Understanding Systemic Risk in Global Financial Markets The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more For a list of available titles, visit our website at www.WileyFinance.com Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional knowledge and understanding Understanding Systemic Risk in Global Financial Markets ARON GOTTESMAN MICHAEL LEIBROCK Copyright © 2017 by John Wiley & Sons, Inc All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750–8400, fax (978) 646–8600, or on the Web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748–6011, fax (201) 748–6008, or online at www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762–2974, outside the United States at (317) 572–3993, or fax (317) 572–4002 Wiley publishes in a variety of print and electronic formats and by print-on-demand Some material included with standard print versions of this book may not be included in e-books or in print-on-demand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about Wiley products, visit www.wiley.com Library of Congress Cataloging-in-Publication Data: Names: Gottesman, Aron, 1970– author | Leibrock, Michael, 1966– author Title: Understanding systemic risk in global financial markets : a professional guide to accounting arbitrations / Aron Gottesman and Michael Leibrock Description: Hoboken, New Jersey : Wiley, [2017] | Series: Wiley finance series; 1935 | Includes bibliographical references and index | Identifiers: LCCN 2017010796 (print) | LCCN 2017023709 (ebook) | ISBN 9781119348542 (pdf) | ISBN 9781119348467 (epub) | ISBN 9781119348504 (cloth : alk paper) | ISBN 9781119348542 (ePDF) Subjects: LCSH: Financial risk management | Financial crises | Risk | Financial institutions Classification: LCC HD61 (ebook) | LCC HD61 G67 2017 (print) | DDC 332/.0415—dc23 LC record available at https://lccn.loc.gov/2017010796 Cover Design: Wiley Cover Images: (top) © jijomathaidesigners/Shutterstock; © arosoft/Shutterstock; (bottom) © NPFire/Shutterstock Printed in the United States of America 10 ML To my wife, Roseann, and my children, Jaclyn, Victoria, and Michael AG In memory of my mother, Susan Rachel Raizel Gottesman z’l Contents Preface xiii Acknowledgments xvii About the Authors xviii CHAPTER Introduction to Systemic Risk What Is Systemic Risk? Systemic Risk Drivers Why Systemic Risk Must Be Understood, Monitored, and Managed CHAPTER How We Got Here: A History of Financial Crises Common Drivers of Historical Crises Bursting of Asset Bubbles Banking Crises Sovereign Debt Crisis International Contagion CHAPTER The Credit Crisis of 2007–2009 Planting the Seeds of a Bubble: The Early 2000s Wall Street’s Role The U.S Government Takeover of the GSEs The Tipping Point: Lehman Brothers’ Failure Aftermath of the Credit Crisis Cost of Government Bailouts CHAPTER Systemic Risk, Economic and Behavioral Theories: What Can We Learn? Minsky Three-Part Model Debt Deflation Cycle 10 10 14 15 18 24 25 27 30 32 35 37 44 45 46 vii viii Contents Benign Neglect Behavioral Theories Risk Aversion Bias Asset Prices Homogeneous Expectations versus Heterogeneity Anchoring Heuristic Excessive Optimism Familiarity Bias Fallacy of Composition Fight or Flight CHAPTER Systemic Risk Data Key Data Attributes Key Policy Changes to Address Data Gaps Data Sources Data Collection Challenges and Remaining Gaps Move Toward Standardization: Legal Entity Identifier Initiative CHAPTER Macroprudential versus Microprudential Oversight A Comparison of Macroprudential versus Microprudential Microprudential Policies Macroprudential Policies A Historical Perspective on Macroprudential Tools Choice of Macroprudential Policy Tools CHAPTER Introduction to the U.S Regulatory Regime Who Are the Regulators? U.S Regulatory Approaches Comparison of U.S versus International Financial Regulatory Regimes Introduction to the Dodd-Frank Act CHAPTER Introduction to International Regulatory Regimes The Financial Stability Board The Basel Accords The European Systemic Risk Board Principles for Financial Market Infrastructures 47 48 49 50 51 52 52 53 53 53 59 60 60 63 63 68 73 74 74 76 77 79 84 84 86 87 90 97 97 99 99 102 Contents CHAPTER Systemically Important Entities Introduction to Systemically Important Entities Classification of Entities as Systemically Important by the FSOC Bank SIFIs Nonbank SIFIs SIFMUs Globally Systemically Important Banks Total Loss-Absorbing Capacity (TLAC) Requirements Broad Impact of Financial Stability Requirements CHAPTER 10 The Volcker Rule Introduction to the Volcker Rule The Volcker Rule: Details Prohibition of Proprietary Trading Prohibition of Ownership or Sponsorship of Hedge Funds and Private Equity Funds The Volcker Rule and Systemically Risky Nonbank Financial Companies Activities That Are Permitted Despite the Volcker Rule Implementation of the Volcker Rule Volcker Rule: Criticism CHAPTER 11 Counterparty Credit Risk Overview of Derivative Securities Counterparty Exposure How Counterparty Credit Risk Is Managed Collateral Netting Central Counterparties Counterparty Credit Risk and Systemic Risk CHAPTER 12 The Dodd-Frank Act and Counterparty Credit Risk Measuring Counterparty Exposure in the OTC Derivatives Market Overview of Historical Data The Evolution of the U.S Regulatory Approach toward OTC Derivatives ix 107 107 108 110 110 112 112 114 117 120 120 122 123 123 123 124 125 126 130 130 133 136 136 136 139 142 147 147 149 152 x Contents Key Provisions of Title VII of the Dodd-Frank Act Mandatory Clearing Execution Platforms and Data Repositories Registration Requirements The Push-Out Rule The End User Exemption Criticism of Title VII of the Dodd-Frank Act CHAPTER 13 The Basel Accords What Are the Basel Accords? The Approach of the Basel Accords Basel I Basel II Pillar 1: Minimum Capital Requirements Pillar 2: Supervisory Review Pillar 3: Market Discipline Basel II.5 Basel III The Continuing Evolution of the Basel Accords CHAPTER 14 Lender of Last Resort Lender of Last Resort Concept Henry Thornton, Walter Bagehot, and Alternative Views The Fed’s Role in the Great Depression The Credit Crisis of 2007–2009 CHAPTER 15 Interconnectedness Risk A Case Study of Interconnectedness Interconnectedness Categories The Depository Trust & Clearing Corporation Post-Crisis Regulatory View of Interconnectedness Basel Committee on Banking Supervision Office of Financial Research CPMI IOSCO Principles An Approach to Analyzing Interconnectedness Risk The Depository Trust & Clearing Corporation 153 154 154 155 155 155 155 159 159 160 161 163 163 164 165 165 165 166 169 169 170 172 173 177 178 179 180 181 181 182 184 185 185 Contents CHAPTER 16 Conclusion: Looking Ahead It’s Not a Question of If, but When, Where, and How A Summary of Global Surveys Sources of Systemic Risk Preparing for the Next Crisis Appendix: Systemic Risk Models Structural versus Reduced-Form Credit Models Contingent Claims and Default Models Merton versus Garch Studies in Support of Merton Macroeconomic Measures Probability Distribution Measures Illiquidity Measures Counterparty Risk Measures Behavioral Models xi 190 192 192 193 194 198 198 199 204 205 210 211 214 215 217 Solutions to the Knowledge Check Questions 223 Index 239 Solutions to the Knowledge Check Questions 237 A15.7: T he two broad categories of interconnectedness are: (1) direct and indirect financial connections: including (i) lending relationship between two firms, (ii) derivatives contract between two firms, and (iii) trading relationships between firms and financial market infrastructures; and (2) operational connections: including (i) vendors and other critical third-party suppliers, (ii) settling banks, and (iii) clearing banks A15.8: The OFR applies three measures to its interconnectedness category: (i) intra–financial system liabilities; (ii) intra–financial system assets, and (iii) Market Value of Securities Outstanding A15.9: The OFR applies three measures to its substitutability category: (i) assets under custody; (ii) payments cleared and settled through payment systems, and (iii) values of underwritten transactions in debt and equity markets A15.10: T he first step a firm should take if it decides to undertake an analysis of its interconnectedness risks is to make a comprehensive inventory of external entities on which it relies Most financial institutions rely on adequate funding and liquidity, credit, access to markets and market infrastructures, as well as the provision of reliable and timely data—among many other processes External entities that provide or support these services represent external interconnections to your firm Given that insolvencies occur at a legal entity level, intragroup dependencies between distinct legal entities should also be represented as external interconnections Index absorption ratio, 210 accounting standards, 26 adjustable-rate mortgages (ARMs), 28 American International Group (AIG), 1, 24, 34, 37, 87, 110, 177, 213, 214, 215 arbitrage efficient markets and, 48–49 regulatory, 87 Argentina, 4, 16, 17, 98 Asia, 11 asset-backed securities (ABS), 27–28 asset bubbles banking crises and, 5, 190 causes of, 10, 51, 217 Credit Crisis and, 37, 38 credit supply and, 45–46 definition of, 4, 10 examples of, 1, 12–13 financial crises and, 7, 11, 20, 21 monitoring for, 60 assets, risk-weighted, 161–167 asset valuation approaches to, 25, 214 for banks, 160 for derivatives, 133–136, 143, 144, 148 in Great Depression, 172 human behavior and, 50, 51–52, 55 Australia, 88, 98 Austria, 11, 16, 17 auto companies bailouts of, 37 Great Depression and, 46 Bagehot, Walter, 48, 170–171, 174 bailouts of auto companies, 37 of banks, 5, 15, 37 of Bear Stearns, 179 Credit Crisis and, 25, 34, 37–39, 47–48, 177, 178, 196, 209 Dodd-Frank Act and, 90, 95, 155, 157 of government-sponsored entities, 37 moral hazard and, 47 systemic events and, Bank for International Settlements (BIS), 66–67, 70, 98, 149 bank holding companies, 85, 91, 93, 116, 123 Banking Act of 1933 (Glass-Steagall Act), 20, 77, 122, 128 banking crises definition of, 5, 14 equity prices and, 36 frequency of, 14–15, 21, 190 GDP growth and, 36 government default and, 18 in Great Depression, 14, 15, 172 predicting, 208, 210–211 systemic events and, 5–6, 7, 11, 21 banking entity, definition of, 123 banking stability index (BSI), 212 Bank of America, 34 Bank of England, 47, 170, 171, 192, 193 bankruptcy closeout netting and, 136–137 of Lehman Brothers, 34, 39, 196 precipitating factors in, 1, 6, 19 probability of, 200–201 239 Understanding Systemic Risk in Global Financial Markets, Aron Gottesman and Michael Leibrock © 2017 by John Wiley & Sons, Inc Published by John Wiley & Sons, Inc 240 banks bailouts of, 5, 15, 37 capital requirements for, 78, 81, 99, 101, 104, 159–167 data collection on, 67 failures of, 78, 122, 166, 173, 183–184, 190 foreign, 85, 93 international, 66–67, 70, 159, 160 reserve requirements for, 77, 81 risk sources for, 160 runs on, 47, 170, 172, 173 systemically important, 67, 109–111, 117, 182, 196 Volcker Rule and, 120, 121–128 See also central banks; commercial banks; Globally Systemically Important Banks; investment banks Barclays, 34 Baring, Francis, 170 Basel Accords Basel I, 99, 104, 159, 161–163, 167 Basel II, 99, 104, 159, 163–165, 167 Basel II.5, 165 Basel III, 99, 104, 113, 117, 159, 165–166, 167 evolution of, 166, 167 objectives of, 159–161, 166, 195 Basel Committee on Banking Supervision Basel Accords established by, 99, 159, 165, 166 as FSB member, 98 identification of G-SIBs by, 113–114, 117 on interconnectedness, 181–182, 187 as international financial institution, 94 objective of, 89, 99 Bear Stearns, 1, 24, 33, 178–179, 208, 214 behavioral factors financial crises and, 48–49, 195 investing and, 49–55 in systemic risk modeling, 215–218 INDEX benign neglect theory, 47–48, 55 Bernanke, Ben, 25, 34, 173, 179 Black-Scholes-Merton Option Pricing Model (BSOP Model), 198–205 Bolivia, 17 borrowers as credit risks, 160 monitoring behavior of, 62 protections for, 77 types of, 45, 55 Brazil, 17, 88, 98 broker-dealers, regulation of, 92, 155 BSMD (multivariate density) function, 211, 212–213 BSOP Model See Black-Scholes-Merton Option Pricing Model bubbles credit supply and, 46 dot-com, 1, 11, 13, 46, 217 speculation and, 12, 13, 217 in stock markets, 4, 5, 12, 21 See also asset bubbles; real estate bubbles Bush, George W., 32 Callan, Erin, 33 call options, 131–132, 134, 143 Canada, 88, 98 capital for commercial banks, 160 tiers of, 161–163, 165 capital adequacy ratio, 160–161, 164, 165, 166, 167 Capital Asset Pricing Model (CAPM), 49 capital conservation buffer, 165, 167 capital flow Credit Crisis and, 24 international, 18, 21, 66 capital productivity, 63 capital requirements, 78, 81, 99, 101, 104, 159–167 caps, 132, 134, 144 Case-Shiller Housing Price Index, 24, 35 CBOE Skew Index (SKEW), 65 Index CBOE/S&P 500 Implied Correlation Index, 64 CBOE Volatility Index (VIX), 64, 198 central banks credit risk and, 163 credit supply and, financial crises and, 192 interest rates and, 26 as lenders of last resort, 169, 171 regulation of, 98, 103, 104 central counterparties, 182 central counterparty clearinghouses (CCPs), 136, 139–141, 142, 144, 145, 154–157 central securities depositories (CSDs), 184 Chicago Fed National Financial Conditions Index, 64 Chicago Mercantile Exchange (CME), 113 Chile, 17 China, 88, 98 Citigroup, 214 Citigroup Economic Surprise Indices, 65 clearinghouse certificates, 47 Clearing House Interbank Payments System (CHIPS), 113 Clearing House Payments Company, 113 Clinton, Bill, 31, 39 closeout netting, 136–139, 144, 148, 149, 152, 156 CLS Bank International, 113 collateral for lenders of last resort, 171 in managing counterparty credit risk, 136, 144 in measuring counterparty credit risk, 148, 149, 152, 156 collateralization, regulation of, 92 collateralized credit valuation adjustment (CCVA), 216 collateralized debt obligations (CDOs), 28–30, 38, 143, 208, 210 Columbia, 17, 35 241 commercial banks assets of, 160 vs investment banks, 122 Committee on Payment and Settlement Systems, 94 Committee on Payments and Market Infrastructures (CPMI), 89, 98, 102, 184, 187 Committee on the Global Financial System, 89, 94, 98 Commodities Exchange Act of 1936, 153, 157 Commodities Futures Modernization Act of 2000, 153, 157 Commodities Futures Trading Commission (CFTC), 68, 85, 86–87, 94, 109, 126, 128, 154 commodities risk, 161 commodity prices, data collected on, 63 Community Reinvestment Act, 31, 39 Comptroller of the Currency, 84, 85, 86, 90, 91, 93, 109 conditional value at risk (CoVaR), 213–214 conflicts of interest financial stability and, 202 under Volcker Rule, 121, 125, 127 Consumer Financial Protection Bureau (CFPB), 85, 87, 92, 94, 109 consumer protection, 85, 86, 87, 90, 92, 94, 95 contagion risk counterparty risk and, 215 in Credit Crisis, 37, 186 international, 18–21, 59, 178, 186–187, 190, 191, 192 need to analyze, 60 systemically important entities and, 108 See also interconnectedness contingent claims analysis (CCA), 199–200, 206, 208 contract markets, 154 contracts derivatives, 131–136 regulation of, 92 242 corporate governance, regulation of, 92 Costa Rica, 17 countercyclical buffer, 165, 167 counterparty credit risk management of, 136–141, 144, 153, 154 measuring for OTC derivatives, 147–149, 156 sources of, 130, 134, 136, 156, 157 systemic risk and, 142–143, 145, 177, 199, 215–217 Credit Crisis of 2007–2009 bailouts and, 37–38, 47–48 Basel Accords and, 159, 165, 166 causes of, 4, 25–30, 38–39, 46, 99, 173, 191, 196, 208, 209 counterparty credit risk and, 142, 143, 145, 152–153 equity volatility in, 204–205 Federal Reserve and, 173–174, 175 financial data gaps and, 59, 60, 69 GSEs and, 31 impact of, 16, 24, 25, 35–36, 37, 39, 191, 196 interconnectedness and, 66–67, 177–178, 186, 191 investment banks and, 32–34 investor behavior and, 52, 53, 56 macroprudential oversight and, 73, 76, 81 magnitude of, 190 nonregulated institutions and, 210 Ponzi borrowing and, 45–46 regulatory responses to, 92, 97, 99, 101, 195 risk aversion and, 50 systemically important entities and, 107, 214, 215 as systemic event, 1, 5, 7, 11 credit default swaps (CDS) at AIG, 87 CDOs and, 28 counterparty credit risk and, 134, 142 data repositories on, 68 definition of, 132, 144 INDEX as speculation, 38 in systemic risk modeling, 208, 214, 216 credit rating agencies, 92 credit risk assessing, 198–218 for banks, 160–164, 167 exposure to, 143, 144 foreign, 66, 70, 161 management of, See also counterparty credit risk credit supply in economic booms, 4, 46 excessive, 101, 104 financial crises and, 6, 11, 45, 46, 190 GSEs and, 30–31 U.S residential mortgages and, 32, 39 credit unions, regulation of, 85, 86, 93 cross-currency swaps, 132, 134, 144 currency debasement of, 3–4, foreign exchange value of, 19, 21 gold standard and, 19–20 cybersecurity, 192, 193, 194, 196 data repositories, 69, 70, 154, 155, 157 debt non-government accumulation of, 45 shrinking levels of, 46–47 default counterparty risk and, 216 government, 4, 5, 15–17, 18, 21 probability of (PD), 200–210 default intensity model (DIM), 209 Defense Production Act, 78 deflation, 20, 46–47 Depository Trust & Clearing Corporation (DTCC), 180, 185–186, 192, 193, 194 Depository Trust Company (DTC), 113 depression (economic), causes of, 46 derivatives data collection on, 68, 69 definition of, 130, 143 OTC (See over-the-counter [OTC] derivatives) regulation of, 85, 86, 93, 94 243 Index transactions with, 133–136, 143 types of, 131–133 valuation of, 133 devaluation, 3, 15 distress dependence matrix (DDM), 212 distressed insurance premium (DIP), 209–210 Dodd-Frank Wall Street Reform and Consumer Protection Act data repositories and, 69, 154, 155, 157 impetus for, 191 objectives of, 90–93, 95, 195 OTC derivatives regulation and, 153–157 systemically important entities and, 108, 110, 112, 183–184 system risk identification and, 61 See also Volcker Rule Dominican Republic, 17 dot-com bubble, 1, 11, 13, 46, 217 Dow Jones Industrial Average, 34, 36 Dutch Tulip Mania, 7, 11, 12, 21, 190, 217 economy booms in, 4, 11, 18, 21, 25, 46 gold standard and, 20 impact of systemic risk on, 2–3, post-crisis downturns in, 35 spillover events and, 14 stress buildup in, 210 Ecuador, 17 Efficient Market Hypothesis (EMH), 48–49, 55 El Salvador, 17 Emergency Economic Stabilization Act, 92 emerging market countries government default and, 17 stock markets in, 4, 12 employment Credit Crisis and, 37, 39 Great Depression and, 172 risk-monitoring data collected on, 63 systemic events and, 1, England, 11, 16 equity position risk, 161 equity prices post–Credit Crisis, 36 risk-monitoring data collected on, 63 euphoria, 12, 21, 46 Europe/European Union Credit Crisis and, 35, 36, 76, 191, 196 Dutch Tulip Mania and, 12, 21 financial crises in, 11 financial regulation in, 87–88, 94, 98, 101 government defaults in, 16, 17, 21 identifying financial vulnerabilities in, 62, 70 recession in, 15, 24, 38, 40 European Banking Authority (EBA), 62, 87, 88, 94, 101 European Central Bank (ECB), 62, 101 European Insurance and Occupational Pensions Authority (EIOPA), 87, 88, 94, 101 European Securities and Market Authority (ESMA), 87, 88, 94, 101 European Systemic Risk Board (ESRB), 62, 70, 88, 94, 99–102, 104, 191 European System of Financial Supervision (ESFS), 88, 94 exchange rates international financial crises and, 18, 19, 21 market risk and, 160 exchange-traded derivatives, 132, 142, 143 exchange-traded funds (ETFs), 123, 210 executive compensation, regulation of, 92 exposure restrictions, 102, 104 fair value accounting, 25 fallacy of composition, 53 familiarity bias, 53, 56 Fannie Mae See Federal National Mortgage Association FAS 157, 25 244 Federal Deposit Insurance Corporation (FDIC) creation of, 122 Credit Crisis and, 37 Dodd-Frank Act and, 90 FSOC and, 109 function of, 84–85, 86, 93 nonregulated financial institutions and, 210 in systemic risk modeling, 206–207 Volcker Rule and, 126, 128 Federal Financial Institutions Examinations Council (FFIEC), 85, 94 Federal Home Loan Mortgage Corporation (Freddie Mac), 28, 31, 37, 124 Federal Housing Administration (FHA), 31, 32, 37 Federal Housing Finance Administration (FHFA), 32, 78, 85, 86, 94, 109 Federal Insurance Office, 91 Federal National Mortgage Association (Fannie Mae), 28, 30–32, 37, 124 Federal Reserve Bear Stearns and, 179 Credit Crisis and, 26, 32, 34, 38, 39 Dodd-Frank Act and, 92 equity margin requirements and, 78 financial data collection and, 67, 68 FSOC and, 109 gold standard and, 20–21 Great Depression and, 173, 175 G-SIBs and, 181, 187 as lender of last resort, 169, 210 as regulatory agency, 85, 86, 90, 93 stress testing by, 211 systemically important entity oversight by, 110, 115, 123–124 Volcker Rule and, 126, 127, 128 fight-or-flight response, 53–54, 55 Financial Action Task Force, 89, 94 financial crises behavioral factors in, 48–49 data gaps and, 59, 60–62 INDEX drivers of, 9–16, 21, 35, 44, 46–47, 195 examples of, 21, 190 frequency of, 1, 192 government defaults and, 4, 16 impact of, 35 international spread of, 18–21 macroprudential oversight and, 76 predicting, 6, 194–197 resolution of, 47–48 See also banking crises; Credit Crisis of 2007–2009; systemic events Financial Crisis Inquiry Commission (FCIC), 37, 179 financial data closing gaps in, 60–62, 67, 70 indicators, 79 quality of, 63, 66–68, 70 repositories for, 68, 69, 70 sources of, 63, 64–65 standardization of, 68–69, 70–71 financial decision making interconnectedness and, 191 psycho-physical factors in, 53–56 financial institutions bailouts of, 37 Credit Crisis and, 38 creditworthiness of, 170, 174 data collection from, 59–71 de-capitalization of, 19 failure of, 12, 24, 142, 145, 196 global, 66, 70, 98 interconnectedness of, 67, 177–187 liquidation of, 90 mainstream access to, 92 non-bank, 90, 110–112, 117, 120–124, 127, 128 nonregulated, 210 regulation of (See regulations) risk management by, 6–7, 153, 195 See also Systemically Important Financial Institutions; specific types financial instruments, definition of, 126 financial market infrastructures (FMIs), 102–104, 105, 184 Index financial market utilities (FMUs), 112, 113, 186 See also Systemically Important Financial Market Utilities Financial Services Modernization Act of 1999 (Gramm-Leach-Bliley Act), 122 financial stability Dodd-Frank Act and, 155–156 lenders of last resort and, 170 monitoring of, 59–71, 90, 91, 95, 97, 102, 104, 108 requirements for, 116, 117 sources of risk to, 101–102, 122 Volcker Rule and, 125, 126, 127–128 Financial Stability Board (FSB) central counterparty clearinghouses and, 156 on data gaps, 67 impetus for, 191 as international financial institution, 94 member institutions of, 98 objective of, 89, 97–99, 104 systemically important entities and, 108, 113, 114, 117, 191–192 Financial Stability Forum, 97, 98 Financial Stability Oversight Council (FSOC) data collection for, 69, 70 establishment of, 90, 101 function of, 85, 94 impetus for, 191 insurance industry and, 91 Office of Financial Research and, 61, 62 risk management standards and, 156 systemically important entities and, 108–112, 117 Volcker Rule and, 121, 123, 125, 128 financial systems entities included in, 182 key standards for, 100 financial turbulence model, 211, 212 Finland, 11, 35 Fisher, Irving, 46 245 Fixed Income Clearing Corporation (FICC), 113 floors, 132, 134, 144 foreign credit risk, 66, 70, 161 foreign exchange crisis, forward/futures contracts, 131, 134, 143, 153, 157 France, 16, 17, 19, 21, 88, 98 Freddie Mac See Federal Home Loan Mortgage Corporation futures contracts See forward/futures contracts G19, 97, 113, 191 Gadinis, Stavros, 99 GARCH model, 204–205 General Electric Capital Corporation, 110–112 geopolitical events, 192, 193, 194 George, Eddie, 171 Germany, 11, 16, 17, 19, 88, 98 Ginnie Mae See Government National Mortgage Association Glass-Steagall Act See Banking Act of 1933 Global Financial Stress Index (GFSI), 64, 198 globalization financial crises and, 18 of financial institutions, 66 Globally Systemically Important Banks (G-SIBs), 107, 112–117, 181–184, 187, 191–192, 215 Goldman Sachs, 33 gold standard, 18, 19–20, 21 Goodfriend, Marvin, 171 Goodhart, Charles, 171 government default frequency of, 17, 21 as systemic event driver, 4–5, 7, 11, 15–17, 21 government intervention assessing need for, 61 financial panic and, 47 See also bailouts 246 Government National Mortgage Association (Ginnie Mae), 31, 124 government-sponsored enterprises (GSEs) bailouts of, 37, 39 Credit Crisis and, 34, 39 function of, 30 regulation of, 85, 94 securitization and, 27 Gramm-Leach-Bliley Act See Financial Services Modernization Act of 1999 Great Depression bailouts and, 37 bank failures and, 5–6, 11, 15, 122 factors in, 14, 20, 46, 172 Federal Reserve and, 172–173 gold standard and, 19, 21 government default and, 17 GSEs created during, 30 magnitude of, 190 stock margin requirements and, 77 Great Recession See Credit Crisis of 2007–2009 Greece, 4, 5, 16, 17 Greenspan, Alan, 25 Gregory, Joe, 33 gross credit exposure, for OTC derivatives, 148, 149–152, 156 gross domestic product (GDP) banking crises and, 36 Credit Crisis and, 32, 36, 38, 196 global, 15 government default and, 5, 16 in Great Depression, 172 in macroeconomic systemic risk modeling, 211 Taylor Rule and, 26 gross market value, for OTC derivatives, 148, 149–152, 156 Group of Thirty, 86, 98, 120 groupthink, 13, 190 Guatemala, 17 INDEX hedge borrowers, 45, 55 hedge funds, 1, 91, 121–128, 178, 182, 210, 215 heterogeneous vs homogeneous expectations, 51–52, 55, 195 homeownership, 31, 35, 39 Honduras, 17 Hong Kong, 34, 88, 98 housing prices, 35, 38, 39, 40, 52, 53, 56 Hungary, 17 ICE Clear Credit, 113 illiquidity-based systemic risk modeling, 214–215 India, 98 indicators, financial cycle, 79 Indonesia, 35, 98 inflation gold standard and, 19 government default and, 16 interest rates and, 26 international financial crises and, 18, 21 risk-monitoring data collected on, 63 insolvency, definition of, 160 insurance companies in financial system, 182 regulation of, 91 systemic risk in, 213, 215 interbank market failure, 170 interconnectedness categories of, 179–180, 181 counterparty risk and, 215 impact of, 177–178, 186, 192 increase in, 212–213 persistence of, 196 regulatory oversight and, 181–184 risk analysis for, 185–186, 187, 191 See also contagion interest rate risk, 161 interest rates ceilings on, 77–78, 81 Credit Crisis and, 211 gold standard and, 20 inflation and, 26 Index money supply and, 172 on residential mortgages, 32, 39 risk-monitoring data collected on, 63 interest rate swaps, 132, 133, 134, 144 International Accounting Standards Board, 98 International Association of Deposit Insurers, 89 International Association of Insurance Supervisors, 89, 94, 98 international contagion, 18–21, 59, 178, 186–187, 190, 191, 192 International Monetary Fund (IMF), 67, 98, 213, 214 International Organization of Securities Commissions (IOSCO), 89, 94, 98, 102, 184, 187, 192, 194 investment banks Credit Crisis and, 25, 27–30 in financial system, 182 Glass-Steagall Act and, 122 U.S., 32 investors behavioral factors for, 51–56, 195 protection of, 86, 92 rational expectations of, 13, 21, 46, 48, 49 risk aversion of, 49–50, 51 Isaac, William, 26 Italy, 88, 98 Japan banking crisis in, 11, 15, 166 financial regulation in, 88, 98 housing prices in, 35 real estate bubble in, 1, 4, 10–11 U.S capital outflow to, 18 Joint Forum, 94 joint probability of default (JPoD), 212 J.P Morgan, 179 junk bonds, 1, 11 Kansas City Financial Stress Index, 64 King, Robert, 171 Kobrak, Christopher, 166 247 labor productivity, 63 de Larosiére, Jacques, 99, 191 de Larosiére report, 99, 191 Latin America, 1, 11, 17, 21 Legal Entity Identifier (LEI), 59, 68–69, 70–71 Lehman Brothers, 1, 24, 32–34, 39, 68, 177, 180, 187, 191, 196, 214, 215 lender of last resort definition of, 169–170 Federal Reserve as, 172–175 function of, 170–171, 174 lenders monitoring behavior of, 62 regulation of, 77, 85, 92, 93–94 leverage ratio, for banks, 165, 167 Lincoln, Blanche, 155 Lincoln Amendment, 155 liquidation, 90, 91 liquidity coverage ratio, 166, 167 liquidity risk for banks, 161, 166, 167, 214 management of, 7, 101 loans, as bank assets, 160 Long-Term Capital Management, 1, 11 loss aversion bias, 50 Mackintosh, Stuart P.M., 98 macroeconomic indicators, 79, 210–211 macroprudential risk monitoring of, 60, 67, 70, 73–81, 88, 99, 191 tools for addressing, 79–80, 81 mahalanobis distance, 212 mandatory clearing requirement, 154, 155, 157 mania, 13, 21 market crashes, causes of, 218 market liquidity, 192, 194, 196 market risk for banks, 160–165, 167 management of, mark-to-market accounting, 25, 214 Martingale Property, 50 maximum likelihood method, 204 248 Mellon, Andrew, 47 Merkley, Jeff, 122 Merrill Lynch, 32, 179 MetLife Inc., 110 Mexico, 4, 11, 16, 88, 98 microprudential risk, 60, 70, 73–76, 81 Minsky, Hyman, 45–46, 55 Mississippi Bubble, 217 Modern Portfolio Theory, 51 money supply contraction in, 20–21, 172 gold standard and, 19–20 increase in, 18 Moody’s KMV, 202, 204 Moody’s rating service, 50 moral hazard government bailouts and, 47 lenders of last resort and, 170, 171, 174 regulation to address, 102, 104 Volcker Rule and, 121, 122, 127 Morgan Stanley, 32 mortgage-backed securities, 25, 28–32, 38, 173, 174, 178–179 residential, 28, 29, 31, 38 mortgages bailouts and, 37 delinquency rates on, 35 GSEs and, 30–32 regulatory reform and, 92 MSCI World Index, 36 multivariate density (BSMD) function, 211, 212–213 mutual funds, 123, 182, 210 National Credit Union Administration (NCUA), 85, 86, 93, 109 National Securities Clearing Corporation (NSCC), 113 Netherlands, 88, 98 net stable funding ratio, 166, 167 netting bilateral, 136–139, 142, 145, 154 to manage counterparty credit risk, 144 multilateral, 140, 142, 145, 154 INDEX New York Stock Exchange (NYSE), 47 Nicaragua, 17 Nomura Holdings, 34 Norway, 11, 35 notional principal, 133, 144, 148, 149, 150, 156 novation, 140, 145, 154 off-exchange futures, 153, 157 Office of Financial Research (OFR) creation of, 61, 70, 90 data collection and, 61–62, 67, 68, 69, 70 on interconnectedness, 182–184, 187 systemic risk assessment by, 193, 194 Office of the Comptroller of the Currency (OCC), 84, 85, 86, 90, 93, 126, 128 Office of Thrift Supervision (OTS), 87, 90 O’Neill, Paul, 25 operational risk for banks, 160, 163–164, 167 management of, option contracts, 131–132, 143 Option-iPoD model, 208 option pricing models, 199–210 Options Clearing Corporation (OCC), 113 Organization for Economic Co-operation and Development (OECD), 98 over-the-counter (OTC) derivatives as bilateral agreements, 142 counterparty risk and, 93, 132, 147–149, 156, 215 Credit Crisis and, 33 definition of, 130 G-SIBs and, 114 regulation of, 91, 147, 152–157 trading platforms for, 143, 144, 154, 157 Panama, 17 panics, 47, 54, 55, 170, 171, 172, 175 Paraguay, 17 Index Paulson, Henry, 33 payment, clearing, and settlement services, 92 payment netting, 136, 144 pension funds, 182 Peru, 17 Philippines, 35 Ponzi borrowers, 45, 55 pooling, 27, 31 Portugal, 16, 17 President’s Working Group on Financial Markets (PWG), 85, 94 prices debt-deflation cycle and, 46–47 of derivative securities, 131–132 human behavior and, 48–49, 51–55 information available from, 50, 55 Principles for Financial Market Infrastructures (PFMI), 102–104, 105, 195 private equity funds, 121–125, 127–128 probability distribution systemic risk modeling, 211–214 probability of cascade effects (PCE), 212 probability of default (PD), 200–210 joint, 212 productivity capital, 63 labor, 63 proprietary trading, 121–128 Prospect Theory, 49–50, 55 Prudential Financial Inc., 110 push-out rule, 155, 157 put/call ratio, 65 put options, 131, 134, 143 Qatar, 88 rating agencies, 30, 38, 50 Rational Expectations Theory, 13, 21, 48, 49, 55, 195 real estate bubbles banking crises and, 249 as financial crisis driver, 10, 12, 14, 21, 35, 209 frequency of, investor behavior and, 53 in U.S., 1, 11, 24–28, 32, 35, 38 recession causes of, 1, 6, 15, 24, 46 post–Credit Crisis, 35, 36, 38, 39 Reconstruction Finance Corporation, 31, 37 reduced-form systemic risk models, 199, 201, 216 Regulation Q, 78 regulations Credit Crisis and, 26, 37 housing, 31, 39 international, 87–89, 94, 97–105, 215 micro-/macroprudential policies and, 73–81 on OTC derivatives, 152–153 post–Credit Crisis, of systemically important entities, 107, 117 for systemic risk mitigation, 195 in U.S., 84–95, 97, 215 See also specific regulations regulators approaches of, 86–87, 94 focuses of, 84–86 independence of, 99 international, 89 regulatory arbitrage, 87 regulatory reporting for banks, 165, 167 data standardization and, 69 Volcker Rule and, 126 repurchase agreements (repo), 67–68, 70, 126, 179 reserve requirements, 77, 81 residential mortgage-backed securities (RMBS), 28, 29, 31, 38 risk identification of, 62, 76 sources of, for banks, 160 See also specific types 250 risk analysis data used in, 62–69 interconnectedness and, 178, 185–186, 187, 191 need for, 60 risk aversion, 49–50, 51, 195 risk management for financial market infrastructures, 184 micro-vs macroprudential, 73–81 for SIFIs, 156 systemic risk analysis and, 6, 196 risk-weighted assets, 161–167 Russia, 4, 16, 98 S&P 500 Index, 36 Saudi Arabia, 98 savings and loan crisis (U.S.), 1, 15, 78 scenario analysis, 186 securities mortgage-backed, 25, 28–30 price changes in, 18, 19, 21 ratings of, 29, 30, 38, 50 regulation of, 85, 86, 92, 93, 94, 102 Volcker Rule and, 124, 128 See also specific types Securities and Exchange Commission (SEC) FAS 157 and, 25 financial data collection and, 67, 68 FSOC and, 109 regulatory focus of, 85, 86–87, 94, 154 Volcker Rule and, 126, 128 securities brokers/dealers, 182, 213 securities exchanges, 154 securities lending, 68, 70 securitization Credit Crisis and, 38 function of, 27 regulation of, 92 shadow banking, 192, 210, 214 Sharpe-Lintner Capital Asset Pricing Model (CAPM), 49 Simpson, Herbert, 13 Singapore, 88, 98 INDEX Smith, Adam, 14 South Africa, 98 Southeast Asian financial crisis, 19 South Korea, 98 South Sea Company bubble, 11, 13–14, 47, 49, 190, 217 sovereign default See government default Spain, 11, 16, 17, 21, 35, 88, 98 speculation bailouts and, 47 bubbles and, 12, 13, 217 Credit Crisis and, 29, 38 financial crises and, 21, 190, 192 Great Depression and, 14 speculative borrowers, 45, 55 stable funding ratio, 166 standards for accounting, 26 for sound financial systems, 100 for systemically important entities, 109, 110, 112, 114, 117 underwriting, 77, 81 St Louis Fed Financial Stress Index, 64, 198 stock margin requirements, 77, 81 stock markets bubbles in, 4, 5, 12, 21 closures of, 47 crash of 1929, 20, 122, 172, 175 Credit Crisis and, 15, 36 international financial crises and, 18, 19, 21 stress testing, 52, 62, 186, 195, 196, 211 Structural GARCH model, 205 structural systemic risk models, 198–204 structured investment vehicles (SIVs), 210 subordination, 29, 30 subprime mortgage assets, 25, 27, 29–30, 32, 34, 39, 48 substitutability, 181 Supervisory Capital Assessment Program (SCAP), 211 Index swap data repositories, 68, 70 Swap Exemption of 1993, 153, 157 swaps credit default, 28, 39, 68, 87 regulation of, 92, 153–157 transacting, 133, 144, 148 types of, 132 swaptions, 132, 134, 144 Sweden, 11, 35 Switzerland, 88, 98 synthetic CDOs, 28, 29 systemically important entities classification of, 108–109, 117 definition of, 107–108, 117 failure of, 192 Systemically Important Financial Institutions (SIFIs), 67, 69, 70, 92, 107, 109–112, 116, 117, 123, 156, 191, 211 Systemically Important Financial Market Utilities (SIFMUs), 107, 109, 112, 113, 117, 191 systemic events definition of, drivers of, 3–5, 6, 14, 18, 190, 210, 215 identifying, 192–193, 197 impact of, 196 recent examples of, See also banking crises; financial crises systemic expected shortfall (SES), 213 systemic risk counterparty credit risk and, 142–143, 145 Credit Crisis and, 37 definitions of, 2–3, 6, Dodd-Frank Act and, 90, 95 G-SIBs and, 114 importance of, 1–2 interconnectedness and, 67, 177–178, 182 management of, 5–7 micro-vs macroprudential supervision of, 73–81, 191 251 models for, 200–218 monitoring/measuring of, 59–71, 85, 86, 88, 94, 98, 99, 101, 102, 183, 195, 196, 216 sources of, 193–194 Systemic Risk Barometer Survey, 193, 194 TARP See Troubled Asset Relief Program Taylor Rule, 26 Thakor, Anjan, 127 Third Way, 116, 117 Thomson, James, 107–108 Thornton, Henry, 170–171, 174 Tier capital, 161, 163, 165 Tier capital, 161, 163 Tier capital, 161–163 “too big to fail,” 90, 95, 107, 155, 156, 157 total loss-absorbing capacity (TLAC), 114–115 trade execution platforms for OTC derivatives, 154, 157 registration of, 155 trading account, definition of, 123, 126, 127 Trading with the Enemy Act, 78 tranching, 27 Troege, Michael, 166 Troubled Asset Relief Program (TARP), 34, 37, 39, 48, 92 Turkey, 17, 98 underwriting standards, 77, 81 United Kingdom (U.K.) financial regulation in, 88, 98 gold standard in, 19 stock market in, 15 systemic risk in, 193 United States bank failures in, 15 Credit Crisis and, 25–36, 76, 191, 196 financial crises in, 11 252 United States (Continued) financial regulation in, 84–95, 97, 98, 152–153, 195 gold standard in, 19–20 identifying financial vulnerabilities in, 61, 70 real estate bubble in, 1, 11, 24–28, 33, 35–36, 38 recession in, 15, 24, 38, 40 stock market in, 15, 19, 20 systemic events in, Uruguay, 17 U.S Comprehensive Capital Analysis and Review (CCAR), 62 U.S Treasury, 37 U.S Treasury Secretary, 33, 61, 109 INDEX U.S Treasury securities, 124, 174, 214–215 Venezuela, 17, 21 Volcker, Paul, 120–121 Volcker Rule, 91, 92, 120–128 Wall Street Credit Crisis and, 27–30, 38 regulation of, 91 Wall Street Transparency and Accountability Act of 2010, 153 Whitehead, Charles, 126 wrong-way risk, 216 Zero Down Payment Initiative, 32 ... by John Wiley & Sons, Inc Published by John Wiley & Sons, Inc 2 UNDERSTANDING SYSTEMIC RISK IN GLOBAL FINANCIAL MARKETS global financial regulators, the focus on systemic risk has skyrocketed... the failure of UNDERSTANDING SYSTEMIC RISK IN GLOBAL FINANCIAL MARKETS hundreds of banks and other financial institutions in the United States and globally, deep and long-lasting global recessions,... Great Understanding Systemic Risk in Global Financial Markets, Aron Gottesman and Michael Leibrock © 2017 by John Wiley & Sons, Inc Published by John Wiley & Sons, Inc 10 UNDERSTANDING SYSTEMIC RISK