Topic: The Anatomy of Systemic Risk
Speaker: Frank Milne, BMO Professor of Economics and Finance, Queen's University
Date: April 2nd, 2014 (Wed.)
Time: 1:00-2:30pm
Location: Building 4, Room 101
Language: English
Abstract:
This paper advances three innovations in systemic risk.
First, based on newly available data, the paper shows that systemic risk is generated by a small number of systemically important real sectors (“SIRS”) with identifiable characteristics. These characteristics drive SIRS volatility. Their existence permits an ex ante identification of the source and scale of emerging systemic risk.
Second, the paper shows that a complete model incorporating SIRS and risk can generate most of the key characteristics of a systemic crisis. This result contrasts with earlier models of systemic risk which rely on market imperfections to generate systemic risk. The scope for reducing the costs of systemic risk through policies to counter particular imperfections in actual markets is therefore limited. Unless tailored to specific imperfections, such policies risk introducing inefficiencies.
Third, with the introduction of uncertainty, the model produces all the major phenomena of a systemic crisis. The analysis explains why the standard reduced form risk models based on high frequency data from recent periods suffer high rates of Type II errors and failed to predict the financial crisis. The analysis points to a significant weakness in the Official Sector program of financial reform which relies heavily on the use of reduced form risk models. The program lacks an explicit requirement for real sector risk analysis as an essential component of credit risk evaluation. With a reliance on heavy capitalization to compensate for unidentified systemic risk, the reform will result in substantial over-capitalization relative to real risk for many banks, along with pockets of material under-capitalization in the operations of weak banks. This undercapitalization will remain invisible to the regulators and can threaten a systemic crisis.
About the speaker:
Professor Frank Milne is a BMO Professor of Economics and Finance at Queen's University. Professor Milne started his research career after he received his Ph.D. form Australian National University in 1975, and has been working at Queen’s University as a professor since July 1991. Professor Milne has held SSHRC research grants almost continuously since 1992, both as a primary investigator and as co-investigator. His research has been published in numerous academic journals, such as Journal of Financial Economics, Journal of Financial and Quantitative Analysis and Review of Economic Studies. He also has published three books in finance.
