Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Is there any such thing as macro-prudential risk?

I have been grappling with this question ever since reading The Fundamental
Principles of Financial Regulation
by Markus Brunnermeier, Andrew
Crockett, Charles Goodhart, Avinash D. Persaud and Hyun Shin. All the
authors are well respected economists; and Brunnermeier, Persaud and
Shin, in particular, have been among those whose writings I have
admired a lot during this crisis. Yet, I am not convinced about their
concept of macro-prudential risk as opposed to the micro-prudential
risk that traditional risk models are allegedly concerned with.

My problem is that at least since Markowitz, risk has always meant
portfolio risk. The riskiness of any asset is the contribution that it
makes to the portfolio in which it is held. For an equity portfolio,
therefore the risk of a stock is its covariance with the portfolio
which is the approximately the same as the beta if the portfolio is
highly correlated with the market portfolio. In a value at risk (VaR)
model for a credit portfolio, the marginal risk of a loan is equal to
its expected loss conditional on the total portfolio loss being equal
to the VaR level (see for example, Hans Rau-Bredow,
). This is true in particular of the Basel II models as well.

Brunnermeier et al are rightly worried about herding behaviour
where many banks hold similar portfolios and are thus exposed to the
same risks. But in this situation, each bank’s portfolio is
highly correlated with the aggregate portfolio of the banking
system. Thus Basel II and similar allegedly micro-prudential risk
models are in fact capturing the macro-prudential risk of each
loan. At this point, (following Brunnermeier et al) I am also ignoring
the technical inadequacies of the Basel II risk models. The question
being asked is whether conceptually they are addressing the right
risk. I think they are.

One of the problems I had with Brunnermeier et al is that they
seemed to be focused on the wrong conditional probability. They
frequently ask the question: conditional on a bank failing what is the
probability that there is a systemic crisis. They argue correctly that
this probability is higher for a bank with a AAA portfolio than for a
bank with a BBB portfolio. I think the correct question to ask is the
reverse conditional probability: conditional on a systemic crisis,
what is the probability that the banks in question fail. This
probability is higher for the bank with a BBB portfolio and this is
consistent with the Basel II risk weights.

At this point, it is also worthwhile to remember that the capital
required for a AAA loan is far in excess of its unconditional
probability of default. In fact, the unconditional probability of
default is the “expected loss” which in Basel II is
supposed to be covered by the credit spread and is not supposed to
come out of the capital charge at all. The capital charge deals
exclusively with the “unexpected loss” and is defined by
conditionalizing on a systemic shock.

In short, I think today’s risk models are conceptually
addressing macro-prudential risk because in any portfolio risk model
these are the only risks that matter. Whether they are measuring these
risks right is a totally different question (see my last
blog post

Brunnermeier et al have a long discussion about liquidity risk and
maturity mismatches as a macro-prudential risk. The example of
Northern Rock permeates this discussion. I think the diagnosis of
Northern Rock as a liquidity risk which seemed to make sense in 2007
(I was guilty of this diagnosis myself) has been invalidated by
developments in 2008. The silent run that banks like WaMu witnessed
have shown that there is no safety for a bank in retail deposits. Nor
is there safety in retail term deposits. All banks allow customers to
prematurely encash their term deposits with modest penalties. In bank
runs, people queue up to do exactly that as for example in the mini
runs that we had on ICICI Bank in India. The behavioural maturity of
core deposits is a meaningful notion in normal times; in periods of
crisis, the behavioural maturity is zero. In wholesale markets,
maturity is ill defined because of put and call features combined with
step-up coupons. Normal maturity assumptions about these bonds have
been invalidated during the current crisis. In short, maturity
mismatch is not a well defined term during a systemic crisis.

In this context, I am perplexed by the irrational fear of bank runs
among regulators and academics alike. We must not forget that frequent
runs and near runs are the principal defence that we have against
Ponzi schemes (both Madoff and Stanford were ultimately exposed by
runs on them). Solvent institutions with normal access to central bank
liquidity support can survive runs. Banks that cannot survive a run
despite the central bank liquidity window are fundamentally flawed;
they need to fail.


3 responses to “Is there any such thing as macro-prudential risk?

  1. Ritwik March 6, 2009 at 8:03 pm


    One reason for the conditional probability being considered by the authors may be the fact that the event ‘bank failure’ is much more well defined than the event ‘systemic crisis’. Hence, the attempt to figure out a systemic crisis from the knowledge of a bank failure.

    Also, bank runs are important for bursting Ponzi schemes, but Austrian economists have been arguing that the entire concept of fractional reserve banking is a huge Ponzi scheme! Bank runs are probably hated so much because they are supposed to be infectious and beyond a certain threshold even healthy banks may get hit badly and a spate of bank runs on banks that all have access to central bank liquidity may constitute a near-run on the central bank itself.

  2. unibet January 29, 2010 at 8:01 am

    Hi, It im sure your page does not viewed decently in ie6

    • Jayanth Varma January 29, 2010 at 8:34 pm

      Do you mean the odd line breaks? I have not been able to solve this problem as I write html code separately, validate it and then paste it into WordPress. WordPress converts every line break in the html code into a line break in the web page and I neither know why it does this nor how to solve the problem.

      Apart from this, I find the page renders OK in IE 8 and in Firefox 3.5. It also validates as valid xhtml and valid css.

      Any inputs that you have is most welcome.

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