Understanding Systemic Risk in Global Financial Markets

ARON GOTTESMAN is Professor of Finance and the chair of the Department of Finance and Economics at the Lubin School of Business at Pace University. He is widely published in academic journals and is the author of Derivatives Essentials: An Introduction to Forwards, Futures, Options, and Swaps. MICHAEL LEIBROCK is managing director, chief systemic risk officer, and head of Counterparty Credit Risk for The Depository Trust & Clearing Corporation (DTCC). He serves as chair of DTCC’s Model Risk Governance Committee and co-chair of the Systemic Risk Council, and is an active speaker globally on the topics of systemic and credit risk.

• Preface xiiiAcknowledgments xviiAbout the Authors xviiiChapter 1 Introduction to Systemic Risk 1What Is Systemic Risk? 2Systemic Risk Drivers 3Why Systemic Risk Must Be Understood, Monitored, and Managed 5Chapter 2 How We Got Here: A History of Financial Crises 9Common Drivers of Historical Crises 10Bursting of Asset Bubbles 10Banking Crises 14Sovereign Debt Crisis 15International Contagion 18Chapter 3 The Credit Crisis of 2007–2009 24Planting the Seeds of a Bubble: The Early 2000s 25Wall Street’s Role 27The U.S. Government Takeover of the GSEs 30The Tipping Point: Lehman Brothers’ Failure 32Aftermath of the Credit Crisis 35Cost of Government Bailouts 37Chapter 4 Systemic Risk, Economic and Behavioral Theories: What Can We Learn? 44Minsky Three-Part Model 45Debt Deflation Cycle 46Benign Neglect 47Behavioral Theories 48Risk Aversion Bias 49Asset Prices 50Homogeneous Expectations versus Heterogeneity 51Anchoring Heuristic 52Excessive Optimism 52Familiarity Bias 53Fallacy of Composition 53Fight or Flight 53Chapter 5 Systemic Risk Data 59Key Data Attributes 60Key Policy Changes to Address Data Gaps 60Data Sources 63Data Collection Challenges and Remaining Gaps 63Move Toward Standardization: Legal Entity Identifier Initiative 68Chapter 6 Macroprudential versus Microprudential Oversight 73A Comparison of Macroprudential versus Microprudential 74Microprudential Policies 74Macroprudential Policies 76A Historical Perspective on Macroprudential Tools 77Choice of Macroprudential Policy Tools 79Chapter 7 Introduction to the U.S. Regulatory Regime 84Who Are the Regulators? 84U.S. Regulatory Approaches 86Comparison of U.S. versus International Financial Regulatory Regimes 87Introduction to the Dodd-Frank Act 90Chapter 8 Introduction to International Regulatory Regimes 97The Financial Stability Board 97The Basel Accords 99The European Systemic Risk Board 99Principles for Financial Market Infrastructures 102Chapter 9 Systemically Important Entities 107Introduction to Systemically Important Entities 107Classification of Entities as Systemically Important by the FSOC 108Bank SIFIs 110Nonbank SIFIs 110SIFMUs 112Globally Systemically Important Banks 112Total Loss-Absorbing Capacity (TLAC) Requirements 114Broad Impact of Financial Stability Requirements 117Chapter 10 The Volcker Rule 120Introduction to the Volcker Rule 120The Volcker Rule: Details 122Prohibition of Proprietary Trading 123Prohibition of Ownership or Sponsorship of Hedge Funds and Private Equity Funds 123The Volcker Rule and Systemically Risky Nonbank Financial Companies 123Activities That Are Permitted Despite the Volcker Rule 124Implementation of the Volcker Rule 125Volcker Rule: Criticism 126Chapter 11 Counterparty Credit Risk 130Overview of Derivative Securities 130Counterparty Exposure 133How Counterparty Credit Risk Is Managed 136Collateral 136Netting 136Central Counterparties 139Counterparty Credit Risk and Systemic Risk 142Chapter 12 The Dodd-Frank Act and Counterparty Credit Risk 147Measuring Counterparty Exposure in the OTC Derivatives Market 147Overview of Historical Data 149The Evolution of the U.S. Regulatory Approach toward OTC Derivatives 152Key Provisions of Title VII of the Dodd-Frank Act 153Mandatory Clearing 154Execution Platforms and Data Repositories 154Registration Requirements 155The Push-Out Rule 155The End User Exemption 155Criticism of Title VII of the Dodd-Frank Act 155Chapter 13 The Basel Accords 159What Are the Basel Accords? 159The Approach of the Basel Accords 160Basel I 161Basel II 163Pillar 1: Minimum Capital Requirements 163Pillar 2: Supervisory Review 164Pillar 3: Market Discipline 165Basel II. 5 165Basel III 165The Continuing Evolution of the Basel Accords 166Chapter 14 Lender of Last Resort 169Lender of Last Resort Concept 169Henry Thornton, Walter Bagehot, and Alternative Views 170The Fed’s Role in the Great Depression 172The Credit Crisis of 2007–2009 173Chapter 15 Interconnectedness Risk 177A Case Study of Interconnectedness 178Interconnectedness Categories 179The Depository Trust & Clearing Corporation 180Post-Crisis Regulatory View of Interconnectedness 181Basel Committee on Banking Supervision 181Office of Financial Research 182CPMI IOSCO Principles 184An Approach to Analyzing Interconnectedness Risk 185The Depository Trust & Clearing Corporation 185Chapter 16 Conclusion: Looking Ahead 190It’s Not a Question of If, but When, Where, and How 192A Summary of Global Surveys 192Sources of Systemic Risk 193Preparing for the Next Crisis 194Appendix: Systemic Risk Models 198Structural versus Reduced-Form Credit Models 198Contingent Claims and Default Models 199Merton versus Garch 204Studies in Support of Merton 205Macroeconomic Measures 210Probability Distribution Measures 211Illiquidity Measures 214Counterparty Risk Measures 215Behavioral Models 217Solutions to the Knowledge Check Questions 223Index 239