SUMMARY - The Illusion of Control - Jón Daníelsson

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Here is a summary of the key points:

  • Banking systems are vulnerable to bank runs and issues stemming from fractional reserve banking.

  • Under fractional reserve banking, banks lend out most deposits, expanding the money supply but making individual banks illiquid.

  • If depositors lose confidence in a bank's solvency, they may engage in a "bank run" where everyone tries to withdraw funds at once, which can collapse the bank.

  • Bank runs were a major factor in the Great Depression, devastating the money supply and exacerbating the economic crisis.

  • Banking crises generally emerge after periods of easy credit fuel excessive risk-taking and bubbles that eventually burst, though some were caused by corruption in rare cases.

  • The vulnerabilities of fractional reserve banking and potential for bank runs make the banking system prone to crises stemming from loss of confidence.

    Here is a summary:

  • Banking crises can occur due to various triggers like individual bank problems spreading via fractional reserve banking vulnerabilities, wars, natural disasters, or disastrous policies as seen in Venezuela currently.

  • Individual bank failures or runs can cascade into broader systemic issues when the banking system is under stress due to banks lending out most deposits and relying on confidence.

  • Effective deposit insurance like the FDIC has helped prevent bank runs and promote financial stability in some countries. However, issues can still emerge if banks take on too much risk or become overly interconnected as seen in the 2008 global crisis.

  • Bank regulations aim to promote stability but regulators face challenges of enforcing rules given complex financial systems and banks' strategic responses to try and circumvent rules. Strong oversight is needed of both banks and regulators.

    Here is a summary of the key points about increasing risks prior to the 2008 crisis:

  • Risk models and measurements tended to show low risk levels in the years leading up to the 2008 financial crisis, providing a false sense of security.

  • Factors like historically low volatility, increased complexity of financial products, and rising debt levels were not properly accounted for in many risk assessments.

  • During periods of prolonged stability and growth, markets tend to take on more risk as perceptions of risk decrease. This dynamic can fuel asset bubbles and excess leverage.

  • Minsky's financial instability hypothesis theorizes that banking crises are often preceded by periods where risk levels appear low but risks are actually building up underneath due to shifting risk perceptions over the economic cycle.

  • Empirical evidence supports a relationship between unexpectedly low volatility and higher odds of subsequent financial crises, as this signals declining risk assessments that encourage over-borrowing and speculative behavior.

  • The limitations of risk models in accounting for changing risk conditions, uncertainty, and rare but extreme events made accurate crisis prediction difficult prior to 2008.

    Here is a summary:

  • While risk measurement tools like value-at-risk (VaR) can be useful for monitoring risks, they have limitations and can be easily manipulated if not used properly.

  • Models are inherently backward-looking since they rely on historical data, but risks evolve over time. They may fail to capture "tail risks" of low probability but severe events.

  • Banks have incentives to minimize measured risks to reduce capital requirements, rather than focusing on actual risks. They can achieve this by selective model usage and portfolio construction.

  • The cat-and-mouse game between traders seeking riskier positions and risk managers aiming to rein them in leads to ongoing attempts to exploit loopholes in models or understandings. True separation is difficult.

  • Overreliance on risk metrics by regulators created moral hazard, as banks took on risks without sufficient capital buffers. Metrics became less reliable under pressure to portray lower risks.

  • For riskometers to be useful, their limitations must be clear and models continuously updated as conditions change. But they are not substitutes for prudent risk management and oversight of incentives.

    Here is a summary of the key points:

  • Macroprudential regulation aims to promote financial stability by addressing systemic risks in the financial system, but it faces many challenges.

  • There is no consensus on its precise objectives or how to implement policies effectively given the evolving nature of financial systems. Countries and organizations have varying approaches.

  • It has to deal with procyclicality and potentially use "tools" like limiting credit growth or reserves, but with limited understanding of how and when each tool works best.

  • Systemic risk is difficult to measure accurately given infrequent crises and changing conditions. This limits the ability to calibrate macroprudential policies in a timely manner.

  • While real estate bubbles are a focus, macroprudential tools can only address symptoms, not underlying causes influenced by other policies.

  • Politics also poses challenges, as restrictions aimed at stability can face public backlash, and democratic processes make preemptive action difficult.

  • Overall, macroprudential regulation is still a work in progress, with open questions around objectives, implementation approaches, and navigating political realities. Effectively adapting to evolving risks remains challenging.

    Here is a summary of the key points made in the passage:

  • Current macroprudential regulatory frameworks struggle to account for political risk, even though political factors often drive systemic risk and financial crises. Macroprudential policy can be undermined by political influences and lobbying.

  • Central banks face challenges enacting macroprudential policy in a way that is not seen as politicized, since they derive their authority from political systems. It is difficult for regulators to publicly anticipate or contain crisis risks with political origins.

  • Relying solely on macroprudential tools to prevent financial crises is misguided given their inherent politicization. Political realities mean macroprudential rules may not be effective countercyclical buffers when needed most during crises.

  • When analyzing non-bank sectors for systemic risk, regulators tend to apply a banking lens (e.g. focusing on capital levels) even though risks may be different. This can lead to unnecessary regulatory burdens without increasing financial stability.

  • Macroprudential policy risks being procyclical rather than countercyclical due to issues like difficulty accurately measuring risks in real time, lagged policy responses, and political pressures exacerbating procyclical behaviors.

  • Overall, the passage casts doubt on the ability of macroprudential policy alone to ensure financial stability, given political influences on rule setting and implementation as well as challenges identifying systemic risks across sectors in a timely manner. More research is still needed.

    Here is a summary of the key points:

  • Financial stability should not be the sole goal of regulation - it must also promote economic growth and efficiency. An overly stable system could stifle innovation.

  • Risk measurement tools like 'riskometers' provide a false sense of comfort by oversimplifying complex risks. They often fail to capture long-term threats like crisis risks.

  • Regulations should address 'endogenous risks' like excessive leverage and moral hazard, not just react to past triggers. Underlying vulnerabilities need to be reduced to prevent future crises.

  • Diversity within the financial system promotes stability by allowing different reactions that counterbalance each other rather than amplifying shocks. Uniformity increases systemic risk.

  • National banking systems concentrate lending among a few large banks, increasing risks. Market-based systems like in the US promote more diversity and competition which supports innovation and resilience.

  • regulatory approaches must balance stability, growth and innovation to achieve long-term benefits for the real economy at a reasonable cost to society. Short-termism should be avoided.

    Here is a summary of the key points:

  • Jón Daníelsson argues for an endogenous risk hypothesis that views risk as something created within the financial system itself through feedback loops between perceptions, actions, and outcomes, rather than being entirely external.

  • Models that assume risk is exogenous fail to account for how participant actions informed by those models can end up changing the underlying risk over time. This endogenous nature of risk poses challenges for modeling and policymaking.

  • Attempts to measure and manage risk can inadvertently increase risk through unintended consequences as participants strategically respond to regulations and policies.

  • Daníelsson advocates considering risk as emerging dynamically from within the financial system, rather than seeing it as fixed and outside the system. This endogenous risk perspective offers an alternative to standard external risk views underlying most models.

  • The key point is that risk is shaped endogenously by the financial system and actions of participants in response to models, regulations, and policies, rather than existing independently outside the system. This dynamic nature of risk is important for risk assessment and policymaking.

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