Saturday, August 28, 2010

Information and financial crises

No economics paper better captures the essence of the 2008 financial crisis than Ricardo Caballero and Alp Simsek's Fire Sales in a Model of Complexity. From the abstract:
In this paper we present a model of fire sales and market breakdowns, and of the financial amplification mechanism that follows from them. The distinctive feature of our model is the central role played by endogenous (payoff relevant) complexity: As asset prices implode, more "banks" within the financial network become distressed, which increases each (non-distressed) banks' likelihood of being hit by an indirect shock. As this happens, banks face an increasingly complex environment since they need to understand more and more interlinkages in making their financial decisions. This complexity brings about confusion and uncertainty, which makes relatively healthy banks, and hence potential asset buyers, reluctant to buy since they now fear becoming embroiled in a cascade they do not control or understand. The liquidity of the market quickly vanishes and a financial crisis ensues.
This all underscores the centrality of information to the stability of the financial system. If everyone knew exactly which banks were insolvent, in theory the resolution to a crisis would be rather simple: insolvent banks would fail, and the rest of the financial system would keep chugging along. In reality, of course, the lack of any orderly way to liquidate large banks (now purportedly fixed by Dodd-Frank) leads to a long and costly bankruptcy process, but in a world with better legal institutions this arguably wouldn't be as much of an issue. So why should we be concerned with protecting "systemically important" institutions?

As Caballero and Simsek point out, the problem is that indirect exposure to risks is extremely difficult to measure. Even if banks have a reasonably good idea about which institutions are likely to fail, they may not know which additional banks have exposure to those highly troubled institutions. Banks lacking any obvious proximity to the crisis may nevertheless be in danger if they're dependent on institutions that were affected.

And this doesn't stop at the second degree! Even if you have a good handle on which banks are exposed to banks with bad assets, you're unlikely to know which banks are exposed to banks that are exposed to banks that are exposed to banks that are exposed to banks with bad assets. (Just writing the sentence gives me a headache.) The risks to any individual bank may fall as we move farther from the source of the original imbalance, but the vastly larger pool of banks connected in some way to the crisis makes risk management just as difficult.

Meanwhile, as Caballero and Simsek establish in their model, all this risk and complexity induces banks to hoard liquidity. This necessitates selling assets, but in a world where virtually every institution is in some way connected to the crisis, the pool of willing buyers isn't very deep. As a result, we see plummeting asset values and fire sales, which further damage balance sheets and introduce entirely new stresses into the system. This drives further liquidity hoarding and fire sales, and the vicious cycle continues until either the government steps in or our financial system is in tatters.


Anonymous said...

Nice paper, nice comment.

Of course the idea of a dense network, with consequent externalities, is fairly intuitive. For me, we now need to incorporate such instances of asymmetric information into macro (e.g. borrower and lender are the same person in representative agent models). I've just started out on my phd too (albeit with less presitge than yours) and it seems that the freshwater stuff prevails. I hotly anticipate you moving us forward.

Anonymous said...

Banks are no longer providers of tangible assets. I long for the day when reserve banks held 66% of all bank deposits. That defined the bank as a lending instution. One that conservatively used deposits to fund most of their lending. Most banks are no longer held only by their depositor's rather they are held by traders. That produced more entropy thatn the system could bare. OOPL