One of the issues with economic theory, at least parts of it, was that it assumed an efficient financial market. In a lot of these models, the transmission of monetary policy was frictionless as the concept of efficient market hypothesis meant that systemic frictions were impossible. Obviously this was completely obliterated by the recent financial crisis that is still showing its effects. A recent paper has provided an interesting and highly informative analysis of what went wrong in the financial markets in 2007 and 2008. These insights not only help us understand what happened in those turbulent months, but they also guide our focus on preventing the next financial crisis.
Valuable insights gained from a chronology of the financial crisis
Gary Gorton, Andrew Metrick and Lei Xie (hereafter GMX) used a sophisticated technique to test for breakpoints in panel data of money market series. By showing these breakpoints, they are able to piece together the chronology of the crisis and reveal that there was a build-up of risk during the crisis. This was followed by the shock of the Lehman collapse, which then was followed by more breakpoints in money markets.
To understand the evolution of the crisis in the US money market in 2007, a brief description of the various instruments is needed. From GMX:
- Repo involves providing specific collateral to depositors who are lending money. The collateral might be government bonds or privately-created “high quality” bonds, such as asset-backed securities. Depositors must agree with borrowers on the type of collateral and its market value, and then depositors/lenders take possession of the collateral.
- Commercial paper (CP) issuers are screened by the investors and rating agencies. Only high quality financial and nonfinancial firms can issue CP. CP does not have explicit insurance or specific collateral, but access to the CP market is reserved for low-risk issuers with strong credit ratings. Commercial paper (CP) issuers are screened by the investors and rating agencies. Only high quality financial and nonfinancial firms can issue CP. CP does not have explicit insurance or specific collateral, but access to the CP market is reserved for low-risk issuers with strong credit ratings.
- [GMX] also examine the two largest interbank markets, the London interbank market (the “Euro-dollar” or “LIBOR” market) and the U.S. federal funds market. In the LIBOR market banks deposit excess U.S. dollars with other banks, sometimes referred to as “Eurodollar deposits,” and earn interest at the London interbank offered rate (LIBOR).7 The Eurodollar or LIBOR market involves large global banks, which are monitored by their domestic bank regulators. The LIBOR and federal funds markets are unsecured, but both rely on screening and monitoring by bank regulators.
The chronology, via breakpoints, shows the signs of financial market distress
The timing of the major breakpoints in money markets is best captured by the following diagram from GMX, which shows the chronology of the crisis:
A different take on the exogenous nature of the financial shock
This diagram helps to illustrate an important point from GMX. The authors challenge the view that the crisis was caused by the failure of Lehman Brothers. In their analysis, the shock of the Lehman collapse was endogenous, as it came from the build-up of risk and fragility in the financial system – specifically, the increasing fragility in the money market at the time caused by the shortening of maturities.
In viewing the Lehman collapse as endogenous to a fragile financial system, a different perspective is gained on possible financial market regulation. While the Basel III rules on capital and liquidity (even with the recent softening of these rules) is a move in the right direction, the chronology spelt out by GMX shows that a shock in the financial system is unlikely to come without prior warning signs. Of course, one might argue that higher capital ratios and liquidity provisions should enhance the inherent stability of the financial system, but the targeted spotlight of regulators could also ensure a crisis is resolved before a shock takes place.
Regulators should stop any early signs of a financial crisis turning into a full-blown financial shock. Although the next financial crisis will not show the same presentation of events as the last one, these breakpoints in money markets provide warning signs that can and should be monitored.
The technique offered in this paper for assessing breakpoints is highly valuable, but I can’t help but also think about assessing financial and money market conditions with error correction models.
GMX chronicled the flight from maturity in the crisis, as industry participants tried to shorten maturities and re-create the ‘money-ness’ of their instruments. In normal times, money market instruments are essentially riskless, becoming like money. In these times, the spreads are all very low and the term structures are flat. In the crisis, these relationships did not hold.
Perhaps, therefore, this lends itself to an ECM approach, as the long run relationships are of low spreads and the ‘money-ness’ of these instruments. An ECM can capture these relationships and give insights into when the market is out of its long run equilibrium. Depending on the length of the time series, some event analysis could be used around times when these money markets were significantly out of their equilibrium. Perhaps there’s some interesting lessons to learn from this exercise.
 Gorton, G, Metrick, A, & Xie, L (2012). The Flight from Maturity.