Diagnosing the Market Failures
In this article, we analyze the failures, specifically of stress-testing and other risk management tools, that contributed to the global financial crisis of 2007-2012. The market failure was the root cause of these risk management problems. These market failures fall roughly into three categories:
- Disaster myopia
- Network externalities
- Misaligned incentives
All three have impeccable microeconomic credentials and potentially disastrous macroeconomic consequences.
Disaster Myopia
In a nutshell, disaster myopia refers to agents’ propensity to underestimate the probability of adverse outcomes, in particular small probability events from the distant past. It is well-established in cognitive psychology that economic agents have a tendency to base decision rules around rough heuristics or rules of thumb.
The longer the period since an event occurred, the lower the subjective probability attached to it by agents (the so-called “availability heuristic”). And below a certain bound, this subjective probability will effectively be set at zero (the “threshold heuristic”).
If the period of stability is sufficiently long – a Golden Decade perhaps? - this subjective approach to evaluating probabilities looks increasingly like a fully-rational, Bayesian approach to updating probabilities. As time passes, convincing the crowds that you are not naked becomes progressively easier. It is perhaps no coincidence that the last three truly systemic crises – October 1987, August 1998, and the credit crunch which commenced in 2007 – were roughly separated by a decade. Perhaps ten years is the threshold heuristic for risk managers.
In the context of financial crises, disaster myopia has been used to explain the LDC debt crisis, the US savings and loans debacle and various commercial property crises. The credit crunch of the past 18 months is but the latest in a long line of myopia-induced disasters.
Network Externalities
Any asset portfolio is, in essence, a financial network. So the balance sheet of a large financial institution is a network, with nodes defined by the assets and links defined by the correlations among those assets. The financial system is similarly a network, with nodes defined by the financial institutions and links defined by the financial interconnections between these institutions.
Evaluating risk within these networks is a complex science. When assessing nodal risk, it is not enough to know your counterparty; you need to know your counterparty’s counterparty too. In other words, there are network externalities. In financial networks, these externalities are often referred to as contagion or spillovers. There have been many examples of such spillover during this crisis, with Lehman Brothers’ failure a particularly painful one. That is why there have been recent calls to calibrate regulatory requirements to these risk externalities.