Understanding Systemic Risk in Global Financial Markets. Gottesman Aron
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Q1.1: What development differentiates a systemic risk event from other types of financial crisis?
Q1.2: Are systemic events only a phenomenon of modern history?
Q1.3: What are the six most common causes of systemic events throughout history?
Q1.4: Significant failures within which segment of the global financial sector have fueled several of the worst systemic events in history?
Q1.5: Why is it important that the level of understanding, monitoring, and managing of systemic risks improves globally?
CHAPTER 2
How We Got Here: A History of Financial Crises
INTRODUCTION
Financial crises are far from a new phenomenon, having occurred as long as money and financial markets have been in existence. On the surface, it may appear that there is little to be learned from any event that occurred hundreds of years ago. Clearly the global financial services industry that exists today bears little resemblance to the one that existed even 50 years ago, due to changes in market structures, technological advances, the sophistication of risk analytical tools, and the highly developed nature of global financial regulatory frameworks.
It is outside the scope of this book to categorize every crisis throughout history, or to draw definitive conclusions about their primary causes. However, despite the vast differences in the way financial markets operate today, a brief review of key past events will reveal some common themes with respect to the nature and causes of such events. An understanding of these themes can assist the many actors involved in the study of systemic risk (e.g., risk managers, academics, policymakers, or regulators) to obtain a broader perspective on certain risks that have manifested themselves repeatedly throughout history and potentially identify the buildup of these risks before they become a full-fledged crisis. Consider the following remarks by well-known academics Carmen Reinhart and Kenneth Rogoff;
Until very recently, studies of banking crisis have focused either on episodes drawn from the history of advanced countries (mainly the banking panics before World War II) or on the experience of modern day emerging markets. This dichotomy has perhaps been shaped by the belief that for advanced economies, destabilizing, multi-country financial crises are a relic of the past. Of course, the Second Great Contraction, the global financial crisis that recently engulfed the United States and Europe, has dashed this misconception, albeit at a great social cost. 14
After reading this chapter you will be able to:
● Cite examples of some of the most noteworthy financial crises in history.
● Explain some of the common themes behind prior systemic events.
● Understand what is meant by an “asset bubble” and describe the economic conditions that typically lead to a bubble.
● Describe which countries have been the source of most sovereign defaults in history.
● Understand the ways in which international contagion either fueled or contributed to the severity of prior financial crises, including the Great Depression.
COMMON DRIVERS OF HISTORICAL CRISES
Table 2.1 presents a timeline of select historical crises. In nearly all cases, a close examination of each of the crises listed in Table 2.1 will result in a myriad of causes. Furthermore, in all cases the occurrence of just one of the underlying events likely wouldn't have led to the full-fledged crisis that ensued. Rather, it was often the simultaneous occurrence of multiple underlying events or the spillover and linkages among multiple countries or markets that ultimately caused these systemic events to take place. Given the multitude of underlying causes and the inherent complexity of every crisis, we attempt to group such causes into higher-level themes as a starting point for trying to understand, analyze, and identify tools that might help avoid similar events in the future.
Table 2.1 Timeline of Selected Historical Crises
Table 2.1 provides several examples of asset bubbles throughout history. One definition of an asset bubble is an upward price movement of an asset over an extended time period of 15–40 months, which then implodes. Economists use the term to mean any deviation in the price of an asset, security, or commodity that can't be explained solely by fundamentals. Asset price bubbles are most often fueled by a combination of a rapid growth in the availability of credit and the irrational behavior of investors and markets.
Although bubbles can theoretically take place with respect to any asset that has an observed value, most bubbles have tended to occur within a securities asset class, individual security, or real estate. In the past 30 years alone, major real estate bubbles have burst in Japan, non-Japan Asia, and most recently in the United States.
The following sequence of events are representative of a typical model of a financial crisis fueled by an asset bubble:
● Economic expansion/boom
● Euphoria and rapid increase in asset prices
● Pause in asset-price increases
● Distress/panic/crash
Asset price bubbles, at least the large ones, are almost always associated with economic euphoria. In contrast, the bursting of bubbles leads to a downturn in economic activity and is often associated with the failure of financial institutions, frequently on a large scale. The failure of these institutions disrupts the channels of credit, which in turn can lead to a slowdown in economic activity. As mentioned previously, bubbles in stock markets and real estate are often closely linked with three prominent examples of linkages and connections between these two asset markets:15
1. In many countries, and especially smaller nations and those in early stages of industrialization, a substantial amount of the stock market valuation consists of real estate companies and construction companies and firms in other industries that are closely associated with real estate, including banks.
2. Another connection is that individuals whose wealth has increased sharply because of the increase in real estate values want to keep their wealth diversified and so they buy stocks.
3. The third connection is the mirror-image of the second: the individual investors who have profited extensively tend to buy larger and more expensive homes.
Dutch Tulip Crisis: One of the earliest financial crises that was documented extensively is often referred to as the Dutch Tulip Crisis or Mania, when the prices of tulip bulbs increased by several hundred percent in the autumn of 1636. For more exotic and rare bulbs, price increases were even more dramatic.
In the mid-16th century tulips were introduced to Holland via the Ottoman Empire and quickly became a status symbol among its citizens, setting off a frenzy of speculative behavior across the country. The speculation became rampant in September 1636 as the bulbs were in their normal planting cycle and therefore could no longer be physically inspected by potential buyers who had to commit to purchases long before the spring bloom. This led to many investors purchasing bulbs at extraordinary prices that they had never seen.
Nobles, citizens, farmers, mechanics, footman, maid-servants, even chimney sweeps and old clothe woman dabbled in tulips. 16
This frenzy was accompanied by the introduction of call options that further fueled speculative buying, resulting in a 20-fold increase in prices between November 1636 and February 1637.
As traditional bank financing was not fully developed at that time, most investors used in-kind down payments, which included things such as tracts of land, houses, furniture, silver and gold vessels, paintings, and so on. When the prices of tulip bulbs crashed, it led to
Reinhart, Carmen M., and Rogoff, Kenneth S., 2009,
Mackay, C., 1841, “Extraordinary Popular Delusions and the Madness of Crowds.” Vol. 1. Richard Bentley, London.