Global Financial Systems: Stability & Risk

442 Pages·2013·32.678 MB·English

by  Jon Danielsson

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Global Financial
Global Financial Systems
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Stability and Risk
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Systems
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Jon Danielsson
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i Stability and Risk
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Under what circumstances have we achieved financial stability?
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Which previous crises inform the current ones and in what way? S
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What are the common themes and lessons for policy, regulation and financial theory?
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Global Financial Systems: Stability and Risk is an innovative textbook that explores the ‘why’ behind
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global financial stability, providing insightful discussions on the international financial system and the
Jon Danielsson
contemporary issues of today. Drawing on economic theory, finance, mathematical modelling and risk s

theory, this book presents a comprehensive, coherent and current economic analysis of the inherent
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instabilities of the financial system, and the design of optimal policy response.
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Key features y

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• Up-to-date and thorough analysis of the 2007/08 financial crisis.
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• Case studies and practical examples illustrate key arguments and apply the theory to the d
real world.
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• End-of-chapter questions provoke discussion and critical thinking, and provide i
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opportunities to test your understanding.
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• Accompanied by instructor resources including PowerPoint slides, plus an author-hosted

website featuring regular updates on current events in the global financial system and links D
to useful websites.
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Jon Danielsson is Reader in Finance and member of the Financial
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Markets Group at the London School of Economics and Political
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Science, and co-director of the LSE’s Financial Markets Group’s n
Systemic Risk Centre.
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Global Financial
SYSTEMS
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Global Financial
SYSTEMS
Stability and RiSk
Jon Danielsson
Director, Systemic Risk Centre
London School of Economics
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PEARSON EDUCATION LIMITED
Edinburgh Gate
Harlow CM20 2JE
United Kingdom
Tel: [phone]
Web: www.pearson.com/uk
First published 2013 (print and electronic)
© Jon Danielsson 2013 (print and electronic)
The right of Jon Danielsson to be identified as author of this work has been asserted by him in accordance
with the Copyright, Designs and Patents Act 1988.
The print publication is protected by copyright. Prior to any prohibited reproduction, storage in a retrieval
system, distribution or transmission in any form or by any means, electronic, mechanical, recording or
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Saffron House, 6–10 Kirby Street, London EC1N 8TS.
The ePublication is protected by copyright and must not be copied, reproduced, transferred, distributed,
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publishers, as allowed under the terms and conditions under which it was purchased, or as strictly permitted
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the author's and the publishers' rights and those responsible may be liable in law accordingly.
All trademarks used herein are the property of their respective owners. The use of any trademark in this text
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Pearson Education is not responsible for the content of third-party internet sites.
ISBN: 978-0-273-77466-2 (print)
978-0-273-77471-6 (PDF)
978-0-273-77467-9 (eText)
British Library Cataloguing-in-Publication Data
A catalogue record for the print edition is available from the British Library
Library of Congress Cataloging-in-Publication Data
Daníelsson, Jón.
Global financial systems / Jon Danielsson.
pages cm
ISBN 978-0-273-77466-2
1. International finance. I. Title.
HG3881.D3266 2013
332'.042—dc23
2013012036
10 9 8 7 6 5 4 3 2 1
16 15 14 13
Print edition typeset in 9.25/13.5 Stone Humanist ITC Std by 75
Print edition printed and bound in Slovenia by Svet Print – Ljubljana d.o.o.
NOTE THAT ANY PAGE CROSS-REFERENCES REFER TO THE PRINT EDITION
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conTEnTS
author’s acknowledgements xi
Publisher’s acknowledgements xii
introduction xiii
1 Systemic risk 1
1.1 Case study: the 1914 crisis 2
1.2 The concept of systemic risk 4
1.3 Who creates systemic risk? 9
1.4 Fundamental origins of systemic risk 11
1.5 Summary 17
References 18
2 The Great Depression, 1929–1933 19
2.1 Build-up to a depression 20
2.2 The Great Depression 25
2.3 Causes of the Great Depression 29
2.4 Implications for future policy 35
2.5 Summary 37
References 38
3 Endogenous risk 39
3.1 Millennium Bridge 41
3.2 Dual role of prices 43
3.3 Risk 46
3.4 Dynamic trading strategies 48
3.5 Actual and perceived risk and bubbles 53
3.6 The LTCM crisis of 1998 56
3.7 Conclusion 59
References 60
4 liquidity 61
4.1 The liquidity crisis of 1998 62
4.2 What is liquidity? 65
4.3 Liquidity models 70
4.4 Policy implications 73
4.5 Summary 75
References 76
v
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Contents
5 The central bank 77
5.1 The origins of central banks 78
5.2 Banking supervision 80
5.3 Monetary policy 82
5.4 Financial stability 86
5.5 Bailing out governments 87
5.6 Challenges for central banking 90
5.7 Summary 93
Appendix: central bank interest rate 94
References 95
6 The asian crisis of 1997 and the iMF 97
6.1 Building up to a crisis 99
6.2 The crisis in individual countries 102
6.3 Reasons for the crisis 106
6.4 Policy options for the crisis countries 109
6.5 Role of the IMF 112
6.6 Wider lessons 115
6.7 Summary 117
References 118
7 banking crises 119
7.1 Money and early banking 121
7.2 Moral hazard 123
7.3 Costs of banking crises 124
7.4 Causes of banking crises 126
7.5 Bank and banking system failures 128
7.6 Summary 134
References 135
8 bank runs and deposit insurance 137
8.1 Bank runs and crises 139
8.2 Modelling deposit insurance 142
8.3 Pros and cons of deposit insurance 147
8.4 Summary 149
References 150
9 Trading and speculation 151
9.1 Trading scandals and abuse 152
9.2 Trading and risk 154
9.3 Trading activities 156
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Contents
9.4 Policy issues 163
9.5 Summary 171
Appendix: basic terminology of trading 171
References 173
10 credit markets 175
10.1 Market for credit 176
10.2 Credit rating agencies 179
10.3 Credit models 183
10.4 Margins, haircuts and mark-to-market 185
10.5 Securitisation 188
10.6 Summary 191
References 191
11 currency markets 193
11.1 Fixed or floating 195
11.2 Foreign exchange interventions 197
11.3 Capital controls 200
11.4 Exchange rate regimes 203
11.5 Perils of overvaluation 208
11.6 Undervaluation and ‘currency wars’ 209
11.7 Reserve currency 210
11.8 Summary 212
Appendix: exchange rate regimes 213
References 215
12 currency crisis models 217
12.1 First-generation models 219
12.2 The Argentinian crisis 222
12.3 Second-generation models 224
12.4 The European crisis, 1992–1993 228
12.5 Global games currency crisis model 231
12.6 Summary 234
References 236
13 Financial regulations 237
13.1 Banking regulations 239
13.2 Bank capital 245
13.3 International financial regulations: Basel 250
13.4 Summary 257
Appendix: Value-at-Risk 257
References 259
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Contents
14 bailouts 261
14.1 Successful and unsuccessful bailouts 263
14.2 The historical origins of lending of last resort (LOLR) 265
14.3 What are bailouts? 267
14.4 Alternatives to bailouts 272
14.5 Bailouts in the crisis starting in 2007 273
14.6 Bailouts, moral hazard and politics 278
14.7 Model of asset bubbles 279
14.8 Summary 283
References 284
15 Dangerous financial instruments 285
15.1 Complexity kills 287
15.2 Derivatives 288
15.3 Credit default swaps 289
15.4 Collateralised debt obligations 293
15.5 Summary 301
Appendix A: mechanics of CDSs 301
Appendix B: CDO calculations 303
References 308
16 Failures in risk management and regulations
before the crisis 309
16.1 Regulatory failures 310
16.2 Capital and the crisis 317
16.3 Summary 323
References 323
17 The ongoing crisis: 2007–2009 phase 325
17.1 Build-up to a crisis 326
17.2 Hidden and ignored risk 330
17.3 The changing nature of banking 331
17.4 Crisis, 2007–2008 333
17.5 Was it a subprime crisis? 337
17.6 Policy response 338
17.7 Summary 339
References 339
18 ongoing developments in financial regulation 341
18.1 New and changed institutions 344
18.2 Basel III 348
18.3 Liquidity 352
18.4 How much capital? 356
viii
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