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

Part 2: Current Trends in Economic Research on Systemic Risk

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

Part 2: Current Trends in Economic Research on Systemic Risk

Article excerpt

A conference session on current research directions featured three papers examining market-based crises--crises in which financial institutions are affected by shocks that propagate through asset prices and market liquidity. (1) In these crisis models, shocks affect financial institutions through the prices of securities that the institutions hold in common--not through chains of connections between institutions, as in a payments network.

While market-oriented models of financial crises differ from the traditional bank-oriented models in the way shocks are propagated, they share with bank models the possibility of multiple equilibria and transitions driven by positive feedback. Thus, a shock can cause a transition from a normal state to a crisis state from which the system need not recover endogenously. Indeed, the models often feature path-dependent behavior in which the transition out of a crisis state entails a path different from the one leading to the crisis and may require some form of external intervention. These characteristics of market-based models--and the dynamics of the models more generally--are the subject of the three papers presented.

As the discussion that followed the presentations made clear, the papers open some potentially productive new avenues for research. More insight is needed into how financial markets recover from crisis states and what policies or regulatory regimes would speed that recovery and contribute to a more robust financial system. (2) A related issue that merits further research is the trade-off in risk management practices between the objective of limiting risk ex ante and the effects of risk management constraints in the midst of a crisis. For instance, mark-to-market accounting is a risk management practice that makes trading performance transparent and prevents managers and traders from concealing losses while trying to gamble their way out of losing positions. (3) Further, marking to market the value of trading positions, combined with risk management loss limits that force a closeout of a losing position, can prevent a loss from becoming large enough to bring down a firm. (Some bank failures and catastrophic investment fund losses are attributable to the failure to adhere to this basic risk management discipline.) However, as the papers presented suggest, the collective and mechanical exercise of such discipline on a widespread scale after a large market shock can create the type of liquidity spiral that leads to a market crisis.

Wealth Transfers and Portfolio Constraints

The first paper, by Anna Pavlova of the London Business School and Roberto Rigobon of MIT (presented by Rigobon), examined the transmission of shocks between countries with cross-border trade and investment. Pavlova and Rigobon (2006) began studying this issue after they uncovered a divergence of views on a simple question: Would it be good for the stock market in the United States if the dollar depreciated? They found that the answer depended on whether the initial shock was a supply or a demand shock and also on the effects of wealth redistribution arising from the changes in the relative prices of goods and financial assets. The presentation focused on how a shock plays out in the real side of the economy and in the financial system and how the two sectors interact through the effects of wealth redistribution.

The paper highlights the ways in which financial market imperfections and institutional features of the financial system affect the transmission of shocks across countries. The model presented has a center country and two peripheral countries; significantly, it also includes a constraint on the center country's financial sector that can be interpreted as a risk management constraint on that country's investors--for instance, a constraint against concentration risk. With this model, Pavlova and Rigobon seek to understand how the exchange rates, interest rates, and stock markets in the three countries evolve in response to shocks. …

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