Calibrating limits for large interbank exposures from a ... · Vajont dam disaster (Italy, 1963) Three Mile Island nuclear accident (USA, 1979) Bhopal fertilizer plant gas leak (India,

Calibrating limits for large interbank exposures from a system-wide perspective

Enrique Batiz-Zuk, Fabrizio López-Gallo, Serafín Martínez-Jaramillo, and Juan Pablo Solórzano-Margain

network model of a banking system originally developed by Graf et al. (2005) involving a diverse set of (SIB and non-SIB), namely domestic banks, which are linked together by their claims. !sequential default algorithm to study contagion of defaults under different conditions and stress tests + strategic bank behaviour response; !impact of an individual bank failure on the rest of the banks in an interbank network. !stress tests through reduction of capital ratios of banks !calibration of the model to emerging country banking sector data (i.e., Mexico) by using proprietary data of Banco de México that includes detailed actual aggregated bilateral interbank exposures



first comprehensive calibration on interbank exposures from a system-wide perspective !large credit losses may happen as a result of specific banks’ behavioural responses in the presence of tighter limits, through a rule using “lending preference index” to re-network the bank connections !network topology and core-periphery structure are important !a more complete network is more sensitive to contagion !nonlinear (non-monotonous) effect on the share of destroyed assets as a function of the capital ratio requirement <= influence of the re-networking of the banks after default of counter parties



Pb that the last crisis came from “common cause” of subprime mortgages, Analogy with Probabilistic Safety Analysis in nuclear industry safety, where cascades occur in the presence of a common cause (tsunami) engulfing all lines of defence simultaneously notwithstanding all the redundancy and lines of defences !moderate loss of assets in contagion scenarios, but this neglects the effect observed in the subprime crisis that all assets can become illiquid and the loss much larger !nature of shocks may be much too simple: Ex is links of banks to the firms and households… + financial instruments in particular derivatives !!Cf fluctuation-susceptibility theorem in out-of-equilibrium systems !

D-MTEC Chair of Entrepreneurial RisksProf. Dr. Didier Sornette www.er.ethz.ch

Guidelines from Physics: perturb and study the response

(“Impulse response” approach in Econometrics)

4

Fluctuation-dissipation theorem far from equilibrium is not expected to hold in general, but...

D. Ruelle, Physics Today, May 2004

§Externally imposed perturbations may be different from spontaneous fluctuations (external fluctuations lie outside the complex attractor) !§Attractor of dynamics may exhibit bifurcations



!Figure 4 shows six Panels that serve to compare the difference in the structure of the interbank network (SIB vs non-SIB) for a specific point in time under analysis => not clear and deserve quantitative metrics (small world, assortativity, betweenness, k-core, etc) !Debtrank approach inspired by PageRang of Google search engine Stefano Battiston, Michelangelo Puliga, Rahul Kaushik, Paolo Tasca, Guido Caldarelli, DebtRank: Too Central to Fail? Financial Networks, the FED and Systemic Risk, Scientific Reports, Vol. 2 (2 August 2012), doi:10.1038/srep00541

pre-crisis peak of crisis



Systematic classification of cascade models: Tessone, Claudio Juan; Garas, Antonios; Guerra, Beniamino; Schweitzer, Frank, How big is too big? Critical shocks for systemic failure cascades, Journal of Statistical Physics 151, 765-783 (2013) !Lorenz, Jan; Battiston, Stefano; Schweitzer, Frank, Systemic risk in a unifying framework for cascading processes on networks, The European Physical Journal B 71, 441-460 (2009) !Pawel Sieczka, Didier Sornette and Janusz A. Holyst, The Lehman Brothers Effect and Bankruptcy Cascades, European Physical Journal B 82 (3-4), 257-269 (2011) (http://ssrn.com/abstract=1547172) [credit worthiness contagion effect with feedback => phase transitions + bailing out the first few defaulting firms does not solve the problem, but does have the effect of alleviating considerably the global shock, as measured by the fraction of firms that are not defaulting as a consequence.]



default is assumed immediate upon reaching the bank capital ratio limit => in reality, different shadow banking operations may occur so that the system becomes over-critical or meta-stable (Repo 105) => emergence of dragon-kings !!

9

A. Johansen and D. Sornette, Large Stock Market Price Drawdowns Are Outliers, Journal of Risk 4(2), 69-110, Winter 2001/02

A. Johansen and D. Sornette, Stock market crashes are outliers, European Physical Journal B 1, 141-143 (1998)

Interaction (coupling) strength

Heterogeneity - diversity

10

1

0.1

0.01

0.0010.001 0.01 0.1 1 10

SYNCHRONIZATION EXTREME RISKS

SELF-ORGANIZED CRITICALITY

Coexistence of SOC and Synchronized behavior

INCOHERENT

By classifying a system in a given regime, we can assert its degree of predictability.

Generic Risk Prediction Phase Diagram

MODELING PUBLIC COLLABORATIVE PROCESSES: !THE CASE OF SAFEGUARDING FINANCIAL STABILITY!

Peter Sarlin and Henrik J. Nyman

• aim of efficient safeguard of financial stability and resilience of the global financial system!!

• Macroprudential needs system-wide approach !!

• Inspiration from business process management (feedback loops, improvement and alignment)!!

• Public collaborative process defined as multiple organisation working together with a common objective!!

• event-driven process chain!!

Definitions and measures of stress in social science

Resilience comes into several levels:

I. The “engineering resilience”: !described by a local analysis, in terms of the stability of the linearized dynamics in the neighborhood of the equilibrium point. !II. The “ecological resilience”: !encompasses and generalizes “engineering resilience” by referring to the non-local dynamics occurring within the basin of attraction of the equilibrium state. !The “resilience triangle” approach: !the quadruplet of parameters (λ, τ1, Λ, τ2). !III. The concept of viability: !extends further the idea by focusing on the conditions that the system must obey to remain “viable”, for instance functional or alive: 1) the desired property of the system can be defined as a set of states, which are not necessarily attractors; 2) the possibility of management actions. !IV. Adaptation, evolution, transformation: !1) the possibility for the system to adapt its constituents so as to influence its resilience; 2) more generally, the dynamical system may incorporate stochastic components, such as deterministic, quasi-periodic or even random deformations of the attractors due to the modulation of some control parameters, as long as the conditions of viability are respected; 3) pushed to the extreme, the system may even transform itself into a completely different structure via its capacity to evolve, as described by the theory of complex adaptive systems.

Walker et al. (2004)

Deffuant, G. and N. Gilbert, eds. (2011)

II. The “ecological resilience”

III. The concept of viability

The “resilience triangle” approach

Tatyana Kovalenko and Didier Sornette, Dynamical Diagnosis and Solutions for Resilient Natural and Social Systems, Planet@Risk 1 (1), 7-33 (2013) Davos, Global Risk Forum (GRF) Davos

!1) distributed swiss citizen surveillance!!!!!!!!2) distributed intelligence: DARPA red balloon competition (Oct. 2009) !=> The key to mobilizing large numbers of people is incentives (Pickard et al., 2011)!!!!3) GOOGLE SEARCH: predicting the present by google trend!-Google Searches as a Means of Improving the Nowcasts of Key Macroeconomic Variables (Kholodilin et al., 2009; Choi and Varian, 2012)

Human limits and operational solutions

Identification of stress signals and reactions to them: ! 1) gathering information; 2) aggregating and communicating data; 3) maintaining a state of attention. !+ Acceptance of the unavoidable nature of stress. + Development of an appropriate stimulating mechanisms.

The “illusion of control” syndrome !Langer, 1975 Satinover and Sornette (2007; 2011): !in dynamical first-entry games, the low entropy (more informative) strategies typically under-perform high entropy (random) strategies in situations where there is a large amount of randomness, of uncertainty as well as the presence of negative feedbacks of the decision makers’ actions onto the system.

The “logic of failure” !Dörner et al., 1990; Dörner, 1997 - a logic in the origins and processes leading to failures: !(a) humans experience failure more often than success when intervening in complex systems, (b) the failures are not random, but exhibit common patterns and (c) the understanding of these patterns offer operational rules to prevent the failures.

T D-MTEC Chair of Entrepreneurial RisksProf. Dr. Didier Sornette www.er.ethz.ch 2008.02.29

WE ELABORATED MORE THAN 25 CASES OF LARGE-SCALE DISASTERS: !INDUSTRIAL SECTOR

❑ Vajont dam disaster (Italy, 1963) ❑ Three Mile Island nuclear accident (USA, 1979) ❑ Bhopal fertilizer plant gas leak (India, 1984) ❑ Challenger Space Shuttle disaster (USA, 1986) ❑ Chernobyl nuclear disaster (USSR, 1986) ❑ Exxon Valdez oil spill (USA, 1989) ❑ Ufa train disaster (USSR, 1989) ❑ Deepwater Horizon oil spill (USA, 2010) ❑ Raspadskaya coalmine burnout (Russia, 2010) ❑ Fukushima-Daiichi nuclear disaster (Japan, 2011) ❑ Minamata mercury poisoning (Japan, 1932-1968) ❑ Asbestos crisis (worldwide, 1970s) ❑ Sayano-Shushenskaya hydropower station accident (Russia, 2009) ❑ Shale energy production (USA, since 2005)

FINANCIAL SECTOR ❑ Barings bank collapse (Singapore-UK, 1995) ❑ Enron’s bankruptcy (USA, 2001) ❑ Subprime mortgage crisis (USA, 2007-2008) ❑ US total debt problem and hiding of liabilities (ongoing case) ❑ Falsification/manipulation of Chinese GDP and problems in banking sector (ongoing case)

MILITARY, SOCIAL AND NATURAL DISASTERS ❑ Unreadiness of the Soviet Red Army for invasion of the Nazi (1941) ❑ Worldwide Spanish flu and SARS outbreaks (1918-1919, 2003) ❑ Great wildfires in the European part of Russia (Russia, 2010) ❑ Krymsk flooding (Russia, 2012)

RISK CONCEALMENT IN THE RETAIL PRODUCTION INDUSTRY ❑ Cost reduction rate and Toyota problems (USA-Japan, 2000s) ❑ Poly Implant Prothese fraud (France, 1993-2010) ❑ Cigarette industry (worldwide)

Dmitry Chernov, Didier Sornette Handbook for decision-makers, risk specialists and responsible citizens “RISK INFORMATION CONCEALMENT BEFORE AND AFTER MAJOR DISASTERS”


EXTERNAL ENVIRONMENT OF AN ORGANIZATION

Wishful thinking/

Self-deception -85%

Short-term financial and managerial objectives

- 85%

Permanent “rush work”

culture -85%

!“Success

at any price” - “no bad news”

culture - 95%

!Fragmentary perception of picture

of risks among executives

- 45%

Weak internal control within

an organization - 45%

Habituation - 45%

Global short-term

political and business

philosophy - 95%*Cozy

relationships between

government representatives and industries

- 55%

Unwise governmental

regulation concerning innovative doctrines

- 60%

Governmental indulgence

of giant mergers and weak control

over complex systems - 50%

Low qualification

of representatives of government

regulators -45%

Poor communication

channels of risk transmission

(with internal and external audiences)

Unwillingness to investigate

the causes of previous an accident

- 70%

Absence of a prompt

industry-wide risk assessment

system - 65%

!Absence of

a risk knowledge management system - 65%

Problem of “looking good

in the eyes of superiors” and reluctance

to admit personal mistakes, caused by fears of being

seen as incompetent or punished

- 70%

Unrealistic projections of personal

performance - 70%

RISK COMMUNICATION CHANNELS

INTERNAL ENVIRONMENT OF AN ORGANIZATION

INTERNAL ECOLOGY OF AN

ORGANIZATION

RISK ASSESSMENT AND RISK KNOWLEDGE MANAGEMENT

PERSONAL FEATURES OF EMPLOYEES

* - frequency of concealment causes in elaborated cases,%

Dmitry Chernov, Didier Sornette Handbook for decision-makers, risk specialists and responsible citizens “RISK INFORMATION CONCEALMENT BEFORE AND AFTER MAJOR DISASTERS”

source: U.S. Bureau of Labor Statistics.

Fighting the last war and hindsight bias: example of THE GREAT MODERATION

Nasdaq value March 2000 UK real-estate

mid-2004

USA real-estate mid-2006

S&P500 Oct-2007

The Global Bubble (2003-2008) and

the illusion of the perpetual money machine (1980-2008)

200820072006200520042003

Index of over-

valuation

The “perpetual money machine” broke.

2009

D. Sornette and P. Cauwels, The Illusion of the Perpetual Money Machine, Notenstein Academy White Paper Series (Dec. 2012) (http://arxiv.org/abs/1212.2833)

PCA first component on a data set containing, emerging markets equity indices, freight indices, soft commodities, base and precious metals, energy, currencies...

United States Share of wages and of private consumption in Gross Domestic Product (GDP) Source of data and graphics: http://hussonet.free.fr/toxicap.xls

Rate of profit and rate of accumulation: The United States + European Union + Japan * Rate of accumulation = rate of growth rate of the net volume of capital * Rate of profit = profit/capital (base: 100 in 2000)

Sources and data of the graphs: http://hussonet.free.fr/toxicap.xls

Thee gap widens between the share of wages and the share of consumption (gray zones), so as to compensate for the difference between profit and accumulation. FINANCE al lows increasing debt and virtual wealth growh... which can only be transitory (even if very long).

20

rate of profit

savings

consumption

wages

The illusionary “PERPETUAL MONEY MACHINE”

transfer of wealth from populations (young debtors buying houses to financial assets (older sellers) (Spencer Dale, Chief economist Bank of England

1982

Example of a Long Time Scale Signal – DAX

Early Bubble Warning – Long Time Scale Signal !DAX !November 5th, 2013

Bubble End Flag – Long Time Scale Signal

http://risikopedia.ethz.ch:2375/The Financial Crisis Observatory

Early Bubble Warning – Long Time Scale Signal !NASDAQ !November 5th, 2013

Bubble End Flag – Long Time Scale Signal

Example of a Long Time Scale Signal – NASDAQhttp://risikopedia.ethz.ch:2375/


In addition to building sophisticated supervising of a very complex system, why not simplify the system by working on

the incentives?

!Loss of “Fiduciary Principle” ‘no man can serve two masters’!(J. Bogle, former CEO Vanguard group, JPM 2009)!!“Legal relationship of confidence or trust between two parties”!!The issue of “moral relativism”!!Moral hazard!!Incentives!

Documents

Calibrating limits for large interbank exposures from a ... · Vajont dam disaster (Italy, 1963) Three Mile Island nuclear accident (USA, 1979) Bhopal fertilizer plant gas leak (India,