What were the causes of the financial crisis of 2008? A new paper from researchers at the Institute for New Economic Thinking at the Oxford Martin School shows that managing risk using the procedure recommended by Basel II, which is called Value at Risk, may have played a central role.
The paper, published in the Journal of Financial Stability, makes a very simple model for the banking system that captures the key elements of risk management under Value at Risk. Providing the banks’ only take modest risks, the financial system remains stable. But if they take higher risks, or if the banking sector gets larger, the market begins to spontaneously oscillate, in a way that resembles the period leading up to and including the Global Financial Crisis. For about 10 - 15 years prices and leverage slowly rise while volatility slowly falls, then prices and leverage suddenly crash and volatility spikes, as they did in the crisis.
The key problem is that Value at Risk manages risk as if each bank existed in its own universe. But if all banks follow it, the buying and selling necessary to maintain individual risk targets can destabilize the market.
The authors investigate alternative methods of managing risk and show that it is possible to do much better. The best policy depends on the size of the banking sector in relation to the rest of the market and how much risk the banks take. While the model does not show that the financial crisis and the period leading up to it were due to the use of Value at Risk, it does suggest that they could have been caused by it, and that the housing bubble may have just been the spark that triggered the crisis.
INET's Professor Doyne Farmer, a co-author on the paper, said "Our model indicates that policy makers should take a serious look at current policies as embodied in Basel III and ask whether they still suffer from the same problem we identified for Basel II. Our impression is that Basel III is an improvement, but that it doesn’t go far enough. Our model could be extended to model the financial system in more detail, including Basel III. Given that the Dallas Federal Reserve Bank has estimated that the financial crisis of 2008 cost the US between 6 and 14 trillion dollars (and it certainly cost the world a lot more), this seems like a project that deserves the relatively small amount of resources that would be required.”
You can read the full paper here.