Abstract
Much was debated in the past years about the causes of the financial crisis which was triggered by the collapse of the US real estate market and the implied huge losses in complex-structured credit securities by large financial institutions, mostly banks. The crisis also reveals fundamental failures in the measurement, management, and transfer of risk in the financial system as well as methodological weaknesses (to say the least) in the regulation of financial institutions. Much has been learned about the (il-)liquidity of markets and its self-reinforcing effects, but the real problem is deeper.
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Notes
- 1.
It should be noticed that the expected losses as reflected in the global financial sector potential writedowns were constantly revised upwards between 2007 and 2009; starting at some US$400 billion, the estimates ended up at some US$4000 billion in April 2009, including all banks in the USA, Europe, and Japan, and including loans as well as securities (source: International Monetary Fund, Global Financial Stability Report, April 2009, p. 35). A different question is how these estimates are related to the actual losses of the banking (respectively, the entire financial) system, and how “losses” are defined.
- 2.
Nontrivial machines are characterized by a state-dependent operating system (program), where the state is determined by the input to the system. Depending on the circularity of the system’s architecture, the model can be used to analyze the dynamic behavior of systems such as learning, memory, adaptive behavior, and randomness. But the model also clarifies the limited knowledge which can be retrieved from the observed in- and outputs of a system about its internal unobservable “program”—even under very simple assumptions. See v. Foerster (2003), pp. 309–313.
- 3.
Among the numerous and almost uncountable references, the following are particularly worth reading from a financial economist’s point of view: French et al. (2010) and Acharya et al. (2009).
- 4.
Although widely debated, in order to simplify the discussion, we do not distinguish between risk and uncertainty in this chapter.
- 5.
Notice that an implied volatility is only defined with respect to a specific option pricing model, which in turn depends on a specific stochastic process of the underlying securities and the implied arbitrage mechanism. In the Black-Scholes model, this reduces to an assumption about the standard deviation (volatility) of logarithmic price changes.
- 6.
Within the social sciences literature, a similar argument (with respect to option pricing models) can be found in MacKenzie (2006), although his focus is slightly different from the constructivist perspective advanced in the text here. A general analysis of the relationship between mathematical models and realities (ontological, personal, social, and formal) can be found in Henning (2009).
- 7.
See Foerster/Pörksen (1998), p. 82.
- 8.
The term “representation” is always tricky to use in a constructivist setting. Of course, representation does not only apply to abstract categories which are not directly accessible to sensual perception, but also refers to a general epistemological category. In this chapter, the term is used to characterize a device, by which objects—whether “real” (in the traditional meaning of an objective ontological reality) or “constructed”—are made accessible to our practical experience. While our point of view is fundamentally constructivist, we do not go as far as E. von Glasersfeld’s who, in the absence of an observer-independent world in itself, abandons the expression right away (e.g., in v. Glasersfeld 1996). We agree with von Foerster that the term “re-presentation” (in German: “Ab-Abbildung”) is inadequate or misleading with respect to a “reality” being “presented” (see v. Foerster 2013). However, our understanding is that representation reflects a state of knowledge (or a basis for acquiring knowledge) of an observing individual.
- 9.
A very illuminating collection of essays on this subject (in German, however) can be found in Gendola/Kamphusmann (1999).
- 10.
Beck (1992), p. 29; the original version was published in German (Beck 1986). Interestingly, in the English version, the quoted sentence is supplemented by the following remark: “In some circles it is said that risks which are not yet technically manageable do not exist—at least not in scientific calculation or jurisdictional judgment. These uncalculable threats add up to an unknown residual risk which becomes the industrial endowment for everyone everywhere” (p. 29). This is extremely revealing in the context of the systemic relevance of liquidity risk discussed below.
- 11.
At least, there are generally accepted risk management “principles” (GARP).
- 12.
As mentioned earlier, von Glasersfeld strictly avoids the term “re-presentation” in his characterization of cognitive action, because he relates it to an unknowable ontological reality. However, in a less strict view, the “concepts or conceptual constructs” also require a representation, a representation reflecting a certain state of knowledge. The quoted phrases are from v. Glasersfeld (1998).
- 13.
See v. Foerster (1997), p. 165 (original German edition).
- 14.
In his Tractatus, Ludwig Wittgenstein characterized the language as located on the very limit between the speakable and the unspeakable. I would suggest that representations of risk, e.g., by a probabilistic risk model, are similarly located at the borderline between safety and uncertainty.
- 15.
Two typical forms of liquidity risks are “market” liquidity and “funding” liquidity; their relationship is analyzed by Brunnermeier/Pedersen (2009).
- 16.
Or in attenuated form: the object (market price) which is required for the representation of risk loses its suitability or quality.
- 17.
Some early estimates about this relationship are reported in the Financial Stability Review of the ECB (European Central Bank), June 2008: the reported correlation coefficient for a cross section of 10 countries is roughly 0.8.
- 18.
An insightful analysis of the liquidity-credit risk spiral during the financial crisis can be found in Brunnermeier (2009).
- 19.
The literature analyzing the stock market crash of 1987 has emphasized many of these problems. The informational externalities related to invisible and uncoordinated dynamic portfolio insurance strategies and their effect on market liquidity was studied in detail by S. Grossman. A selection of his papers can be found in Grossman (1989).
- 20.
Concerns were related to structural weaknesses and the potential insolvency of central counterparties of credit derivatives (which were the major, highly leveraged investors of US mortgages), the strong dependency between hedge funds and investment banks, cross-border and cross-currency issues in the lending process between central banks, or dysfunctions in international clearing and settlement transactions. See, e.g., Zimmermann (2007) for a discussion of the subjects in the public concern just instances before the breakout of the financial crisis.
- 21.
Only a few eminent economists can be credited to having foreseen a financial crisis caused by structural deficits of the US real estate market. Nobel laureate Robert Shiller is a prominent exception. Also Frankel (2006) reveals the structural weakness of the US subprime market in great detail, without implying a global financial crisis however.
- 22.
See, for example, the consultation paper from the Basel Committee on “Principles for Sound Liquidity Risk Management and Supervision” (BIZ 2008).
- 23.
See Zimmermann (1999) for a detailed discussion of this development. The self-confidence, or arrogance, by which this knowledge is communicated to the world outside is sometimes remarkable. The wording of a white paper published by a major investment bank is revealing: “More than You Ever Wanted to Know about Volatility Swaps (But Less than Can Be Said).”
- 24.
By Gödel’s theorem, incompleteness is even an inherent property of arithmetic systems.
- 25.
From “Responsibilities of Competence,” in: v. Foerster (2003), pp 191–197. Originally published in 1972.
- 26.
This may sound rather abstract. An example: Metallgesellschaft in the early 1990s sold long-term commitments to deliver gasoline and hedged the exposure thereof by rolling over short-term futures contracts. The company assumed that futures markets remain in backwardation. When the futures market turned into contango, the company was forced to adjust the hedging strategy. Because of the substantial market share of the company and the illiquidity of the market, this adjustment amplified the adverse price behavior, i.e., increased exactly that risk which ought to be hedged. The company finally got insolvent. A detailed analysis can be found in Culp/Miller (1995).
- 27.
The use of “standard” is somehow ambiguous in the literature. In the field of law and prudential regulation, the term has a rather broad meaning (e.g., includes the principles released by the Bank of International Settlements). A decade ago, Nobel (2005) lists more than 60 standards in use in the field of international financial regulation.
- 28.
Admati/Hellwig (2012) provide an in-depth discussion of financial regulation, the role of banks’ capital, and the safety of the banking system.
- 29.
A good example is the capital ratio of banks which has consistently decreased over time with the implementation of stricter and more sophisticated minimum capital requirements. The increasing cost of equity capital is consistently used to rationalize this trend by the banking industry. Of course, causality runs in the opposite direction—whether it is a moral hazard issue or perception bias remains open here, but the effect on the systemic risk is striking.
- 30.
One of the editors of this volume, Robert A. Schwartz, can be credited as one of the pioneers in this field.
- 31.
The work by Nobel laureate Jean Tirole, and more recently by Markus Brunnermeier (see, e.g., the referenced article) and Hyun Song Shin, to mention just a few representative researchers, is remarkable. They focus on the relationship between market liquidity and financing patterns (leverage, collateralization) to analyze contagion effects and financial stability. Shin (2010) gives an overview on this research. Shin’s nomination as Economic Advisor and Head of Economic Research at the Bank of International Settlements (2014) is a promising perspective in this light.
- 32.
See Meyer/Tschudin (2012).
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Zimmermann, H. (2017). Risk and Representation: The Limits of Risk Management. In: Francioni, R., Schwartz, R. (eds) Equity Markets in Transition. Springer, Cham. https://doi.org/10.1007/978-3-319-45848-9_16
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