The financial stability puzzle

Several indexes have emerged in recent months, designed to warn investors about increases in systemic risk. But these products could, in some instances, worsen the problem, argues Barry Schachter

On November 29, Bank of America Merrill Lynch announced the creation of a systemic risk index. It is meant to measure market vulnerability to shocks and possibly provide clients with some advance warning of conditions that could be associated with a crash. This index is just one of a variety of recently developed investor tools and strategies for avoiding or mitigating losses from the next market crash – State Street unveiled something similar on October 14, for example. The irony is these tools may actually increase systemic risk.

What goes on in the minds of investors is a central element in the complex dynamics contributing to a market crash. Many investors who had never heard of systemic risk prior to 2007 will now have visions of economic Armageddon at the sound of those words. These reactions influence trading behaviour.

The financial crisis has highlighted the need to rethink our assumptions about the dynamics of investor behaviour (among other things), and has drawn more attention to explanations of sometimes discontinuous market price dynamics derived from behavioural finance and complex systems theories. The key aspects of investor actions in such theories are limited rationality, adaptive behaviour and positive feedback effects.

Limited (or bounded) rationality is a term used to describe a wide variety of investor behaviour, documented through various methods, but most notably through experimental laboratory studies. Some of the behaviour is referred to as cognitive bias, reflecting limitations in our ability to fully and accurately process all the information presented by a situation.

One such cognitive bias is the problem of accurately estimating the likelihood of low-frequency events. This bias has multiple manifestations, but the one of interest here is a tendency to overestimate the probability of low-frequency events when they have been experienced recently by an individual.

Mark Twain warned against the effects of this bias: “We should be careful to get out of an experience only the wisdom that is in it – and stop there, lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again – and that is well, but also she will never sit down on a cold one any more.”

Adaptive behaviour by investors arises in cases of limited rationality. Because investors aren’t sure of the optimal set of decision rules, they revise their investment strategy over time based on their experience (and observation of the experiences of others). In fact, in a world of investors with limited rationality, anyone who won’t adapt meets the definition of insanity attributed by legend to Einstein – namely, doing the same thing over and over again and expecting different results.

Positive feedback can be a potent force. It acts to amplify the direction of movement of a process. Synthetic portfolio insurance strategies, which may have been a contributing factor in the 1987 stock market crash, exhibit a form of positive feedback by requiring the insurance provider to sell more of the reference index with each incremental fall in stock prices.

In a world with limited rationality and adaptive behaviour, the introduction of a new investment tool or source of information can affect the strategies followed by investors. The revised tactics can conceivably embed positive feedback effects enabled through the new tool or source of information.

If, as a result of the ‘hot stove lid’ effect, investors are, by virtue of their cognitive biases, willing to commit to new strategies they expect will protect them from adverse market outcomes, the dynamics of the market may differ from what has been observed previously – and, under some circumstances, deviate in ways that increase systemic fragility.

For instance, if one systemic risk index passes its crash warning threshold, investors will take note. Irrespective of whether the signal is a true or false one, some may think it prudent to cut equity exposure. These individual actions, occurring simultaneously, may result in a drop in equities and a blip in volatility. At this, other investors may react, seeing confirmation of the signal. The resulting market dynamics might trigger warnings from other systemic risk indexes, encouraging more investors to flee equities. The ultimate result might be the very crash that investors wish to avoid, partly induced by the positive feedback channel created by this information.

On October 6, one week before the unveiling of the State Street index, the US Financial Stability Oversight Council published a set of questions as a first step towards setting criteria for determining which non-bank financial companies pose a threat to systemic stability. However, important factors contributing to systemic risk may not be easily associated with answers to questions about individual companies.