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Dynamic Loss Probabilities and Implications for Financial Regulation2014
Much of financial regulation and supervision is devoted to ensuring the safety and soundness of financial institutions. Such micro- and macroprudential policies are almost always formulated as capital requirements, leverage constraints, and other statutory restrictions designed to limit the probability of extreme financial loss to some small but acceptable threshold. However, if the risks of a financial institution's assets vary over time and across circumstances, then the efficacy of financial regulations necessarily varies in lockstep unless the regulations are adaptive. We illustrate this principle with empirical examples drawn from the financial industry, and show how the interaction of certain regulations with dynamic loss probabilities can have the unintended consequence of amplifying financial losses. We propose an ambitious research agenda in which legal scholars and financial economists collaborate to develop optimally adaptive regulations that anticipate the endogeneity of risk-taking behavior.
When Do Stop-Loss Rules Stop Losses?2014
We propose a simple analytical framework to measure the value added or subtracted by stoploss rules—predetermined policies that reduce a portfolio’s exposure after reaching a certain threshold of cumulative losses—on the expected return and volatility of an arbitrary portfolio strategy. Using daily futures price data, we provide an empirical analysis of stop-loss policies applied to a buy-and-hold strategy using index futures contracts. At longer sampling frequencies, certain stop-loss policies can increase expected return while substantially reducing volatility, consistent with their objectives in practical applications.
Quantifying Systemic Risk2013
In the aftermath of the recent financial crisis, the federal government has pursued significant regulatory reforms, including proposals to measure and monitor systemic risk. However, there is much debate about how this might be accomplished quantitatively and objectively—or whether this is even possible. A key issue is determining the appropriate trade-offs between risk and reward from a policy and social welfare perspective given the potential negative impact of crises.
One of the first books to address the challenges of measuring statistical risk from a system-wide perspective, Quantifying Systemic Risk looks at the means of measuring systemic risk and explores alternative approaches. Among the topics discussed are the challenges of tying regulations to specific quantitative measures, the effects of learning and adaptation on the evolution of the market, and the distinction between the shocks that start a crisis and the mechanisms that enable it to grow.
On a New Approach for Analyzing and Managing Macrofinancial Risks2013
At the fifth annual CFA Institute European Investment Conference on 19 October 2012 in Prague, Robert C. Merton gave a presentation on analyzing and managing macrofinancial risk. This article is based on his talk and on research he carried out with his coauthors.
Systemic Risk and the Refinancing Ratchet Effect2013
The combination of rising home prices, declining interest rates, and near-frictionless refinancing opportunities can create unintentional synchronization of home owner leverage, leading to a ‘‘ratchet’’ effect on leverage because homes are indivisible and owner-occupants cannot raise equity to reduce leverage when home prices fall. Our simulation of the U.S. housing market yields potential losses of $1.7 trillion from June 2006 to December 2008 with cash-out refinancing vs. only $330 billion in the absence of cash-out refinancing. The refinancing ratchet effect is a new type of systemic risk in the financial system and does not rely on any dysfunctional behaviors.
What’s the Use of Economics? Teaching the Dismal Science after the Crisis, Chapter 72012
With the financial crisis continuing after five years, people are questioning why economics failed either to send an adequate early warning ahead of the crisis or to resolve it quickly. The gap between important real-world problems and the workhorse mathematical model-based economics being taught to students has become a chasm. Students continue to be taught as if not much has changed since the crisis, as there is no consensus about how to change the curriculum. Meanwhile, employer discontent with the knowledge and skills of their graduate economist recruits has been growing. This book examines what economists need to bring to their jobs, and the way in which education in universities could be improved to fit graduates better for the real world. It is based on an international conference in February 2012, sponsored by the UK Government Economic Service and the Bank of England, which brought employers and academics together. Three themes emerged: the narrow range of skills and knowledge demonstrated by graduates; the need for reform of the content of the courses they are taught; and the barriers to curriculum reform. While some issues remain unresolved, there was strong agreement on such key issues as the strengthening of economic history, the teaching of inductive as well as deductive reasoning, critical evaluation and communication skills, and a better alignment of lecturers' incentives with the needs of their students.
Rethinking the Financial Crisis2012
Some economic events are so major and unsettling that they “change everything.” Such is the case with the financial crisis that started in the summer of 2007 and is still a drag on the world economy. Yet enough time has now elapsed for economists to consider questions that run deeper than the usual focus on the immediate causes and consequences of the crisis. How have these stunning events changed our thinking about the role of the financial system in the economy, about the costs and benefits of financial innovation, about the efficiency of financial markets, and about the role the government should play in regulating finance? In Rethinking the Financial Crisis, some of the nation’s most renowned economists share their assessments of particular aspects of the crisis and reconsider the way we think about the financial system and its role in the economy.
A Survey of Systemic Risk Analytics2012
We provide a survey of 31 quantitative measures of systemic risk in the economics and finance literature, chosen to span key themes and issues in systemic risk measurement and management. We motivate these measures from the supervisory, research, and data perspectives in the main text, and present concise definitions of each risk measure--including required inputs, expected outputs, and data requirements--in an extensive appendix. To encourage experimentation and innovation among as broad an audience as possible, we have developed open-source Matlab code for most of the analytics surveyed, available for download above.
Do Labyrinthine Legal Limits on Leverage Lessen the Likelihood of Losses? An Analytical Framework2012
A common theme in the regulation of financial institutions and transactions is leverage constraints. Although such constraints are implemented in various ways—from minimum net capital rules to margin requirements to credit limits—the basic motivation is the same: to limit the potential losses of certain counterparties. However, the emergence of dynamic trading strategies, derivative securities, and other financial innovations poses new challenges to these constraints. We propose a simple analytical framework for specifying leverage constraints that addresses this challenge by explicitly linking the likelihood of financial loss to the behavior of the financial entity under supervision and prevailing market conditions. An immediate implication of this framework is that not all leverage is created equal, and any fixed numerical limit can lead to dramatically different loss probabilities over time and across assets and investment styles. This framework can also be used to investigate the macroprudential policy implications of microprudential regulations through the general-equilibrium impact of leverage constraints on market parameters such as volatility and tail probabilities.
Reading About the Financial Crisis: A Twenty-One-Book Review2012
The recent financial crisis has generated many distinct perspectives from various quarters. In this article, I review a diverse set of 21 books on the crisis, 11 written by academics, and 10 written by journalists and one former Treasury Secretary. No single narrative emerges from this broad and often contradictory collection of interpretations, but the sheer variety of conclusions is informative, and underscores the desperate need for the economics profession to establish a single set of facts from which more accurate inferences and narratives can be constructed.
Econometric Measures of Connectedness and Systemic Risk in the Finance and Insurance Sectors2012
A significant contributing factor to the Financial Crisis of 2007–2009 was the apparent interconnectedness among hedge funds, banks, brokers, and insurance companies, which amplified shocks into systemic events. In this paper, we propose five measures of systemic risk based on statistical relations among the market returns of these four types of financial institutions. Using correlations, cross-autocorrelations, principal components analysis, regime-switching models, and Granger causality tests, we find that all four sectors have become highly interrelated and less liquid over the past decade, increasing the level of systemic risk in the finance and insurance industries. These measures can also identify and quantify financial crisis periods. Our results suggest that while hedge funds can provide early indications of market dislocation, their contributions to systemic risk may not be as significant as those of banks, insurance companies, and brokers who take on risks more appropriate for hedge funds.
Privacy-Preserving Methods for Sharing Financial Risk Exposures2012
Unlike other industries in which intellectual property is patentable, the financial industry relies on trade secrecy to protect its business processes and methods, which can obscure critical financial risk exposures from regulators and the public. We develop methods for sharing and aggregating such risk exposures that protect the privacy of all parties involved and without the need for a trusted third party. Our approach employs secure multi-party computation techniques from cryptography in which multiple parties are able to compute joint functions without revealing their individual inputs. In our framework, individual financial institutions evaluate a protocol on their proprietary data which cannot be inverted, leading to secure computations of real-valued statistics such as concentration indexes, pairwise correlations, and other single- and multi-point statistics. The proposed protocols are computationally tractable on realistic sample sizes. Potential financial applications include: the construction of privacy-preserving real-time indexes of bank capital and leverage ratios; the monitoring of delegated portfolio investments; financial audits, and the publication of new indexes of proprietary trading strategies.
The FTSE StableRisk Indices2011
Implicit in most asset-allocation policies is the statistical assumption of “stationarity,” which means that the means, variances, and covariances of asset returns are assumed to be constant over time. This assumption is a reasonable approximation during normal market conditions but fails dramatically during periods of market turmoil and dislocation. In such periods, market volatility is highly dynamic, correlations can jump to 100% in a matter of days, and risk premia can become negative for months at a time. FTSE and AlphaSimplex Group have developed a family of rule-driven (passive), transparent, and high-capacity indices whose volatilities are rescaled as often as daily with the goal of maintaining more stable risk levels. By stabilizing the risk of each asset class over time, the FTSE StableRisk Indices have the potential to capture the long-term risk premia of asset classes and simple strategies with less severe maximum drawdowns than those of traditional indices, which have no risk controls.
Managing Real-Time Risks and Returns: The Thomson Reuters NewsScope Event Indices2011
As financial markets grow in size and complexity, risk management protocols must also evolve to address more challenging demands. One of the most difficult of these challenges is managing event risk, the risk posed by unanticipated news that causes major market moves over short time intervals. Often cited but rarely managed, event risk has been relegated to the domain of qualitative judgment and discretion because of its heterogeneity and velocity. In this chapter, we describe one initiative aimed at solving this problem. The Thomson Reuters NewsScope Event Indices Project is an integrated framework for incorporating real-time news from the Thomson Reuters NewsScope subscription service into systematic investment and risk management protocols. The framework consists of a set of real-time event indices—each one taking on numerical values between 0 and 100—designed to capture the occurrence of unusual events of a particular kind. Each index is constructed by applying disciplined pattern recognition algorithms to real-time news feeds, and validated using econometric methods applied to historical data.
What Happened To The Quants In August 2007?: Evidence from Factors and Transactions Data2011
During the week of August 6, 2007, a number of quantitative long/short equity hedge funds experienced unprecedented losses. It has been hypothesized that a coordinated deleveraging of similarly constructed portfolios caused this temporary dislocation in the market. Using the simulated returns of long/short equity portfolios based on five specific valuation factors, we find evidence that the unwinding of these portfolios began in July 2007 and continued until the end of 2007. Using transactions data, we find that the simulated returns of a simple market-making strategy were significantly negative during the week of August 6, 2007, but positive before and after, suggesting that the Quant Meltdown of August 2007 was the combined effects of portfolio deleveraging throughout July and the first week of August, and a temporary withdrawal of market-making risk capital starting August 8th. Our simulations point to two unwinds—a mini-unwind on August 1st starting at 10:45am and ending at 11:30am, and a more sustained unwind starting at the open on August 6th and ending at 1:00pm—that began with stocks in the financial sector and long Book-to-Market and short Earnings Momentum. These conjectures have significant implications for the systemic risks posed by the hedge-fund industry.