of money

M V =P Q
M is the total amount of money in circulation
V is the velocity of money, i.e., how often money changes

hands
P is the price level
Q is an index of the real value of expenditures

Global Financial Systems 2013 Jon Danielsson, page 24 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

2005 US money supply


10

USD trillions

M3M2
M2M1
M1M0
M0

6
4
2
0
M0

M1

M2

M3

Global Financial Systems 2013 Jon Danielsson, page 25 of 44

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Who creates systemic risk?

Origins of systemic risk

Fractional reserve banking


1.
2.
3.
4.

Person X deposits $100 (M0) into bank A


Bank A keeps 10% () which is the reserve requirement
Lends $90 to Person Y who deposits $90 at bank B
Which keeps and lends out $81 and so on
In the limit, M1= 100 + 90 + 81 + ... =

100

= 1000

M1 = M0
5. Hence can be used to control credit As in China

Global Financial Systems 2013 Jon Danielsson, page 26 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Credit expansion of $100


for various reserve requirements

10%

30%

50%

Money supply

$750

$500

$250

6
8
10
Number of iterations

12

14

Global Financial Systems 2013 Jon Danielsson, page 27 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Fragilities of the fractional reserve banking


system

A Bank lends deposits out at long maturities


But deposits are payable on demand
If a sufficient number of depositors want money, the bank

cant pay bank run


Bank runs are contagious

Global Financial Systems 2013 Jon Danielsson, page 28 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Procyclicality

A process that is positively correlated with economic cycle

is said to be procyclical
Banking is inherently procyclical
banks have surplus capital when things are good and

lend too much to increasingly low quality borrowers


banks have too little capital and are too conservative in

busts
A key problem is amplification mechanisms

Global Financial Systems 2013 Jon Danielsson, page 29 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Firesale externalities

Externality is the cost or benefit incurred by someone not

agreeing to the action causing the cost or benefit


The financial system is full of externalities
Firesale externalities are where the sale of assets during
crisis is forced when prices are already low and falling
causing prices to fall even more
Vicious feedback

Global Financial Systems 2013 Jon Danielsson, page 30 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

External
shock
Financial difficulties

Global Financial Systems 2013 Jon Danielsson, page 31 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

External
shock
Financial difficulties

Risk
increases

Global Financial Systems 2013 Jon Danielsson, page 32 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

External
shock
Financial difficulties

Risk
increases

Forced
sales

Global Financial Systems 2013 Jon Danielsson, page 33 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

External
shock
Financial difficulties

Prices
fall

Risk
increases

Forced
sales

Global Financial Systems 2013 Jon Danielsson, page 34 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

External
shock
Financial difficulties

Prices
fall

Firesale

Risk
increases

Forced
sales

Global Financial Systems 2013 Jon Danielsson, page 35 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Leverage and deleverage

When we invest with borrowed money, we amplify the

profits and losses


Financial institutions often use high leverage to boost
profits in boom times
This means during crises their losses can be spectacular
We return to this frequently later in the course
One example is via bank balance sheets and capital
regulations

Global Financial Systems 2013 Jon Danielsson, page 36 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Leverage and growth


Adrian and Shin (2011)
8%
Asset growth

Asset growth

Corporates
6%
4%
2%
0%
1.5%

0.0%
Leverage growth

1.5%

4%
0%

4%
1.0%

0.0%
Leverage growth

1.0%

Commercial banks
Asset growth

Asset growth

Brokerdealers
20%
0%

20%
25%
0%
Leverage growth

Households

25%

5%
2%
0%
25%
0%
25%
Leverage growth

Global Financial Systems 2013 Jon Danielsson, page 37 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Information asymmetry

Financial institutions only have limited information about

the counterparties
It hard to get an idea of the net value of certain
overthecounter instruments (like CDSs)
Crisis of confidence
See slide after next

Global Financial Systems 2013 Jon Danielsson, page 38 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Interdependence

Financial system is a network of interwoven obligations


See next slide
Institutions can have direct and indirect connections
Gives rise to potential for dominostyle failure

Global Financial Systems 2013 Jon Danielsson, page 39 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

A, B and C are exposed to each other


Bank B

Bank A

Bank C

Global Financial Systems 2013 Jon Danielsson, page 40 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

D is exposed to B and C
Bank B

Bank A

Bank D

Bank C

Global Financial Systems 2013 Jon Danielsson, page 41 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

D is indirectly exposed to A via B and C


Bank B

Bank A

sed via B and C


D is exp o

Bank D

Bank C

Global Financial Systems 2013 Jon Danielsson, page 42 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

Perverse incentives
Some have an incentive to increase distress
Lenders who have hedged through CDSs can often make

higher returns from CDS payouts


A predatory approach would be to purchase lots of debt
in conjunction with a large number of CDS contracts
This could render bankruptcy more attractive than
solvency
Six Flags, an American theme-park operator filed for
bankruptcy protection on 13th June 2009, as a result of their
bondholders refusing to aid the debt restructuring effort. The
apparent culprit was a Fidelity mutual fund turning down an
offer that would have granted creditors an 85% equity stake.
Global Financial Systems 2013 Jon Danielsson, page 43 of 44

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What is systemic risk?

Who creates systemic risk?

Origins of systemic risk

More on the causes of systemic risk

We will discuss many more causes later in the course


For example endogenous risk
As well as how we cope with systemic risk
And to what extent regulations protect us and can even

cause harm

Global Financial Systems 2013 Jon Danielsson, page 44 of 44