opinion
The financial stability puzzle
Several indexes have emerged in recent months, designed to warn investors about increases
in systemic risk. But these products could, in some instances, worsen the problem, argues
Barry Schachter
On October 14, State Street
announced the
creation of a systemic risk index. It is meant to measure the
vulnerability of the US equity market to shocks and possibly
provide clients with some advance warning of conditions
that could be associated with a market crash. The
announcement was picked up by media across the globe, but
the index is just one of a variety of recently developed
investor tools and strategies for avoiding or mitigating losses
from the next market crash. The irony is these tools may
actually increase systemic risk.
What goes on in the minds of investors is a central
element in the complex dynamics contributing to a market
crash. Many investors who had never heard of systemic risk
prior to 2007 will now have visions of economic Armaged-
don at the sound of those words. These reactions influence
trading behaviour.
The financial crisis has highlighted the need to rethink
our assumptions about the dynamics of investor behaviour
(among other things), and has drawn more attention to
explanations of sometimes discontinuous market price
dynamics derived from behavioural finance and complex
systems theories. The key aspects of investor actions in such
theories are limited rationality, adaptive behaviour and
positive feedback effects.
Limited (or bounded) rationality is a term used
to describe a wide variety of investor behaviour,
documented through various methods, but
most notably through experimental laboratory
studies. Some of the behaviour is referred to as
cognitive bias, reflecting limitations in our
ability to fully and accurately process all the
information presented by a situation.
One such cognitive bias is the problem of
accurately estimating the likelihood of
low-frequency events. This bias has multiple
manifestations, but the one of interest here is a
tendency to overestimate the probability of
low-frequency events when they have been
experienced recently by an individual.
Mark Twain warned against the effects of
this bias: “We should be careful to get out
of an experience only the wisdom that is
in it – and stop there, lest we be like
the cat that sits down on a hot stove
Barry Schachter is founder of risk
management website GloriaMundi.org
lid. She will never sit down on a hot stove lid again – and
that is well, but also she will never sit down on a cold one
any more.”
Adaptive behaviour by investors arises in cases of limited
rationality. Because investors aren’t sure of the optimal set of
decision rules, they revise their investment strategy over time
based on their experience (and observation of the experiences
of others). In fact, in a world of investors with limited
rationality, anyone who won’t adapt meets the definition of
insanity attributed by legend to Einstein – namely, doing the
same thing over and over again and expecting different results.
Positive feedback can be a potent force. It acts to amplify
the direction of movement of a process. Synthetic portfolio
insurance strategies, which may have been a contributing
factor in the 1987 stock market crash, exhibit a form of
positive feedback by requiring the insurance provider to sell
more of the reference index with each incremental fall in
stock prices.
In a world with limited rationality and adaptive behaviour,
the introduction of a new investment tool or source of
information can affect the strategies followed by investors.
The revised tactics can conceivably embed positive feedback
effects enabled through the new tool or source of information.
If, as a result of the ‘hot stove lid’ effect, investors are, by
virtue of their cognitive biases, willing to commit to new
strategies they expect will protect them from adverse market
outcomes, the dynamics of the market may differ from what
has been observed previously – and, under some circum-
stances, deviate in ways that increase systemic fragility.
For instance, if one systemic risk index passes its ‘crash
warning threshold’, investors will take note. Irrespective of
whether the signal is a true or false one, some may think it
prudent to cut equity exposure. These individual actions,
occurring simultaneously, may result in a drop in equities
and a blip in volatility. At this, other investors may react,
seeing confirmation of the signal. The resulting market
dynamics might trigger warnings from other systemic risk
indexes, inducing additional investors to flee equities. The
ultimate result might be the very crash that investors wish to
avoid, partly induced by the positive feedback channel
created by this information.
On October 6, one week before State Street’s announce-
ment, the US Financial Stability Oversight Council
published a set of questions as a first step towards setting
criteria for determining which non-bank financial
companies pose a threat to systemic stability. However,
important factors contributing to systemic risk may not be
easily associated with answers to questions about indi-
vidual companies. ■
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