cruikshank - distressed financial markets; navigating the shoals of liquidity risk (2008)

Part 1 – The framework 1 Financial crises and their origins 3 Who to blame – external or internal causes, crowds or The problem with statistics and probabilities 14 2 Evolving characteri

Distressed Financial Markets:

Navigating the Shoals of Liquidity Risk

Distressed Financial Markets:

Navigating the Shoals of Liquidity Risk

Eric D Cruikshank

E U R O M O N E Y

B O O K S

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To Cleofor your encouragement to write this bookand your love and support throughout

Part 1 – The framework

1 Financial crises and their origins 3

Who to blame – external or internal causes, crowds or

The problem with statistics and probabilities 14

2 Evolving characteristics of financial markets 17

The institutional importance of a financial market perspective 17The role of legal frameworks 18Macroeconomic preconditions 21Intermediation and disintermediation – how banks and securities

The functions of financial markets and their trade-offs 24Liquidity – what does it mean? What does it matter? 26The convergence of markets and institutions 28Factors affecting the stability of financial markets 37

3 Systemic liquidity and financial market distress 40

The distinction between individual and systemic liquidity 40Identifying financial market distress 42Early warning signs of systemic financial distress 51Macroeconomic and financial sector assessment and surveillance 54

4 Financial risk management and liquidity risk 57

Evolution of the markets for hedging products 57The securitisation explosion and its influence on global financial

The symbiosis between risk markets and securities markets (strengths and weaknesses) 76The difficulty of hedging against sudden illiquidity 83Best practices in institutional liquidity risk management 84

Part 2 – Country cases and global trends

5 Country case histories of financial market distress 89

United States sub-prime (2007) 126

A practical typology for the country case histories 141

6 Financial globalisation – global trends and the new functions,

institutions and markets and their importance for financial

The new institutional realities 150Current developments in financial markets 158

Part 3 – Lessons for policy-makers and portfolio managers

7 Lessons from financial crises for policy-makers 163

Thoughts on contagion 163

Thoughts on orthodox and heterodox economic policies 170Sequencing economic liberalisation 175Prescriptions for individual countries 178When financial crisis crystallises 182Macroeconomic policy lessons 182Financial supervision and regulation 183Global considerations 190

8 Lessons from financial crises for portfolio managers 193

The limits to hedging 193The use of financial leverage 199

Are sovereign ratings sufficient or should portfolio managers develop their own country scorecards? 202Active versus passive management and separating alpha and beta 203Developing the institutional capacity to monitor and manage

The focus of this book is on financial markets, the ways they can become distressed, andthe actions that can be taken to at least mitigate the severity of the impact of distress.However, the definition of ‘market’ will be applied quite broadly since the signs of distresscan originate in environments or ‘transaction spaces’ lacking many of the features of thehighly liquid and well-organised markets we recognise today

For example, the US housing market has on at least two occasions – notably during theS&L crisis of the 1980s and the sub-prime crisis in 2007 – been at the root of abundant financialmarket distress And although we use the term ‘market’ in connection with housing, clearlytransactions in this sector lack many of the features of homogeneity, con tinuity, liquidity, andprice discovery found, for example, in the bond market In fact, even within the US bond market,the extent to which these attributes vary across sub markets for different types of instrument issufficiently wide as to have some of them overlap with the products of banks and other financialinstitutions for which the term ‘market’ is less rigorously applied

Another example is the ‘market’ for banking services To the extent that a dominated system involves competition among privately-owned banks (or combinations ofprivately-owned and state-owned banks), market forces are at work even if the precise ser -vices and corresponding assets themselves are not as readily transferable as capital marketinstruments would be Yet, in times of trouble, the phenomenon known as the ‘flight toquality’, whereby depositors remove their savings from institutions perceived to be weaker

bank-in order to shelter them bank-in those seen as bebank-ing stronger, is bank-in its own way an example ofthe market at work

Finally, with most countries having opened their capital accounts so that financial capitalcan move freely in or out, an understanding of the dynamics of a domestic bank run todayhas broader applicability This occurs because as bank deposits, whether denominated in thedomestic currency or held in local banks in foreign currency accounts, become increasinglyowned by foreigners and sophisticated local inhabitants who are free to invest in othermarkets, the idea of a bank crisis being contained to just the banking sector has become

no more than a theoretical construct In fact, while examples are provided in this book ofcases in which currency crises occurred without a banking crisis having happened (forexample, Brazil in 1999), the converse is much rarer In recent decades, it is unusual to find

a serious banking crisis that did not also precipitate worrisome attacks on the domesticcurrency if not cause an outright currency crisis This is because with open external accounts,

a bank run quickly translates into capital flight as the tighter coupling is felt among today’sstock, debt, currency, and even derivatives markets and the banking sector Therefore, wewill try to avoid focusing excessively on banks or for that matter any one asset market inparticular – instead following the liquidity or lack thereof – in order to gain a better view

as to how distress can take place in any of these segments of a financial sector and quicklyspread to some or all of the other segments

An enquiry into the nature of financial crises and financial market distress invites thetemptation to draw heavily from the theoretical developments of recent decades which are highlyquantitative in nature This temptation has been resisted in this book on several counts:

• Quantitative methods have added much to finance But they have been found especiallywanting in precisely those areas addressed by this book For the majority of circum-stances, statistical and probabilistic approaches are valuable When it comes to extremeevents, however, quotidian relationships break down much the way in plasma physicsdistinctions among (and properties of) the three phases (solids, liquids, and gases) as theyapply to matter became exceedingly blurred This is not to say that pioneering effortshave not been made in trying to quantify the causes and dynamics of financial distress.But it is still very much work in progress

• While the quantitative models and tools used in applied finance today come from tional theory (the efficient market hypothesis, modern portfolio theory, the capital assetpricing model, various option pricing models and so on), many of the phenomena observedleading up to and during financial crises are best explained under the branch of academicfinance known as Behavioural Finance When the notion of ubiquitous investor ration-ality is no longer handed to us as a given but instead scrutinised under the microscope

tradi-of behavioural analysis (thus allowing for individual emotions and institutional agendas,

as well as the ways in which both tend to ‘frame’ the problems and the choices theyencounter), these explanations are usually that much richer if they are not reducedcompletely to mathematical formulae

• As the purpose of this book is to reach professional practitioners, we are less concernedwith tight expositional rigour based on assumptions which greatly simplify (yet ignorethe more mathematically-intractable yet at times crucial aspects of) reality, so as to achievemathematical consistency Instead, we are more interested in how to detect and deal withfinancial market distress in its various manifestations in a much more practical sense –even if this is at the expense of some degree of rigour

In conclusion, the focus of this book is primarily an attempt to synthesise how financialmarkets can become distressed as a consequence of financial institutions, instruments andmarkets interacting with government policies and regulatory approaches in allocatingresources and dealing with risk In this regard, in-depth treatment of the specific designfeatures and working mechanics of most financial instruments has been avoided – the excep-tion being with respect to some of the newer structured finance products The idea, however,

is in no way to pretend to a comprehensive treatment of securitisation and structured financebut merely to provide enough description to illuminate how certain features of these devel-opments, while having introduced new markets and innovative financial products, havenonetheless introduced new types of financial market risk, which at the time of writing haveindeed crystallised on a massive scale

About the author

Eric D Cruikshank is an economist and finance specialist with over 35 years of professionalexperience in more than 40 countries He currently heads his own financial advisory firmsince retiring from the World Bank Group in 2005 following nearly three decades of service.During his career in both the World Bank and its affiliate, the International FinanceCorporation (IFC), he was professionally involved in helping resolve several of the country-specific systemic financial crises described in this book As a former IFC manager, he hadoperational oversight responsibilities for staff in connection with new investments, portfoliosupervision and asset resolution He also served as IFC’s nominee on the boards of severalbanking and financial institutions

Before joining IFC, he served as a World Bank loan officer, senior economist and deputyresident representative He was a Canadian International Development Agency (CIDA) adviser

in several countries, including serving as the executive project director for an energy andwater resource policy and planning team in Nepal

His earlier career included stints in management consulting and securities analysis Mr.Cruikshank holds a BA in economics from Mount Allison University and an MBA and MA

in economics from York University

He is the author of Adding Value in Private Equity: Lessons from Mature and Emerging Markets, a 2006 Euromoney Books publication.

Even the ancients recognised that nature and life ebbed and flowed Those who readilygrasped the idea of cycles and nonlinearities with turning points became shamans or highpriests With the benefit of reasoned observation, they would take actions to forestall theworst effects of recognisable cycles through anticipatory action Of course, they didn’t alwaysget it right, which may explain why certain tribes passed into extinction And many of them,when certain that their calls were right, exploited those successes to maximum advantage

to preserve their reputations as clairvoyants well beyond that which they deserved Members

of the other group, the bulk of the populace, who either lacked the capacity or the inclin ation to take a critical look at events or the willingness to heed those around them who did,found themselves constantly at the mercy of the gods The development of a group survivalimperative, thus no doubt helps explain historically the predilection many societies haveshown for governance systems based on authoritarianism, whether theocratic, despotic, orbased on a ruling elite

-Things today have not changed all that much When modern-day financial crises break,

we find forecasters and their followers in one group and in the other we find those whoseem to have been oblivious to ‘the signs’ all along Like the ancients, some of the formergroup tend to pass into obscurity, if not oblivion, for having made more wrong calls thanright ones (with the most recent calls, of course, more heavily weighted) Those moresuccessful at prediction today, as in the past, tend to advertise their successes and down-play their failures Many of the second group, similar also to their counterparts of the past,continue to find themselves economically in harm’s way

Irrespective of the era in which widespread financial distress is examined, the existence

of cyclicality and oscillating tendencies and the factors which cause them is central to standing the potential for distress Neither the amplitude of oscillations nor the frequency

under-of their occurrence is synonymous with financial distress Yet many crises have culminatedafter periods exhibiting fluctuating and recurring behaviour Distress arises when thoseaffected by change are caught unprepared and consequently cannot respond the way theymust or would like to because of sudden lack of flexibility The confluence of factors whichfrustrates this need or desire to act very often causes contractual undertakings and rela-tionships to break down Things that were promised cannot be delivered and significantdisruption, with the potential for more of the same, tends to mount Because of the bilat-eral (or even, in some cases, multilateral) nature of economic transactions, events or factorsgiving rise to a sudden failure to comply with one side of a contractual undertaking imme-diately convey direct hardship to the counterparties to the transaction Moreover, this hardshipoccurs irrespective of any behavioural aspects

To the extent that those affected by financial distress develop coping responses, theseresponses often result in excessive loss This happens through a combination of them havingboth the need (whether real or perceived) to act and the propensity to panic and overreact

to the evolving situation Such action based on panic tends to trigger similar behaviouralresponses in others and thus can become highly contagious in environments where partici-pants are able to see each other’s actions

When pervasive crises in financial markets occur, the causes of such occurrences mayvary, the transmission mechanisms may vary, but one feature is common to all – it is thematerialisation of liquidity risk In simplest terms, liquidity may be defined as the capacity

to meet one’s needs and obligations on a timely basis without having to expend undue effort

or incur significant losses in doing so And the concept of liquidity risk addresses thosefactors which can (or threaten to) impair this ability, irrespective of the solvency or other-wise of the person or entity involved

At the level of an individual person or company, the financial distress suffered, asimpaired liquidity crystallises, is usually regarded by others in society as either due to badluck (such as from uncontrollable externally-imposed developments – natural catastrophe,illness, sudden loss of employment, manmade accidents involving persons or property andthe rest) or poor financial management (failure to insure, to control spending, to controlindebtedness and so on) At some point, however, when financial distress is shared by amultitude, the problem is seen to pass from being framed as representing a number ofpersonal or individual problems to becoming a social problem The point at which thisoccurs, although difficult to predict, is marked by a sudden impairment of systemic liquiditywhether of a banking system, a currency market, or organised financial markets When thisoccurs, the gravity of the situation transcends the fate of a collective of individuals – nomatter how large the collective The most serious aspect of systemic distress is the threat

it poses, if left unattended, to a country’s system of financial institutions and infrastructure– especially, its payments system

While easy to understand from an ex post perspective, liquidity risk is perhaps the most

elusive of all types of financial risk from the viewpoint of measuring it and drawing able early warnings Liquidity risk is a phenomenon that has been very familiar to bankersthroughout the ages, even in countries where securities markets were non-existent or nascent

reli-A banker’s greatest fear in any country or financial system has always been the spectre ofarriving at the bank one morning to face a queue of frightened depositors all with one aim

in mind – that of withdrawing their deposits from the bank But under circumstances causingwidespread financial distress, the bank run has its counterpart in either a massive stockmarket sell off or mutual fund redemptions Although the structural aspects of fractionalreserve banking are more susceptible to severe liquidity problems than in those types offinancial institution which do not employ financial leverage, nonetheless any number ofevents which erode public confidence can provoke similar stampedes in the capital marketsand at other types of financial institution It may, however, just take a more severe event to

do so

Economic boom and bust cycles go as far back as written history For centuries, thetechnologies and institutions involved did not change appreciably In recent years, however,new forces have been shaping the dynamics of financial interaction and asset valuation in

ways that were perhaps inconceivable only a few decades ago Factors which have changedthe financial landscape internationally include: economic liberalisation, globalisation,telecommunications and computer technology, and the proliferation of new financial prod-ucts and related institutions Many of these developments were designed to improve certainaspects of economic life and have done so In many instances, they have introduced risk-mitigating features themselves But they carry with them sources of new risk and vulnerability

to liquidity problems which require new understanding, vigilance and safeguards

An examination of distress in financial markets will start from how financial distresscan originate and affect an individual person or institution In large measure, the scope foraction and reaction is demarcated by contractual undertakings between economic agents.When events transpire, however, which adversely impact many agents simultaneously, theproblem shifts, as mentioned above, from one best viewed within the context of a series ofbilateral contracts to one characterised by myriad transactions and their underlying contrac-tual arrangements entering the social and even the political sphere The tipping point atwhich these shifts take place varies geographically and in time Up until this point is reached,those in net debtor positions will apply one set of coping actions and net creditors willapply another Behavioural responses change dramatically, however, as payment problemstransition from bilateral undertakings to widespread conditions with many in society callingfor a social or political resolution The aim of this book will be to examine the many factorswhich underpin both the causes of and responses to distress in financial markets It willalso provide recommendations to national economic managers and portfolio managersregarding both prudential norms to avoid excessive exposure to the risk of distressed finan-cial markets as well as loss-mitigating actions if caught unawares

This book is divided into three parts The first part sets forth the framework for

under-standing the causes and dynamics of financial market distress

• Chapter 1 begins with a brief overview of financial crises and their origins, providing afew early examples of booms, busts, manias and crashes It addresses some of the formalexplanations of boom and bust dynamics spanning macroeconomics, financial theoriesexplaining the formation of asset price bubbles, behavioural finance and herding theory

It further examines the roles that national economic policy plays on the one hand andthe mass behaviour of markets and crowds plays on the other It concludes with a crit-ical assessment of the problem formal explanations encounter when relying too much onthe assumptions inherent in statistical and probabilistic approaches

• Chapter 2 explores the evolving characteristics of financial markets as they affect cial market stability and the constantly changing challenges to risk management Itaddresses such topics as the role of the legal framework, macroeconomic preconditionsfor achieving a diverse financial market with ample breadth and depth, the ways in whichthe once sharp dichotomy between financial intermediation and disintermediation hasmorphed into a hybrid in which large financial intermediaries now play key roles in theissuance and trading of securities and what this means for risk management It examinesthe role and significance of liquidity, the convergence of some aspects of large financialinstitutions and certain segments of the securities markets It concludes with an assess-ment of the determinants of financial market stability

finan-• Chapter 3 tackles the pivotal role that systemic or overall market liquidity plays inproducing financial market distress From a distinction between the liquidity associatedwith being able to transact quickly and efficiently in a specific homogeneous financialasset and that which pertains to the overall market for the asset in question or indeed abroader swathe of the financial market, the chapter goes on to examine those conditionsleading up to and defining a broader state of financial market distress, including some

of the more important early warning signs within the context of macroeconomic andfinancial sector surveillance

• Chapter 4 provides an overview of how the advent of quantitative financial risk ment spawned markets for new types of financial products aimed at insuring or hedgingdifferent types of financial risk These products also supported both the explosive growth

manage-as well manage-as the transmutation of markets for structured finance products, particularly thecollateralised debt obligation Despite the progress made in the development of riskmanagement tools, the ability to hedge against sudden illiquidity continues to pose amajor challenge The chapter concludes with a summary of best practices in the manage-ment of the liquidity risk facing financial institutions

The second part provides a chronology of the main stylised facts and apparent causes of

a series of country-specific financial crises

• Chapter 5 briefly examines some of the main similarities and differences among a selectedgroup of the countries experiencing financial crises in the latter half of the 20th and firstdecade of the 21st centuries These are:

• Spain (1977)

• Chile (1982)

• United States Savings & Loan (1985)

• United States Black Monday (1987)

• United States sub-prime (2007)

• Chapter 6 examines some of the main ways in which the world began to change cantly, even during many of the crises described in the previous chapter, as to tightenthe couplings defining economic relationships across national boundaries and indeedamong financial institutions, products and markets

signifi-The third part presents some of the key lessons to be drawn from historical crises for

policy-makers as well as for those who manage portfolios of financial assets

• Chapter 7, while not in any way intended to be comprehensive in terms of treatment orprescriptions, attempts to draw some of the main lessons from financial crises and finan-cial market distress which may be of use to economic policy-makers

• Chapter 8, on the other hand, also draws selectively on a few lessons from the tive of those responsible for managing investment portfolios whether at the institutional

perspec-or individual level

• Chapter 9 concludes the book with several observations in the way of synthesis It alsoprovides a look at the future A caveat, however, is in order Those expecting eitherspecific forecasts or predictions will be disappointed Instead, the book concludes with

an examination of those key principles which will need to be embraced and those keyactions which will need to be taken to cushion and indeed to repair the damage done bythe massive blow to international trust and confidence afflicting financial markets, finan-cial institutions and financial market participants even as this is written At the end ofthe day, finance, for all its sophistication, is only as good as its inherent ‘promise to pay’

is generally perceived to be When the quality of that promise has been badly marred at

a systemic level, seeking solutions within the field of finance is likely to be frustrated.Rather, the unequivocal focus must be on a matter which transcends finance and that ishow to restore trust

Part 1

The framework

Chapter 1

Financial crises and their origins

Early examples

Economic cycles can be traced as far back as written history In the Bible, Noah’s warning

of the impending flood precipitated measures to mitigate what would have surely been theultimate distress scenario for mankind It is interesting that accounts of a similar delugehave been historically preserved and re-told by the descendants of other early societies invarious parts of the globe Another economic cycle from the Old Testament was the Pharaoh’sdream of seven fat cows being devoured by seven lean cows This was interpreted by Joseph

as a portent of seven bountiful years to be followed by seven years of famine throughoutancient Egypt Arguably, it was the first historical account of a commodity cycle forecast Since we are more interested in financial markets than in the broader topics of naturalcalamities and even economic cycles for that matter, we will fast forward to ages whichpostdate the creation of money

Tulip mania

Tulip mania, which was based on a phenomenon of speculative excess in 17th centuryHolland, is one with which most are familiar The speculative boom which ensued startedwith rumours about the impending scarcity of certain types of prize tulip bulbs but soonfound its way into the open-air food markets of Amsterdam as even edible bulbs as wellwere bid to stratospheric price levels Like many subsequent price bubbles, the tulip bubbleburst and things returned to ‘normal’, although not without financial pain for many

The South Sea bubble

Another early bubble occurred in England between 1711 and 1720 It began when the Britishgovernment granted exclusive trading rights to the South Sea Company (SSC) in connec-tion with carrying goods and slaves to the Spanish colonies of South America.1 These tradingrights were predicated on the supposition that Britain would win the War of the SpanishSuccession in which it was engaged with Spain at the time As it happened, the war endedfavourably for the British and the Treaty of Utrecht of 1713 provided the expected conces-sion to the SSC although it was one that would not be as comprehensive as originallyanticipated

The British government saw an opportunity to fund £10 million of government debt inconnection with the war by exchanging short-term notes for a new issue of stock in the

SSC with a generous annuity payment involved Then in 1717 and again in 1719, theCompany bought significant portions of the country’s public debt (over half of the £50million then outstanding) with further stock issues By way of an aggressive stock promo-tion campaign, the Company succeeded in ‘talking up’ the price of its stock from £128 pershare in January 1720 to £550 per share by May of that same year Much of the stock thusoffered was placed with high-level government officials and notables without receivingserious financial consideration in return and was done to curry political favour for theCompany By publishing the names of these blue ribbon stockholders, the Company wasable to maintain an inflated share price and attract new investors at these higher price levels Successive rounds of buying drove the share price to £1,000 by August 1720 after which

it quickly plummeted to about £100 a share before the end of that year Before SSC’s shareprice reversed direction, it had created enormous interest not only in the Company’s sharesbut in other companies as well New companies with foreign schemes were formed, manywith entirely fraudulent claims Some were even formed in Paris and in Amsterdam Manyinvestors borrowed heavily to fund their stock purchases Consequently, when the bubbleburst, SSC’s share price decline precipitated a fall in the share prices of other companies

as the panic spread The rush for liquidity expanded quickly even as far as continentalEurope Investors were furious Thousands of individuals were financially ruined And theBritish government was forced to introduce palliative measures

The panic of 1907

The speculative tactics of financial trusts in the United States met with strong resistancefrom a number of New York bankers, one of whom was J P Morgan When one of thebanks, the National Bank of Commerce, refused to honour cheques drawn on KnickerbockerTrust, owned by F Augustus Heinze, this action precipitated a run on the trust which trig-gered similar runs on nearly every other trust in New York as well

The financial panic that ensued led to a decline in the New York stock market of almost50% from its peak in 1906 The panic eventually spread across the nation, leading to thecollapse of numerous banks and businesses It was only with the actions of first the then

US Treasury Secretary, George B Cortelyou, who set aside $35 million of federal money,that the situation was stabilised J P Morgan organised a team of bankers and financialexecutives who redirected money between banks, secured international lines of credit, bought

up distressed corporate shares and succeeded in averting a national disaster Confidence inthe financial sector was restored by February 1908

However, banking reform became a major political priority At the time, the UnitedStates did not have a central bank Monetary stability was achieved through the actions ofthe nation’s lead bankers

In May 1908, the Aldrich-Vreeland Act established the National Monetary Commission

to look into the causes of the 1907 panic and measures which could be taken to guardagainst such occurrences in the future The work of the Commission, particularly itsChairman, Senator Nelson Aldrich, led to the famous Jekyll Island meeting of 1910 attended

by the country’s principal financiers The discussions held at Jekyll Island focused on tary policy and the workings of the banking system They paved the way for the creation

mone-of the Federal Reserve System as an important institution to dampen the effects mone-of futurefinancial panics On the recommendation of the National Monetary Commission, the FederalReserve Act was adopted in 1913.

The Wall Street crash of 1929 and the Great Depression

An historical account of financial crises would be incomplete without reference to the WallStreet market crash of 1929 and the Great Depression Without a doubt, the precipitous drop

in share prices on the New York Stock Exchange (NYSE), which began on October 24 1929(Black Thursday) and continued its catastrophic descent on October 28 and 29 (BlackMonday and Black Tuesday) was seen by the public as the start of a major economic down-turn The financial market dynamics, however, were only part of a much larger set ofeconomic problems which had been in play much earlier and which transcended inter-national borders and the capital markets

Many people blamed the US stock market crash as being the cause of the GreatDepression which followed Many of these individuals used the crash and the GreatDepression to impugn capitalism (with no small measure of success at the time) and toadvance their own alternative solutions These alternative solutions generally tended to runalong a spectrum of organisational arrangements marked by varying degrees of socialismwith a pervasive role for government in virtually all cases What was not well appreciateduntil much later was that the economic conditions following World War I evoked policyresponses in the US, the UK and the western European countries which were largely toblame for a growing malaise Much of the prevailing economic thinking which informedgovernment decision makers at that time was predicated on myths which would eventually

be de-bunked

The year 1929 began in the United States with all the indications of a major economicboom The US capital markets were enjoying not only the influx of speculative capital fromdomestic sources, largely aided by massive use of available credit, but from European capitalseeking higher returns than the European economies seemed to be able to offer in the after-math of World War I The Allies were able to pay back the war debts they owed to theUnited States with reparations payments made by Germany Germany was able to make thereparations payments to the European Allies by borrowing from the United States Despite

a major trade war, the United States was acquiring new customers for its commodity andmanufactured exports in Europe as well as in Latin America, financed in large measure by

US banks Technological innovation (mainly the radio and wire services) were hailed asopening new business frontiers Credit was abundant Signs of a major boom were respon-sible for strong optimism which fanned both consumer and government spending It wasbeing heralded as a ‘new era’ in economics with seemingly no upper limits to stock valuations

From about May 1929 and over the following months, the Federal Reserve began ening credit Higher interest rates attracted more foreign capital but the flow of funds fromNew York to Europe dropped significantly resulting in interest rate increases in Europe inresponse to the credit crunch which was developing there Meanwhile, stock speculation inNew York continued unabated with even greater use of margin credit (with financial leverage

tight-ratios as high as 10 to 1) As stock prices reached successive new heights, the marketsstarted showing signs of nervousness with the arrival of news each day Market dips beganoccurring with regularity Moreover, many speculators were beginning to margin thoseportions of their holdings which had not been previously margined in order to support theiralready-margined holdings which were under water As railroad and pipeline stocks began

to soften in the first half of October, rounds of margin calls went out Once selling activitygot under way, successive margin calls and the abrupt shift from optimism to panic unleashed

a downward spiral in share prices, culminating in the major declines of Monday October

28 and Tuesday October 29 By the end of the day on October 29, the Big Board had lostover a third of its value from where it stood on October 19 (about $30 billion2) Over thefollowing two weeks, the market briefly rebounded then teetered between the opposingforces of value hunters who tried to pick up bargains, and bankers and brokers who tried

to unload distressed holdings from their portfolios On November 13 1929, the marketcontinued its descent to levels as low as where it had stood in July of 1927 (a decline ofalmost 50%) A succession of bankruptcies – both corporate and personal – and suicidesfollowed

It did not take long for the fear to spill into the real economy as businesses revisedtheir purchasing plans sharply downward The Great Depression, which followed, bothexpanded its impact to be felt globally and lasted the better part of a full decade Numerousbooks have been written on the causes of the Great Depression Opposing schools of thoughthave enumerated the causes of these events Among the theories proffered are those whichfocus on:

• the model of social organisation (Marxism versus capitalism);

• savings and income distribution;

• tight money;

• the gold standard;

• psychological explanations; and

• the financial losses realised during the 1929 crash

While each of the aforementioned aspects no doubt was present and played some role

in prolonging or perhaps even exacerbating the magnitude of the Great Depression, manyeconomists and economic historians today attribute the underlying causes to a confluence

of structural weaknesses in the real sectors and to misguided government economic cies, particularly in the United States In this regard, the trade war which the US fannedwith the passage of the Smoot-Hawley Tariff on June 17 1930, invited rounds of counter-vailing protectionist measures by other countries The combination of policies, however,entailed both defensive measures such as quantitative restrictions, tariffs and other restraints

poli-on imports as well as offensive measures such as subsidies, price and wage fixing, creditallocation and special tax treatment The main effects of the trade war and related economicpolicies were to:

• Cripple the economies of Germany and other war-torn European countries indebted tothe United States thus impairing their ability to service their debts to the United States

• Induce companies to invest in over capacity in protected industries and to run nomic surpluses.

uneco-• Induce farmers enjoying price support to over-produce those crops and commodities fiting from the support

bene-• Unleash precipitous drops in commodity prices, mainly in agriculture but also in othercommodities and manufactured goods as the pinch was felt and subsidy support wasoverwhelmed by the failure of export and domestic sales

It is important to note that while the main weaknesses giving rise to the Great Depressionand which prolonged its duration were structural and policy-related, their combined influ-ence was multifaceted, complex, mutually-reinforcing and cumulative

As we examine financial crises which came after the Great Depression in Chapter 5, it

is particularly instructive to note that the Great Depression was in many respects unequalled

in terms of the full array of its causes and its dynamics Some of the main features whichset it apart from later crises include the following

• It was not preceded by commodity or industrial price inflation

• There was no compelling evidence of merchandise inventory anomalies (neither massivebuild-ups nor depletions) to serve as early warning signs

• Interest rates moved upward for awhile but still remained below their earlier highs

• Banks were relatively well capitalised and strong as first the crash and then the sion unfolded (smaller banks did eventually fail in numbers, dragging some larger onesinto their orbit, but not until well into the depression)

depres-• Paradoxically, going into the depression, the United States was sitting on ample goldreserves

• Prices plummeted to pre-World War I levels but without being able to equilibrate.Both the economics profession as well as national economic policy-makers learned muchfrom post-mortems of both the Crash of 1929 and the Great Depression But while some

of the more obvious mistakes have been avoided since then, to this day, other aspects –such as the financial overleveraging which led to the severity of market and personal distress

in 1929 – seem to have been dangerously replicated today, albeit in new ways While theuse of leverage in 1929 was applied directly through ‘buying on margin’ to positions onthe Big Board, stock market regulations today prevent such exposure But, ironically, theadvent of the new risk markets has encouraged and allowed even greater use of leverage inrecent years

Boom–bust dynamics

Thoughts on the causes of bubbles, panics and crashes

An important phenomenon observed in connection with financial crises and distressed cial markets is that in the majority of cases, the correction or crash was preceded by asignificant run up in value This understandably has led to ample generalisation of financial

finan-crises being explained as the bursting or at least rapid and severe deflation of a ing asset price bubble This raises some fundamental questions

correspond-• What is a bubble?

• Does the emergence of a financial market in distress always require the explanation of

a bursting or deflating bubble?

• Alternatively, if examples can be found in which the market in question did not ingly show evidence of the formation of a price bubble, then what other causes can berealistically invoked?

convinc-• What explains the formation and accretion of bubbles?

• When financial markets become distressed, what are the characteristic market modalities

by which distress is transmitted?

• Are there fairly reliable early warning signs which can be used to attenuate the severity

of imminent distress?

• From the perspective of investors and portfolio managers, can the transformative nature

of risk provide guidance regarding appropriate action?

• What are some of the nonlinearities and second-order effects that might counsel cautionfor policy-makers who are inclined to use robust intervention to avert an impending finan-cial crisis?

What is a bubble?

An asset market bubble can be defined as a mechanism or process which is:

• self-reinforcing and perpetuating;

• preventing changes in asset prices from exhibiting random behaviour; and

• involving changes in the market index which are larger than that explained by the duction of any new information in connection with market fundamentals

intro-Are distressed financial markets always caused by bubbles?

Although the collapse of asset markets is very often preceded by a price bubble, distresscan also be brought on by a sudden shift in that market’s fundamentals or by contagion.This means that the compartmentalisation of asset markets of the past owing to geography,national policies and regulations, physical and economic limitations to communications and

so on, allowed the effects of bubbles to be contained The high degree of interdependency

in the world today can result in signs of financial stress (and even distress) appearing pectedly, even though the situation may have been precipitated by a bubble somewhereelse

unex-What other causes can be responsible?

Fundamental changes can occur at the macroeconomic level such as through currency ments or because of the onset of recession in the economy of a major trading partner.Alternatively, it can originate in world commodity markets to the extent that price devel-opments adversely affect both real and financial prospects for the home market Or it can

move-be triggered by adverse developments in sectors – domestically, internationally, or both –which represent an important source of demand for the most prominent sectors or evencompanies which heavily weight the reference market index.

Even those causes labelled as being the result of ‘contagion’ can involve either the national propagation (with transmission) of effects via market fundamentals or spill overeffects from other domestic markets This can happen as in the case of internationalcommodity price shocks, devaluations which affect the terms of trade, or as a consequence

of structural factors affecting the amount and the terms of credit made available by national banks While medical analogies (from which the term ‘contagion’ was borrowed)are common and at times useful to convey in a few words the concept of a phenomenonthat affects many, they risk imprecision This has consequences for any attempts at eitherdiagnosis or prognosis of how effects are transmitted

inter-First of all, even when talking about contagion in health matters, distinctions are ant as between those effects whereby a single external influence may affect a populationsimilarly (such as carbon monoxide poisoning of many people in an enclosed space) andthose where one person or organism passes to another an infection or weakness (such asthe flu or other type of virus), which is subsequently passed from one to another and so

import-on

In the case of financial contagion, similar distinctions are needed between say the impactthat a sudden rise in the price of a key input such as energy might have on nearly allproducers across international borders and, for example, the contagion-like effect that non-performing assets may have where claims against those assets have been tiered several layersdeep through structured finance instruments, resulting in interlocking effects on the balancesheets of several financial institutions crossing one or more borders

However, herding behaviour among international investors, bankers and portfoliomanagers may seem irrational and a form of ‘pure’ contagion Although if there has been

a ‘wake-up call’ effect which causes them to perceive risk and to discount expected returnsdifferently from the way they did previously, such behaviour may well possess its ownrationality For example, highly leveraged institutions required by either charter or bondindentures to maintain positions in nothing lower than investment-grade paper will, oncecrisis strikes obligors adversely in a particular country, attempt pre-emptive selling in coun-tries where obligors share similar characteristics to avoid being caught later when liquidity

in those issues might completely dry up Examples of such behaviour during the Asia (1997)and Russia (1998) financial crises are noteworthy

What explains the formation and accretion of bubbles?

The assumption of the rationality of people (or ‘economic agents’, as many economistswould say), and by extension the financial markets as well, is the cornerstone of traditionalfinancial theory What this means is that people act quickly and efficiently in incorporatingnew information into their belief framework as it becomes available, assimilating it intotheir decisions and that these decisions in the aggregate as reflected in the market are ‘good’

or ‘acceptable’ in some normative sense.3

It took years of agnosticism (supported by abundant empirical research that simplyfailed to provide the solid support for the simplistic view of rational behaviour assumed in

traditional financial theory) that gave birth to behavioural finance This offshoot from mainstream finance posits that finance is better understood if some people are treated as notacting in ways the traditional theory considers to be fully rational It was a view that wasnot readily accepted for some time as anything more serious than a niche area of financewhich looked into a few interesting puzzles and paradoxes.

Although it is beyond the scope of this book to provide either a comprehensive history

or catalogue of behavioural finance topics, from time to time we will draw on importantconcepts developed in this field of enquiry as they help develop our analysis of contributingdeterminants of financial crisis and distressed financial markets

A major contribution of behavioural finance to the analysis of the dynamic iour of financial markets was to include wealth in addition to income as a majordeterminant of consumption Traditional financial theory, on the other hand, posited thatsavings, investment and consumption decisions are predicated on the utility of suitably-discounted future consumption The expected future consumption was considered to bedetermined primarily by the trajectory of income – largely from wages – an individualcould expect to earn over his lifetime All of this, of course, was adjusted for anticipatedinflation Savings figured into the picture but its growth was predicated on the propen-sity to save and a natural rate of return (interest) which could be earned on the savings.The earlier models did not explicitly take into account the effect of the vicissitudes offortune which might require the person to draw from savings unexpectedly In fairness,the alternative ways, the timings and the magnitudes of how this could happen are virtu-ally infinite and involve uncertainties to such an extent that they would be virtuallyimpossible to predict in any event Nor did the traditional framework take into accountsudden or unanticipated windfalls, irrespective of their source, which similarly can happen

behav-in a variety of ways, amounts and moments behav-in time and thus would have defied ible prediction Thus with personal income representing the most tractable quantity toforecast, it is not surprising that real consumption came to be seen as being determinedpreponderantly, if not exclusively, by real income In reality, however, sudden windfalls

cred-do change people’s consumption patterns whether the windfall is the result of winning

a lottery, unexpectedly receiving a large inheritance or seeing one’s store of wealth – inreal or financial assets or both – suddenly multiply in value due to an asset price bubble.The importance of understanding how wealth effects enter into the determination ofconsumption patterns is that when asset price bubbles inflate, consumption rises withincreasing ‘paper profits’ This provides significant economic stimulus which contributes toeven stronger inflation of the bubble Then, as the bubble bursts and the inflated asset marketcollapses, the sudden extinguishing of wealth impacts consumption brutally in the oppositedirection This in turn causes financial distress to spill over into the real economy withenduring trauma The spiral of reduced spending, the contraction of economic output, theassociated unemployment of factor inputs (land, labour and capital) and the subsequentrounds of further compression of consumption and contraction of output and factor utilisa-tion become widespread and protracted One only needs to look to the Great Depression as

a reminder of the potential for financial market distress to translate into broader economicmalaise

Who to blame – external or internal causes, crowds or

it could maintain its exchange rate If not, it might wind up either changing to a floatingexchange rate following a massive devaluation, or it might try a series of orderly devalua-tions until the foreign exchange market showed signs of stabilising

With liberalisation of the financial sector as well as the external capital account in manycountries, the transmission path for external shocks became much more direct and oftenshowed up almost immediately in the host country’s financial sector (and even in its busi-ness sector) In particularly severe cases nonetheless, financial crisis would take the form

of twin currency and banking crises occurring virtually simultaneously

A key issue then is whether or not there are particular economic policy lessons to bedrawn from the multitude of financial crises over the past several decades

Box 1.1

Trends versus mean reversion

When markets are trending, it is commonplace to see professional traders loading up on winning positions and cutting back on losing ones Trend following after all is predicated on momentum and even if the more astute are vigilant regarding turning points, at least in the trend regions prior to evidence suggesting imminent trend reversal, markets are characterised by positive feedback loops Relative value trading on the other hand is predicated on notions of fundamental values and tempo- rary misalignments The entire premise is that relationships that should hold are somehow temporarily off-kilter but with time should undergo convergence If the convergence ultimately occurs during the life of the trade, the trade is considered successful If not, then the losses involved will determine the extent of ‘failure’ Astute traders, however, betting on convergence, will tend to lay on succes- sive trades in the direction of the anticipated convergence If they are large institutional players (and here the notion of what is large is relative to the size of the market in which they are transacting), then the directionality of their successive bets is not without its own influence on the way the market subsequently moves Therefore, market dynamics at any given moment, although affected by poten- tially many things, can be viewed as a set of tensions between the forces of positive feedback inherent in the prevalence of momentum trading on the one hand and the countervailing negative feedback which characterises relative value and market neutral trades on the other

In large measure, the conventional economic wisdom for at least several decades duringthe post-war period recommended that for small emerging market open economies, a fixed-rate exchange rate regime was preferable to a floating rate regime As we will see in greaterdepth in Part 2 and Part 3 of this book, a key underlying assumption was of course thatmost countries of this type would be net debtor countries and that using the exchange rate

as a nominal anchor would curtail runaway inflationary build-up if fiscal policy were not

as conservative as desirable or alternatively it would prevent the country being ravaged by

a burgeoning external debt repayable in ever more expensive foreign currency beyond thepoint of its macroeconomic solvency Further on, we will examine the spate of financialcrises which were unleashed during the 1990s (in Mexico, then the rest of Latin America,then in Asia, moving on to Russia and Brazil) and then post 2000 in Argentina, and severalothers We will also examine other global developments resulting in the US shifting frombeing a surplus economy to one running twin deficits These events conspired to allowmany of the previously deficit countries to begin accumulating excess reserves This embar-rassment of riches also carries with it a responsibility for prudent management of thenewfound wealth which in some cases may be of longer-term duration while in others itmay prove to be short-lived In any event, as we will consider in Chapter 7, althoughmacroeconomic policies may not always precipitate distress in financial markets, earlydetection (with remedial action) to mitigate such distress requires an assessment of thenature of prevailing macroeconomic and sector policies and their potential contribution tofinancial draw downs

In Chapter 5, we will see in the descriptions of individual country episodes that economicpolicies have relevance at the level of individual countries to the extent that they may helpexplain conditions leading up to the formation of national stock market bubbles, creditbubbles or other asset bubbles In this connection, policies can be highly instrumental inshaping these conditions so as to not only raise the prices of financial assets but also increasefunctionally what Sornette calls the ‘crash hazard rate’.4On a grander scale, however, macro-economic policies internationally, taken as an ensemble, produced and have sustained certainpronounced global imbalances In Chapter 6, we will consider that the US economy for thebetter part of the past decade has maintained twin deficits – an external deficit and a budget-ary one At the same time, developing Asian countries have enjoyed a series of surpluses

on external account which have allowed them to accumulate significant excess reserves Theresurgence of commodity prices led by oil and natural gas has also allowed oil-producingcountries to accrete oil-related revenues at an unprecedented rate

Countries which undertook trade liberalisation soon followed it with financial isation The combined effect was to heighten financial fragility in most cases but at thesame time to permit significant economic growth Moreover, financial liberalisation hasusually resulted in financial deepening but with greater volatility which consequently hasexacerbated their boom-bust dynamics.5

liberal-While economic theory would suggest that a country relentlessly amassing excessreserves would find it prudent to manage its exchange rate to equilibrate international pricesand to mop up the excess liquidity with its attendant inflationary pressures which suchreserves tend to produce, this has not been happening Or at least, it has not been happeningfast enough So in a sense, to the extent that the mounting global imbalances are risking

the stability of the global financial system, on this level too the issue of relevant economicpolicies is one worthy of addressing

It is in this context that the role of the US dollar as the world’s reserve currency needs

to be viewed In recent years, countries running large external surpluses, particularly, China,Japan, Russia, and Saudi Arabia, have together held over a trillion6dollars of US Treasurybills, notes and bonds As the dollar started its downward descent in value over the lastseveral years, some of these key holders have toyed with the idea of shifting their inter-national reserves at least partly out of dollars and into, for example, the Euro What isinvolved in such decisions needs to be viewed within the context of global currency symmetryand asymmetry vis-à-vis the world’s reserve currency In short, the rules for managing macro-economic balances via certain key macroeconomic targets apply to all countries alike under

a symmetric international monetary system An asymmetric international monetary system,

on the other hand, accommodates greater tolerance for deviations on the part of the reservecurrency country This is largely because the demand for the reserve currency has a rationalebeyond that which is merely needed for trade For many countries and even certain inter-national commodities, the reserve currency not only serves as the means of payment to

balance the external accounts but acts as a numeraire with all invoicing conducted in that

currency as well (for example, international oil prices are quoted in dollars irrespective ofgeographic location or the fact that contracting parties often do not even involve the UnitedStates either on the buy side or the sell side)

The Euro has been showing sustained robustness and at least preliminary signs thatsome surplus countries want to diversify their international reserves into Euro-denominatedinstruments A key issue then is whether it is possible to identify the point at which anyextra policy latitude enjoyed by the US economy and the dollar, currently afforded by inter-national currency asymmetry, will become sharply constrained by a shift to a more symmetricset of game rules for the entire global community

In a world in which international money no longer has intrinsic backing, the elements

of monetary policy conducted primarily with the end in mind of maintaining economicstability of the domestic economy and controlling domestic price inflation cannot be divorcedfrom management of the external accounts This includes but is not necessarily limited tothe design and management of the exchange rate regime The spectrum of domestic interestrates, which is influenced, if not totally shaped, by central bank general instruments ofmonetary policy is key to determining domestic financial asset values However, in an openeconomy with a relatively liberal capital account, it is the interplay between interest ratesand rational expectations as they apply to the rate of change (depreciation or appreciation)

in the price of foreign exchange which equilibrates both stocks and flows, including economic balances, the domestic inflation rate, and the price trajectory of traded financialassets

macro-The human element in financial markets

Financial theory, as a specialised branch of economics, has been subjected to many of thesame tools and assumptions as have been applied to economics These tools with theirinherent assumptions run the gamut from a predilection to view all decision making in terms

of its rationality, treating humans as economic agents without regard for other passions andmotivations which might explain their behaviour, to mechanistic treatment of a marketdrawing from the physical sciences.

Without necessarily abandoning entirely these depictions of operative forces at work,greater allowance for human behaviour seems essential to a better understanding of financialmarket behaviour with its attendant risks Central to a more humanistic behavioural view isthe phenomenon of imitation or herding A description of this type of behaviour emphasisesthat decision makers may or may not have in their possession the information required tomake rational decisions on the fundamental merits or demerits of investments What drivestheir decision making, however, is a de-emphasis of the information of this nature (whicheither they already have or could acquire) and instead a need to conform to what others aredoing There is both an economically rational and irrational element to this behaviour The rational element is recognition of the fact that in liquid markets when buying at acertain price, it matters little what you should be paid but rather what the market is prepared

to pay when you exit Consequently, an observation of what others are doing and thereforeseem to think is not such an intellectually shallow type of behaviour as fundamentalistswould like to suggest The shorter the time horizon for investing and trading activity, themore cogent this argument actually becomes The irrational aspect can involve a host ofreasons which have little to do with the intrinsic nature of the investment decision at hand

It may have to do with such things as fear of a loss of reputation for ‘going out on a limb’

or even fear of job loss (as in the old saying in business ‘no one has ever been fired forbuying IBM’)

While to the extent such reasoning behind decision making can be described as emotional

or non-pecuniary when framed in terms of a ‘buy’, ‘sell’, or ‘hold’ decision in connectionwith a particular investment or financial asset, this is not to say it is not economic Afterall, for a well-known analyst or financial adviser to make a contrarian recommendation andhave it not pan out, the outcome could be to have such a decision adversely affect theirprofessional reputation with a concomitant loss of income Whether that is fact or percep-tion is not the issue The motivation is still an economic one and thus rational in a broadersense even if it is not considered to be rational when framed strictly within the context ofthe immediate investment decision However, other reasons can play a role in decisionmaking which have no apparent economic basis such as hubris or entertainment value

The problem with statistics and probabilities

Random walk and misleading probabilities

Bachelier7introduced the idea that stock market returns follow a random walk, an idea thathas stuck since its advent in 1900 The resulting assumption of the statistical independence

of stock market returns has been widely adopted and is underpinned by the efficient markethypothesis (EMH) In fact, much of modern portfolio theory (MPT) is predicated on theassumption that stock market returns adhere to a Gaussian or normal distribution Exceptions

to the widespread acceptance of this assumption are found in the adherence of chartists andtechnical analysts to the predictive power of market patterns through time, as well as in the

work undertaken by Fama and French8in the 1990s which revealed that stock market returnsare likely not Gaussian at all but more appropriately fall into the category of stable paretiandistributions – a possibility raised at the conjectural level by the pioneers of MPT back inthe 1970s

In many cases, that is so long as the market remains within certain bounds, the assumption

of a random walk conforms to observable data Therefore, it is not uncommon for quantitativepractitioners to compute probabilities for market fluctuations The problem with this approach

is that fluctuations of different magnitudes in percentage (or logarithmic) terms are assignedprobabilities of occurrence based on the frequency with which they have occurred historically.But even that last statement is misleading What has happened historically and what the analystobserves to have occurred historically can be vastly different The former would require collecting data for all occurrences back to the point at which pre-history and history meet Thelatter in many cases would be lucky if it went back much more than one or two decades’ worth

of data collection and thus would only represent a subset of historical occurrence

Reliance on frequency distributions in which events are assumed to represent randomoccurrences, however, leads to overstatement of the length of time that we would be required

to wait to observe a run of repeating percentages This is because when independence ofoccurrence is assumed, a daily occurrence that has a probability of happening of, for example,1% (representing 1 chance in 100) means that we would on average have to wait 100 days

to witness such an event For it to happen in a run of three successive days, it would takethe value of 0.01 × 0.01 × 0.01 = 0.000001 or one occurrence in a million days (or once

in about 4,000 years, if we assume roughly 250 trading days a year on average) If weexpand a run to only five sequential days, the probabilities become totally absurd – wewould have to wait about 40 million years on average to witness such a run

Clearly, the formation of bubbles (runs of sequential positive returns) and draw downs(runs of sequential negative returns) occur in real life with much greater frequency Thisstrongly suggests that even if periodic returns exhibit seeming independence when an indi-vidual stock or the market as a whole is in a trading range, the formation of a trend represents

a correlation which temporarily emerges Such correlation may even be characterised bynon-linearities The fact that (linear) serial correlation very close to zero may be evidencedover a range of time periods may be more the result of an arbitrariness of the choice oftime period combined with the inherent assumption that the presence of any correlationmust be linear in nature When a trend begins to gather strength, what we may be witnessing

is the sudden emergence of temporary dependence and, within the limits of the length ofthe trend, an emerging degree of predictability So much for the parametric treatment ofcorrelation coefficients based on all historical occurrences!

In recent years (especially during 2007 and 2008), the crystallisation of financial crisesinvolving global financial institutions which used state-of-the-art quantitative methods andmodels for managing risk raises important questions regarding what went wrong The modelswere enormous advances in rigour over the kind of thinking which informed banking andportfolio decisions in past decades (since the advent of MPT in the mid-1960s) So whatwent wrong?

The main problem, as explained by Rebonato, was that quantification was based almostexclusively and to a large degree mechanistically on historical probabilities.9In the attempt

to ensure confidence in the results large quantities of data were employed But achievinglarger sample sizes from which to estimate key parameters with supposedly greater confi-dence by shortening the time spans ignores the importance of capturing outlier risk Certainhistorical events with very low frequencies of occurrence but with enormous impact need

to be taken into account for a quantitative risk calculation to have meaning To the extentthat such events did not take place during the time periods for which the historical datawere collected results in serious understatement of the real risks involved Although data

on certain types of financial variables such as government bonds, key interest rates and eventhe share prices of some companies go back for over a century, most of the instrumentsused as reference assets for many of the risk management analyses simply have not been

in existence for more than even a decade Yet this did not stop risk managers from lating confidence intervals for probabilities significantly greater than 99% The fact that thisspurious accuracy provided the basis for over exposure to risky assets and excessive use offinancial leverage points to a major flaw in modern risk management practices It was that

calcu-of defining the universe calcu-of risk in terms calcu-of the strictly measurable without paying due regard

to less-likely but higher-impact events and indeed to the unknown

1 It is interesting to note that the term ‘South Sea’ in those times referred to the waters off South America

2 Throughout this book, the term ‘billion’ refers to a quantity equal to one thousand million.

3 Thaler (2005, p 1).

4 Sornette (2003, p 149).

5 Tornell and Westermann (2005, p 33).

6 Throughout this book, the term ‘trillion’ is used to refer to a quantity that is equal to one million million or the numeral one followed by twelve zeros.

7 Bachelier (1900).

8 Fama and French (1992).

9 Rebonato (2007).

Chapter 2

Evolving characteristics of

financial markets

The institutional importance of a financial market perspective

Traditionally, financial systems have been neatly characterised as being either dominated or capital-markets-dominated Restrictive laws and regulations have played a role

bank-in this regard The relative simplicity of earlier fbank-inancial products offered did as well – acompany, for example, could choose between seeking a bank loan and issuing an obliga-tion on the stock exchange Direct recourse to organised securities markets, such as sellingbonds or issuing stock on the stock exchange, came to be referred to as financial disinter-mediation The choice between this form of financing and bank loans was for years cast as

a mutually exclusive one However, as the business and technology of securitisation of backed securities became widespread, the distinction between banking and capital marketsfinancing became blurred Today the large bulge-bracket commercial banks play an import-ant role in securities markets, not only in terms of the primary issuance of securities butalso in trading them in the secondary market as well Moreover, when smaller banks ori-ginate and then immediately sell mortgage loans to the government sponsored entities (GSEs)such as Fannie Mae and Freddy Mac, they too are playing a symbiotic role in the financialmarkets

asset-The investing and portfolio management activities of large mutual fund companies,although rightly described as a form of financial intermediation, also play a symbiotic rolewith the capital markets as well This is further complicated by the rise of internal marketswithin large mutual fund companies which enable cross trades, as well as by the emergenceand operation of dark pools of capital ‘Dark pools of liquidity’, as they are also called, arenetworks, some of which are independently operated Others are operated by financial insti-tutions already otherwise engaged as market participants They provide liquidity by permittingcrossing of trades that are not shown in the order books of licenced broker-dealers trans-acting on the major exchanges In fact, in addition to the independents, a number of darkpools are owned and operated by broker-dealers and even by exchanges Not only do thesepools offer additional liquidity but they provide additional value to those traders who donot want to reveal their identities nor signal their intentions through normal market trans-parency Consequently, they also do not reveal crossing prices, thus denying the market theadditional function of ‘price discovery’ which would otherwise be gained from transactionsconducted on the exchanges

The role of legal frameworks

Two essential preconditions for a market economy to thrive are: (1) a system of clearlydefined property rights and mechanisms for their enforcement; and (2) operability of theprinciple of exclusion (and the related concept of ‘the ability to appropriate’)

Regarding the former, in those societies guided by the rule of law, clear title allowsproperty to pass from one holder to another and so forth with minimal doubt or ambiguity

as to rightful ownership, which reduces the costly friction of having to resort constantly tothe court system to resolve contested claims

In the case of the second precondition, the principle of exclusion and its conjugateconcept of the ability to appropriate, the act of possession allows the property holder to

‘exclude’ others from its use or to deny them access to it Carried further, in the event thatothers encroach on the property, it is physically within the power of the property holder(assuming he has the means of enforcement) to ‘appropriate’ the property and in so doingreturn it to his own exclusive possession and use

A person may have uncontested legal title to property but for certain reasons is less to exclude others from access to and use of the property in question And conversely,examples are common in which a property holder or claimant may be successful in excludingothers from the property’s use without the claimant necessarily having uncontested legal title– hence the importance of both preconditions being satisfied for market economy to thrive.Exchange can take place in certain circumstances if only one or the other of these twopreconditions is in place However, the mutual reinforcement of both preconditions is neces-sary for market economy to flourish, particularly one in which the method of paymenttranscends the use of cash alone with ample recourse to the instruments of modern finance The preconditions above apply to all types of market Promoting sound financial markets,however, involves additional legal requirements These include laws pertaining to the following

power-• Property:

• land tenure;

• tenancy;

• transfer; and

• mortgage creation and secured transactions

• Financial insolvency and creditor rights:

• collateral and security interests;

• secured and unsecured lending;

• seizure and sale of movable and immovable goods; and

• bankruptcy and claims resolution

• Companies:

• types of companies and rules for their creation;

• registration and access to information;

• minimal capital;

• issue and transfer of shares; and

• shareholder rights, responsibilities, and governance

• Financial sector consumer protection:

• rights to protection of information and privacy;

• undertakings regarding information security standards and safeguards;

• fair lending and service practices; and

• grievances and dispute resolution

• Central bank:

• role;

• relationship to government; and

• limits on and conditions of lending to government

• Banking:

• sponsor eligibility criteria;

• minimum capital requirements;

• criteria for principals (shareholders, managers, officers and so on);

• powers to accept deposits and conduct business;

revo-• bank secrecy and confidentiality; and

• measures to curb money laundering and financing illegal activities (reference to rate legislation as appropriate)

sepa-• Financial safety nets:

• emergency lending or support arrangements for banks;

• deposit insurance schemes for banks, credit unions, other financial institutions (FIs); and

• crisis stabilisation management framework and inter-agency relationships and sibilities

respon-• Payment systems:

• cash-based systems;

• cheque encashment;

• electronic systems (debit cards and credit cards);

• clearance systems, gross settlement arrangements, netting arrangements, real time andswift-based terminal systems;

• confidentiality, supervision, and rules for netting; and

• ‘zero-hour’ rule provisions

• Government debt:

• primary and secondary government securities markets;

• rights and obligations of dealers and agent banks;

• rules for conducting public auctions;

• maturities offered;

• registration and transfer of ownership; and

• physical and ‘dematerialised’ securities

• Insurance:

• powers and responsibilities of the regulatory body;

• eligibility criteria and conditions for forming insurance and re-insurance companies andregistering them;