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A couple of new research papers have a go at the question of whether we can predict a financial crisis, and they arrive at different conclusions.
With a hat tip to Free Exchange, first up is an NBER submission co-authored by four economists.
They argue that previous studies of systemic risk have tended to focus on just one part of the financial sector, normally the banking system. For their research, by contrast, the authors used econometrics to look for predictors of systemic risk within the increasingly complex network of relationships among hedge funds, banks, insurance companies, and brokers.
Here’s what they found (emphasis FT Alphaville’s):
… the returns of banks and insurers seem to have more significant impact on the returns of hedge funds and brokers than vice versa. We also find that this asymmetry became highly significant prior to the Financial Crisis of 2007"“2009, indicating that our measures may be useful as early warning indicators of systemic risk. This pattern suggests that banks may be more central to systemic risk than the so-called "shadow banking system" (the non-bank financial institutions that engage in banking functions). By competing with other financial institutions in non-traditional businesses, banks and insurers may have taken on risks more appropriate for hedge funds, leading to the emergence of a "shadow hedge-fund system" in which systemic risks could not be managed by traditional regulatory instruments. Another possible interpretation is that, because they are more highly regulated, banks and insurers are more sensitive to Value-at-Risk changes through their capital requirements (Basel II and Solvency II), hence their behavior may generate endogenous feedback loops with perverse spillover effects to other financial institutions.
On that last bit, regarding “endogenous feedback loops”, the authors simply mean that when internal risk measures require an individual bank to unload risky assets, it’s fine for that one bank. But if all banks then follow suit, it leads to a downward spiral of asset prices, and then it can be a problem.
The paper’s fundamental conclusion seems to be that the increasing linkages and illiquidity among the various components of the financial sector indicate a buildup of systemic risk, and the returns of hedge funds in particular can be examined to spot it.
It’s a very dense paper, and if the reader wants a lengthier explanation that is nonetheless friendly to non-economists, FT Alphaville recommends Free Exhange’s take on it.
The second paper, posted at VoxEU and written by Andrew Rose and Mark Spiegel, starts from the premise that perhaps we know less about what causes financial crises than we think.
The authors build on previous econometric work and look at the variables that are commonly cited as either causes of the current financial crisis or factors that made it more severe. Here they are:
The authors did find that across a number of countries, stronger credit market regulation was negatively correlated with the incidence of a financial crisis. And they found that the worse the current account deficit or the greater a country’s short-term external debt, the more intense the crisis.
But then they took these findings a step further, and tested the variables to see if they would have helped predict previous crises.
The answer (emphasis ours):
Unfortunately, we find that even the best estimates gleaned from the Great Recession are not stable predictors of the incidence of global recessions at different periods of time.
Countries with large current-account deficits seemed to suffer more in the Great Recession. The single most robust result of the Great Recession analysis is the negative and significant effect of the credit market regulation variable; looser credit market regulation seemed to hurt recently. But for the two previous global recessions, this effect is often positive and significantly so in a number of the samples; it is never significantly negative. Such sample sensitivity reinforces our scepticism concerning the value of such exercises.
They also point out the inconsistencies in some of the other variables across countries, but the point is clear enough: the causes of the next crisis might be completely different from the causes of this one.
FT Alphaville has been on something of a Reinhart-Rogoff kick lately, so we checked This Time is Different to see what the authors think. Real housing prices, write the authors, top the list of indicators that a banking crisis is on the way–but they are skeptical that any indicator exists that can reliably estimate the starting date of the crisis.
And even if a reliable warning system did exist, there’s a bigger problem that economists probably can’t do much about. From page 281 of This Time is Different:
The most significant hurdle in establishing an effective and credible early warning system, however, is not the design of a systematic framework that is capable of producing relatively reliable signals of distress from the various indicators in a timely manner. The greatest barrier to success is the well-entrenched tendency of policy makers and market participants to treat the signals as irrelevant archaic residuals of an out-dated framework, assuming that old rules of valuation no longer apply. If the past we have studied in this book is any guide, these signals will be dismissed more often than not.
Related links: In the long run, we’re all…just fine (maybe) – FT Alphaville Building better models – Free Exchange
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