Why systemic risk went out of control

According to the widely cited Turner review, published by the UK Financial Services Authority, five key features of the global financial system played a crucial role in increasing systemic risk that led to the meldown.

The growth of the financial sector.
The disproportionate growth of financial sector debt, driven by securitisation led to an explosion of claims within the financial system, between banks and investment banks and hedge funds. This growth of the relative size of the financial sector, magnified the potential impact of financial system instability on the real economy.

Increasing leverage
From about 2003 onwards, there were significant increases in the measured on-balance sheet leverage of many commercial and investment banks. At the same time, ‘risk adjusted’ measures of leverage (e.g. Value at Risk (VAR) relative to equity) showed no such rise. This was because capital requirements against trading books, where the asset growth was concentrated, were extremely light compared with those for banking books. VAR measures suggested that risk relative to the gross market value of positions had declined. Clearly, these measures were faulty and the required trading book capital was inadequate.

The build up to the crisis saw the rapid growth of highly leveraged off-balance sheet vehicles – structured investment vehicles (SIVs) and conduit. The classification of these entities as off-balance sheet resulted in a misrepresentation of true economic risk. Liquidity provision commitments and reputational concerns forced many banks to take the assets back on their balance sheets as the crisis grew, resulting in a significant increase in measured leverage. Moreover, products like CDOs, had very high and imperfectly understood embedded leverage. Their vulnerability to shifts in confidence and liquidity was grossly underestimated.

Changing forms of maturity transformation.
One of the key functions of the banking system is maturity transformation. In recent years, much of the aggregate maturity transformation has been occurring not on the banking books of regulated banks, but in other forms of ‘shadow banking - SIVs, conduits, investment banks. And in the US, mutual funds have made implicit or explicit promises not to allow net asset value to fall below the initial investment value. As a result, during a liquidity crisis, mutual funds may sell assets rapidly to meet redemptions. This can contribute to systemic liquidity strains.

Aggregate maturity transformation being performed by the financial system seems to have increased substantially over the last two decades. And many institutions thought it was safe to hold long term assets funded by short-term liabilities on the grounds that the assets could be sold rapidly in liquid markets if needed. This assumption was valid during the benign economic conditions that prevailed before the sub prime crisis, but became rapidly invalid during the crisis, as many firms attempted to liquidate their positions simultaneously.

A misplaced reliance on sophisticated maths.
There was a general belief that that the increased complexity of structured products had been matched by the evolution of mathematically sophisticated and effective techniques for measuring and managing the resulting risks. Top management and boards found it difficult to understand the complex maths and to assess and exercise judgement over the risks being taken. Mathematical sophistication only ended up providing a false assurance that other visible indicators of increasing risk (e.g. rapid credit extension and balance sheet growth) could be safely ignored.

Hard-wired procyclicality.
The marketability of various assets where no historic record existed, depended on credit ratings. These ratings proved misleading predictors of risk. Senior notes of SIVs, for instance, were often awarded high credit ratings on the grounds that if the asset value fell below defined triggers, the SIV would be wound up before senior note holders were at risk. At the system level, however, this resulted in attempted simultaneous asset sales by multiple SIVs. Liquidity rapidly disappeared as market value limits were triggered and ratings were cut. In case of some derivative contracts, the level of collateral depended on the credit ratings of counterparties. Credit default swaps (CDS) and other OTC derivative contracts entered into by AIG, for instance, required it to post more collateral if its own credit rating fell. When this occurred in September 2008, a downward spiral of increased liquidity stress and falling perceived credit worthiness rapidly ensued.