Academic journal article Federal Reserve Bank of New York Economic Policy Review

Part 1: Introduction

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Part 1: Introduction

Article excerpt

The stability of the financial system and the potential for systemic events to alter its functioning have long been critical issues for central bankers and researchers. Developments such as securitization and greater tradability of financial instruments, the rise in industry consolidation, growing cross-border financial activity, terrorist threats, and a higher dependence on computer technologies underscore the importance of this research area. Recent events, however, such as the terrorist attacks of September 11, 2001, and the collapse of the hedge fund Long-Term Capital Management (LTCM), suggest that older models of systemic shocks in the financial system may no longer fully capture the possible channels of propagation and feedback arising from major disturbances. Nor can existing models account entirely for the increasing complexity of the financial system, the spectrum of financial and information flows, or the endogenous behavior of different agents in the system. Fresh thinking on systemic risk is therefore required.

With that goal in mind, in May 2006 the National Academy of Sciences and the Federal Reserve Bank of New York convened a conference in New York to promote a better understanding of systemic risk. The sessions brought together a broad group of scientists, engineers, economists, and financial market practitioners to engage in a cross-disciplinary examination of systemic risk that could yield insights from the natural and physical sciences useful to researchers in economics and finance. (1) Accordingly, presenters from the natural and mathematical sciences and the engineering disciplines provided examples of tools and techniques used to study systemic collapse in interactive systems in nature and engineering. Similarly, research economists presented studies of systemic risk in cross-border investments, liquidity risk, and the payments system. To provide a context for the discussions, risk managers at large finance institutions described how systemic risk and shocks in the financial system affect trading activities.

Transitioning from a Bank-Based to a Market-Based Financial System

Financial market practitioners began the conference by highlighting various aspects of systemic risk and systemic events in the financial system. The topics of the presentations ranged from historical systemic episodes, such as the liquidity crisis of 1998 and the failure of LTCM, to risk assessment techniques, such as value-at-risk (VaR) analysis and scenario analysis. Charles Lucas of AIG (since retired), a member of the National Academy's Board on Mathematical Sciences and Their Applications, introduced the first session by asking the fundamental question: What is systemic risk?

According to Lucas, economists' theoretical understanding of systemic risk stemmed from the experience of the Great Depression and specifically from John Maynard Keynes's interpretation of that experience in General Theory of Employment, Interest, and Money. Keynes aimed the formulation of his "general theory" at capturing the dynamics that allowed an economy to transition to an inferior but stable equilibrium, in the process overturning the normal full-employment equilibrium that defined classical models. During the Great Depression, the economy underwent a shock that was sustained by sympathetic movements throughout the financial system--a sequence of events that has come to be called "contagion." Because of policy missteps and a feedback loop with the financial system, the real economy settled into a persistent state of underutilized resources and unemployment. Despite structural changes since that time, the idea of a feedback loop between the financial and real sectors of the economy that leads to an inferior equilibrium with negative consequences for the real economy remains pertinent to current analysis of financial stability.

That system has changed dramatically since the Great Depression, as described in the conference background paper on the evolution of systemic risk. …

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