Hot Topics: Network Liquidity Failures of 2008: Did counterparty risk matter and will it count in the future?

Was the financial crisis of 2008 a one-off event, or the result of a flawed financial system desperately in need of reform? Whilst academics generally agree that a run on financial institutions occurred in the autumn of 2008, there are differing views as to the cause of the financial crisis and therefore differing opinions as to what prescriptive measures regulators should introduce to prevent future recurrence.

SWIFT Institute interviewed renowned academics Darrell Duffie, Dean Witter Distinguished Professor of Finance at Stanford University’s Graduate School of Business, and Peter J. Wallison, Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute, regarding their differing perspectives on network liquidity effects.

Both Duffie and Wallison agree that during the last financial crisis there were three main channels through which network effects were felt: counterparty risk; a run on liquidity; and fire sales. It is surrounding the important question of counterparty risk and capital requirements, however, that disparity arises between their respective views.

Darrell Duffie is of the opinion that the new regulations regarding capital and liquidity requirements are a step in the right direction. When questioned on whether he believed the newly required internal liquidity constraints would pose a negative knock-on effect on market liquidity, Duffie observed that the capital requirements are ultimately intended to improve overall liquidity and he firmly believes that they will eventually have a net positive effect. He suggested, “there’s going to be an adjustment period, but I think financial institutions are going to have to learn to accommodate these demands for higher capital and liquidity. These will hurt their shareholders, which is unfortunate for them, but this is not a key concern of the regulators ultimately looking to achieve financial stability.”

Conversely, Peter Wallison disagrees that new capital requirements were necessary. He does not believe that the lack of liquidity standards in 2008 was the ultimate reason for the failure of financial markets. He outlined his belief that 2008 was a rare event, provoked by the US government housing policies that fostered the growth of subprime mortgages in the United States, almost $2 trillion of which were held by the world’s financial institutions through mortgage-backed securities. The subsequent ‘mortgage meltdown’, combined with write-downs by financial institutions of mortgage-backed securities required by mark-to-market accounting created a ‘common shock,’ causing a run on financial institutions after Lehman’s bankruptcy. These were the real causes of the financial crisis of 2008. By focusing on attempting to insulate financial institutions from failure by reforming capital or liquidity standards, regulators now run the risk of exacerbating the lack of liquidity within financial markets. Wallison explained, ‘I think what happened in 2008 was a unique event, not to be repeated again within any reasonable period of time. The last similar event was 100 years ago—the Panic of 1907. It’s a mistake to configure the financial system for an event of remote probability.’

Whilst the regulatory focus is on counterparty risk, the degree to which it affected the recent financial crisis is up for debate. Counterparty risk describes a situation whereby a financial institution or other party cannot meet its contractual obligations, resulting in other institutions suffering a loss and being thereby weakened. This might lead them in turn to default on their respective obligations; a scenario which could then propagate through the financial network. Wallison takes the view that counterparty risk, also called ‘interconnectedness’, was not a significant factor in 2008 and demonstrates the weakness of the interconnectedness argument. He claims that he does not know of a case in which counterparty risk caused another financial institution to fail after the collapse of Lehman Brothers. He agrees that a money market fund, the Primary Reserve Fund that was holding Lehman commercial paper, was affected but suffered relatively small loses of only a few cents on the dollar. Wallison describes the event: ‘In the panic environment at the time, the Reserve Fund’s problem caused a run on other similar funds. But that is all. Odd events like that happen in panics, but thankfully panics are extremely rare.’

Darrell Duffie conversely feels that money market funds have thus far avoided sufficient regulatory treatment and should be included in forthcoming regulations in order to contain counterparty risk. He points out that the panic caused by the Primary Reserve Fund at the time was only stopped by the US Treasury’s offer of a guarantee to all money market funds, explaining, ‘a run was caused on all prime money market funds, even to the extent that there was a danger of impact on the tri-party repo market, which is system-critical plumbing. There was a further impact simply though heightened uncertainty. That was a very, very dangerous event.’ Duffie questions the wisdom of allowing government bailouts to be the only mechanism available to stop these effects from spreading, declaring, ‘the fact that they didn’t actually propagate doesn’t mean that they wouldn’t propagate in the absence of government guarantees.’

Whilst the degree of consensus by academics over the definition of network liquidity and its effect on financial crises may draw closer over time, the regulators will in the meantime continue their attempts to pound out the pockets of risk within the financial system to the chagrin of financial institutions worried about the cost of compliance. Going forward it could be argued that better understanding is needed regarding the liquidity-orientated run features of financial markets in order to generate more effective regulation, and at the same time provide less of a bitter pill for financial institutions to swallow.

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