Discussion of Financial Innovation,

Macroeconomic Stability and Systemic Crises

Arvind KrishnamurthyNorthwestern University

Questions: Effects of financial innovation on macroeconomic

stability. Systemic risk/crises. Costs and benefits of innovation

Relevant questions Geithner quote about credit derivatives

Outline

Paper writes down a stylized model to help think about these questions

My discussion Explain the mechanics that drive the model

Externality/ policy application Non-monotonic effect of maximum loan to value/

leverage ratio ( ) on probability of crises How does the model shed light on the effect

of innovations, such as credit derivatives

Liquidity at date 1

In order to avoid liquidation at date 1, intermediaries/firms need to raise at least

( - xs + b1s ) i0xs < 0 is cash need for business operation

b1s > 0 is debt repayment Raise money in two ways:

Sell capital ( ) Borrow against capital ( )

Selling Capital: Fire Sales Raise ( - xs + b1s ) i0 by selling ks units at price q

ks = ( - xs + b1s ) i0 / q

qkD ()

Fire Sales and Financial Depth () Less financial depth: Demand curve not perfectly

elastic

Multiple equilibria / liquidation externality Policy: Role for the Fed LLR to rule out bad

equilibrium? Same downward sloping supply idea has been used

to discuss Bank Runs, 1987 market crash, 1997 Asian Crisis, 1998 LTCM episode …

Fire Sales and Financial Innovation ( ) Constraint on raising debt:

(at Date 0) b1s < q1s

(at Date 1) b2s < q2s

Raising loosens date 1 constraint, ks down Raising also allows for more borrowing at

date 0: b1s up and i0 up

Cash need is ( - xs + b1s ) i0

Non-monotonicity

Date 0

Agents don’t internalize liquidity externality in date 0 decisions Over-leveraging: too much i0 / too much b1s

Policy: Restrict ex-ante leverage

Financial Innovation: Raising Raises probability of crises over part of the

range Improvements in automobile safety:

Air bags Crumple zones Anti-lock brakes

People drive faster … Perhaps more accidents But we may on net be better off

Is Raising beneficial for Welfare? Something the paper should compute Unclear, for two reasons

On average beneficial (borrowing at date 1) Paper shows externality, but does not show

whether externality increases with My guess: In model, the Date 1 effect

dominates because it helps across all states of the world, whereas date 0 effects are only in the crisis/liquidation states.

Raising : Crisis costs vs. average benefits Conjecture: I think the model could say that

an LLR can solve the date 1 externality, so that LLR plus increase is beneficial

Possibly unambiguous in this case, which would give a different angle on the Fed’s role.

Model and Reality

Financial innovation in the model is about changing Reality: options, credit derivatives, MBS, etc.,

Problem model identifies is that agents over-leverage, not internalizing crisis costs Reality: Risk management of financial firms.

``Insufficient” risk management. Let us think about the risk management of a

new financial asset, i.e. credit derivatives

Financial Innovation is about the New Financial innovations are complex even to

sophisticated market participants Risk management of an unknown product

Learning Model risk Interpreting and acting on outcomes that the

model does not expect Examples

1987 Stock Market Crash 1997 Asian Crises 1998 LTCM Crisis

1987 Stock Market Crash

Insurance Strategies: Synthetic Puts/ Portfolio Insurance

Pre-1987: Compare implied volatilities on out-of-the-money put options to at-the money options (Bates 2000) Out-of-the moneys have 3% higher implied vols

Post-1987: Same comparison Out-of-the moneys have 10% higher implied vols

The crisis led agents to better understand the cost of crises

1997 Asian Crises Integration into world capital markets: Foreign

borrowing, capital inflows Pre-1997: Liability composition tilted towards

Dollar-denominated debt Short-term debt Portfolio inflows

Post-1997: Reserve accumulation Long-term debt FDI flows

Post-crises, countries adopted insurance strategies

1998 Hedge Fund Crisis

Hedge funds become the central liquidity providers in many specialized asset markets (MBS, sovereign debt, equity vol, …)

Pre-crisis risk management: Stress testing based on historical correlations

Crisis: Liquidity shortages cause unusual comovement.

Post-crisis risk management: Stress testing scenarios include liquidity events

Credit Derivatives

Geithner (2006) quote that begins this paper “…uncertainty about how exposures will evolve

and markets will function in less favorable circumstances”

Example: GM and Ford downgrades from last year

What are the true exposures and how will markets play out?

Average Benefits versus Crisis Costs

Model and My Take on Reality In the model, innovation is an increase in allowable leverage ()

Financial innovation is about the new

Realized events do not span the entire event space Uncertainty about outcomes What is the best crisis risk management strategy? Conjecture: Systemic risk is always in the new

assets, and not in the old assets (i.e. portfolio insurance is well understood at this point).

Average Benefits versus Crisis Costs

Model and My Take on Reality Date 1 policy in model: Eliminate liquidation equilibrium (role for an LLR)

I agree, but with a slightly different angle:

The liquidation externalities arise when bad outcomes are realized, and agents are not prepared

Perhaps also some “over-reaction” by agents As in this paper: Role for an LLR

Average Benefits versus Crisis Costs

Model and My Take on Reality Date 0 policy in model: Reduce over-leveraging

More generally, this translates to: Improve date 0 risk management What is date 0? Unclear if anyone (including the Fed) knows the

best strategy

Conclusion

The relevant calculation is average benefits versus crisis costs

There are liquidation externalities

Innovation is about the new…