Building Toward A Resilient Financial System

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Building Toward A Resilient Financial System
Research Workshop Systemic
Risks Policy and Regulatory Responses

• Shaun Wang
• Thomas P. Bowles Chair Professor
• Georgia State University

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Why are we here today?

• Economy is still in crisis
• Despite the recent stock market rally
• Economics is in crisis
• The best and the brightest in the field fight
  over the most basic problems.
• It is time for a profound revamp

By Paul De Grauwe Financial Times, July 21, 2009
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Our financial system got structural issues

• Financial Crisis announced loud and clear
• Wake up! Market participants. The system has
  serious structural issues that need fixing.
• What problem? It was just a bad dream. Look at
  the stock market rally lately.
• Okay. The system is too complex. So what went
  wrong and what needs fixing?

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Jamie Dimon diagnosis ofstructural issues

• The burst of a major housing bubble
• Excessive leverage pervaded the system
• The dramatic growth of structural risks and the
  unanticipated damage they caused
• Regulatory lapses and mistakes
• Pro-cyclical nature of policies, actions and
  events
• The impact of huge trade and financing imbalances
  on interest rates, consumption and speculation

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Our goal building toward a resilient financial
system

• Grown in size, structure and complexity
• New products, players and shadow banking
• New forces due to technology, cross-border flows
• Complex accounting and regulation
• Regulators and risk managers at firms have
  limited time and resources

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We need an ERM approach

• Zoom in (for details) and zoom out (for the
  bigger picture)
• Switch from one area/aspect to another
• financial products, exchanges, real economy,
• economic theory, risk modeling,
• methodology vs. reality (current / urgent)
• When you give comments, you need to identify
  where you are on the overall picture

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Systemic Risk Regulator (SRR)

• A new vocabulary -- Systemic Risk Regulator, a
  doctor dedicated to the health of the system.
• Whoever that may be, the SRR will need
• First order is preventive care
• Diagnose problem areas and root causes
• Develop prescription medicines
• Perform surgical operations when needed
• We are here to help search for solutions

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Recent crisis was due tocollective intelligence
failure

• Intelligence is quickness in seeing things as
  they are -- George Santayana (1863-1952).
• What led to collective intelligence failure?
• Too much noise or misinformation in the system
• Narrow focus due to professional experience
  (division of labor)
• Illusion about ones own capability
• The Theory of Reflexivity by George Soros
• Lack of will-power and mechanism to respond

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Complex models are humbled

• Wired Magazine Recipe for Disaster The Formula
  That Killed Wall Street
• Math wizard actuary David X. Li invented a
  copula formula to price collateral debt
  obligations.
• WSJ Behind AIG's Fall, Risk Models Failed to
  Pass Real-World Test
• Gary Gorton, Yale University,
• Developed models for CDS

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Rajan warned about bubble in capital market

• Prof. Raguram Rajan, U. of Chicago, Chief
  Economist at IMF 2003-2006
• "Has Financial Development Made the World
  Riskier?" (2005)
• Concerned by incentive distortions

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Shiller warned about housing bubble

• Robert Shiller, Yale U.
• Discerned departure from long-term trends
• Discerned Animal Spirits

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Complex math models failed
Risk Intelligence succeeded

• Why?

• Why?

• Not enough attention to the whole system
• Focused on short-term
• Relies on superficial data equations, not paying
  regard to structural issues

• Paid attention to the big picture
• Looked at long-term trends
• Focusing on structural issues, incentives and
  business models

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Current Risk Mgt Approach

• Dominated by the financial engineering approach
• Stochastic modeling of asset prices
• Shocks are exogenous
• Interactions largely handled through correlations
• Diversification a key element of residual risk
• Focused on relatively short time horizons (lt 1y)
• Focused on a single entity
• Predominantly balance sheet driven

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Characteristics of Systemic Risk

• Systemic risks are not purely random
• Macro factors or assets not even held directly
  (e.g., recession, interest rates, price of oil)
• Unwinding of large, unsustainable imbalances
  within the broader system (housing bubble)
• Interactions are a central element of this risk
• Through interconnections and feedback
• Change over time past not a good predictor of
  these
• Not diversifiable

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Characteristics of Systemic Risk

• Encompasses more than 1 firm, 1 industry or 1
  country
• Timeframes extend well beyond 1 year
• Risks we can envision today (e.g., run-away
  inflation, significant USD depreciation) can take
  years to unfold and contingent on many future
  actions

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New Conceptual Framework
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(1) Counter Complexity by Intelligence

• In dealing with complex systems, we resort to
  higher intelligence and understanding to gain
  insights and knowledge about the system.
• Regulators and policymakers, who have limited
  time and resources, must increase their
  effectiveness through study intelligence.

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Implications in Risk Modeling

• Complexity makes one all encompassing model
  impossible
• Need to use Risk Intelligence to sift through and
  prioritize among an infinite number of risks
• Better to seek additional perspectives through
  smaller, more-targeted models

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(2) Identify Structural Issues Analogy of Cancer

• "Cancer" is an abnormal (unbalanced) growth of
  cells anywhere in the body. It occurs when the
  genes (wrong incentives or stimulus) in a cell
  allow it to split (multiply or grow) without
  control.
• Some cancers form solid growths called tumors
  (toxic assets). Others, like cancers of the blood
  (lack of accountability, distrust, loss of
  confidence) travel all over the body. 
• Cancers may harm the body in two ways. They may
  replace normal cells with cells that don't work
  properly, and they may kill normal cells. (crowd
  out normal business activities)
• The farther a cancer spreads, the harder it is to
  control. Early identification is critical to
  successful recovery.

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Incentives for Better Behaviors
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(3) Identify Regime Changes from Structural
Changes

• For example Fostel and Geanakoplo (2008)
• the normal market
• the anxious market,
• the crisis or panicked market
• Early identification of regime change
• Different responses at different regimes
• Pro-cyclical policies should be revisited

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Go Beyond Balance Sheet to Analyze Business
Models
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How does the business model perform in stormy
weathers?
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Game changer in retailing business model Bar Code

• UCLA Sociology Professor Edna Bonacich put it
  simply
• The shift in Wal-Mart's power was when it
  started to really develop its control over
  information technology."
• The key to that was the power of the information
  that is hidden in the ubiquitous bar code.

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Proposed Solutions/Actions

• The SRR assembles a team of multidisciplinary
  experts working on a large SRI Project
• To collect and share data from various sectors
• To analyze and identify structural imbalances
• To examine weakness in various business models
• To spot emerging risks and guide risk-focused
  stress tests for firms

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Propose to map Real Economy against Financial
System

• Protecting the basic needs of people society
• Infrastructure
• Supply Chain of essentials (food, water, and
  energy)
• Disaster relief
• Price stability

• Increase productivity creativity
• Financial engineering to better align incentives
• Technology innovation

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Working Papers

• Wang, Shaun S., Building Toward a Resilient
  Financial System (August, 17 2009). Available at
  SSRN http//ssrn.com/abstract1456345
• Wang, Shaun S., Good Asset Purchase Plan (GAPP)
  A Strategy for Economic Recovery (April 14,
  2009). Available at SSRN http//ssrn.com/abstract
  1381002