In this respect, the relationship between hedge funds and their prime broker-dealers will be of special interest.
The fourth assessment to be made involves hedge funds’ potential for herding behavior. It will be determined whether hedge funds are theoretically prone to herding, and if so whether the data on herding behavior of hedge funds support the theory. The concept of contagion and contagion channels will also be covered while studying the TITF and herding behavior in the hedge fund industry.
economy.3 Thus, a systemic risk, event, or crisis is defined as a financial risk or event which ultimately affects the real economy.4
According to the working definition offered by the Group of Ten, “[s]ystemic financial risk is the risk that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainty about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy.”5 Therefore, a financial rupture or unease which does not have a high probability of causing a disruption in the real economic activities is not considered a systemic risk. The adverse effects of systemic risk appear in the disruptions of payment system, the disruption in credit flows, and the collapse of asset prices.6 The emphasis on the disruptions in the real economy is due to the fact that financial disruptions can affect the level of output of the real goods and services and hence result in massive unemployment. Therefore, the key to understanding contagion and systemic risk is to comprehend the notion of financial risk transmission.7
One of the crucial concepts intricately related to identifying systemic risk is the concept of contagion within the financial system and between financial system and the real economy.
Contagion which lies at the heart of this definition of systemic risk refers to “the mechanisms through which shocks propagate from one element of the financial system to another and from the financial system to the real economy.”8 One of the factors contributing to contagion is
3 Dijkman, A Framework for Assessing Systemic Risk, pp. 5-8.
4 See Kambhu, Schuermann and Stiroh, Hedge Funds, Financial Intermediation, and Systemic Risk, pp. 8-9.
To better understand the concept of systemic risk, it should be put in the context of the main objectives of a financial system. The financial intermediation and financial system as a whole is to channel funds from surplus spending units (individuals and households) to deficit spending ones (firms). If an event or shock can affect this process, it is considered as a systemic event or shock. Needless to say, the shocks to this process will deprive the firms from access to credit and will have negative impact on the real economy. For a similar view, see Schinasi, Safeguarding Financial Stability: Theory and Practice, pp. 77-97.
5 Another definition of systemic risk offered by the Group of Ten is: “a systemic financial risk event can be viewed as a shock whose impact and transmission effects are wide and deep enough to severely impair, with high probability, the allocation of resources and risks throughout the financial and real economic systems.” See Group of Ten, Report on Consolidation in the Financial Sector (Basel, Switzerland: Bank for International Settlements, 2001), pp. 126-127.
6 The report continues to mention that the systemic risk “[P]erhaps induced by a drastic decline in the aggregate money supply caused by bank runs or by a general decline in the liquidity of financial markets, may induce failures of financial as well as non-financial firms and households, and decrease economic activity through a decline in wealth and an increase in uncertainty.” Ibid.
7 For a more detailed study of contagion, see Robert W. Kolb, "What is Financial Contagion?" in Financial Contagion: A Viral Threat to the Wealth of Nations, ed. Robert W. Kolb (Hoboken, New Jersey: John Wiley &
Sons, Inc., 2011), 3-10.
8 Dijkman, A Framework for Assessing Systemic Risk, pp. 5-8.
incomplete information. When a shock occurs in one sector of the financial industry, it may serve as a signal of a coming shock in another sector. In other words, the crisis in one sector may create self-fulfilling prophecies of a crisis in another sector.9 Accordingly, a new shock may change the interpretation of the existing information in the market. Such a reassessment of information can materialize in various forms such as herd behavior, informational cascades, or sudden reappraisal of economic fundamentals.10
Scholars distinguish between real and information contagion channels. On the one hand, contagion through real channels refers to “the direct “knock-on effects” on other parts of the financial system through direct exposures (such as counterparty exposures) and interconnections (such as through payment systems).” On the other hand, “contagion through information channels occurs when economic agents (including counterparties, investors, and depositors) change their behavior in response to a particular event.”11 For example, contagion through information channels happens when a particular bank is in financial distress. In such cases, creditors and investors of that bank would start thinking about the linkages of the bank with other banks having similar business models, or about potential counterparty risks of similar banks towards the bank in distress. This very speculation about the soundness of the bank caused by a shock posed by another bank will worsen the financial outlook of other banks interconnected with the bank in distress. A bank with deteriorated outlook might have difficulty in raising capital due to its need to pay higher interest pursuant to a possible downgrade by a rating agency.
9 Xavier Freixas, Bruno M. Parigi and Jean-Charles Rochet, "Systemic Risk, Interbank Relations, and Liquidity Provision by the Central Bank," Journal of Money, Credit and Banking 32, no. 3 (2000), 611-638.
10 Dijkman, A Framework for Assessing Systemic Risk, pp. 5-8.
Nevertheless, some scholars do not agree on the element that for an externality to be a systemic, it needs to afflict the real economy. In their view, systemic event means “many institutions […] experiencing troubles at the same time”. In this view, for a risk to be systemic, the timing of its happening and the state of the economy at its happening is crucial. See Wagner, In the Quest of Systemic Externalities: A Review of the Literature, p. 96.
Acharya has a similar approach in defining a systemic event. According to Acharya “A financial crisis is “systemic”
in nature if many banks fail together, or if one bank’s failure propagates as a contagion causing the failure of many banks.” Viral V. Acharya, "A Theory of Systemic Risk and Design of Prudential Bank Regulation," Journal of Financial Stability 5 (2009), p. 224.
Daveis associates systemic risk with the disruption of the payments mechanism which undermines the capacity of the financial system to allocate capital. He adds that such patterns should be distinguished from turning-points in the trade cycles, and the theories of the monetary transmission mechanism. See Daveis, Debt, Financial Fragility, and Systemic Risk, p. 117.
11 Dijkman, A Framework for Assessing Systemic Risk, p. 6.
The importance of this distinction in studying the systemic risk is that while the contagion through direct channels can be assessed ex-ante, the contagion through information channels is by far difficult to predict and asses ex-ante and hence it is difficult to contain it.
In addition, timing and situational factors prevailing in the market at the time of the shock can play an important role in determining whether a risk can have systemic implications or not. The overall reaction of the financial markets to specific risks hence depends on factors such as the prevailing market sentiment, the state of the real economy, the resilience of the financial institutions, and the responses by the financial policymakers. Therefore, the systemic relevance of a shock or an event is not a static concept. On the contrary, as Dijkman concludes “in as far as contagion effects arising from direct exposures and interconnections are amplified by contagion through the information channel, systemic risk is driven by circumstances. Put differently:
whether a crisis affecting a certain financial institution is systemic or not depends to a large extent on the circumstances under which the crisis occurs.”12
1.1. Causes of systemic risk
Asset liquidations and especially forced liquidations in the aftermath of a shock can generate systemic risk and contribute to financial instability. The mechanism works through the price system and it is substantially similar to the pecuniary externalities. Nevertheless, the impact of these externalities goes far beyond the collapse in asset prices. They further affect the real output of a given economy. There are two reasons why plummeting asset prices may cause systemic externalities.
First, borrowing constraint is the main reason which can explain why plummeting asset prices can lead to a liquidity crisis and negatively affect other institutions with relatively safe assets in their portfolio. Due to regulatory or transactional constraints, such as assets needed as collateral, a firm’s debt capacity is a function of the amount and the value of the assets that the firm holds.13 The collapse of the asset prices of a firm affects the debt capacity of that firm. Furthermore, by
12 Ibid.
13 Indeed, collateral requirements add additional constraints on the capacity of a firm to take on debt/leverage. Since most loan agreements are in the form of secured transactions which are collateralized, the financial institutions entering into these contracts have constraints on their ability to take on leverage. Almost the same collateral requirements in secured transactions apply to the interbank repo market.
limiting the debt capacity of the firm, plummeting asset prices can interrupt the future plans and even the daily operations of the firm.14
The second reason that a shock which causes asset price declines can have systemic implications and contribute to financial instability is the inelastic demand for assets. Suppose a bank wants to liquidate its assets to meet its regulatory capital adequacy requirements (CAR). If the demand for those assets is elastic, namely, if subsequent to a price decline, there is a more than proportional increase in the demand for the assets and vice versa, the prices will be in new market equilibrium. However, if the demand for assets is inelastic, the asset prices will plummet with a less than proportional rise in the demand to cover the price decline. This in turn contributes to further price declines. This falling price may in turn generate additional rounds of selling, further pushing the prices downwards.15
In this case, the value of assets is determined by the amount of liquidity in the market. In Allen and Gale’s ‘liquidity-based approach’ to financial crises, the central idea is that in incomplete markets, financial institutions may be forced to sell their assets to maintain liquidity.16 As mentioned above, because of the inelasticity of the supply and the demand for liquidity in the short-run, a small degree of aggregate uncertainty can cause large fluctuations in asset prices.
Under this circumstance, the opportunity cost of holding liquidity is substantially high and the only way to bear the high costs of holding liquidity is by buying assets at fire-sale prices.
Therefore, the private provision of liquidity will not be adequate enough to sustain asset price stability and asset price volatility will follow small shocks in the financial markets. Because of
14 It should be noted that in normal market conditions, the fire sales might not contribute to a liquidity crisis. On the contrary, in these times the sale of assets by an individual bank due to illiquidity may create buy opportunities for other banks. Namely, the situation of fire sale in normal market condition may create a zero-sum game in which the loss of one party constitutes the profit of another party. In addition, it is demonstrated that banks’ future expectations of obtaining greater rents following the failure of a competitor makes banks’ speculative lending decisions strategic substitute. This means that if some banks are making speculative loans which are risky and may contribute to their failure, others will hold back and will not do so. In other words, other banks may engage in strategies and activities that can offset the effects of the speculative lending. This means that such activities are strategic substitutes. These counterbalancing activities, if accompanied by an active merger policy allowing the takeover of the failed businesses by survivors can reinforce stability and reduce systemic banking crises. See Enrico C. Perotti and Javier Suarez,
"Last Bank Standing: What do I Gain if You Fail?" European Economic Review 46, no. 9 (2002), pp. 1617-1618
15 Ilhyock Shim and Goetz von Peter, "Distress Selling and Asset Market Feedback," Financial Markets, Institutions and Instruments 16, no. 5 (2007), 243-291. See also Antonio Bernardo E. and Ivo Welch, "Liquidity and Financial Market Runs," The Quarterly Journal of Economics 119, no. 1 (2004), 135-158.
16 Franklin Allen and Douglas Gale, "From Cash-in-the-Market Pricing to Financial Fragility," Journal of the European Economic Association 3, no. 2Ǧ3 (2005), 535-546.
this volatility, banks will not be able to meet their liabilities, and a banking crisis would ensue.17 That might very well explain why the Central Bank intervention to inject liquidity in the market and to prevent the collapse of asset prices can be a Pareto improvement.18
Systemic risk and ensuing financial crisis might have wealth effects on the investors. It might further decrease their propensity to take risks and make them more risk averse than they otherwise would be in normal market conditions. This risk aversion accelerates the velocity of liquidation in the market in distressed times partly because of the “race for liquidity”19 on the part of risk-averse investors. Needless to say, these liquidated positions can amplify the original shocks and exacerbate the liquidity crises.20
As stated earlier, systemic risk is generally defined as a risk whose effects are not limited to financial system, but spill over to the real economy. There are at least three systemic risk spillovers to the real economy. First, firms financed by failing banks may suffer severely if the bank failures are correlated. Under such a circumstance, since industrial firms cannot roll-over their debt, they may be forced to forego the opportunities that they might otherwise have taken advantage of. Secondly, bank failures may cause knock-on effects on the economy if there is a chain of one financial institution’s output used as another financial institution’s input. And thirdly, the disruption of the payment system might be another cost of the systemic risk spilling over to the real economy.21