An additional element threatening the stability of the global financial system was that virtually all of the leveraged Treasury bond investors had similar positions, including major financial institutions. Banks’ direct exposures may be an important aspect of financial instability in periods of financial market volatility. In addition, banks may hold significant exposures with non-bank financial institutions, which themselves suffer from direct market exposures. The Barings crisis in 1995 is an example of the first case, while the LTCM case is an example of the second. In my view, the eventual scale of a systemic crisis might depend on the magnitude of the deviation of asset prices from fundamentals. How, then, do asset price bubbles get created in the first place? They may be created or exacerbated by some form of herding and overly buoyant investor expectations, as groups of investors imitate leading institutions’ strategies. Bubbles may be further boosted by a lack of adequate disclosure, problems of conflicts of interest, and destabilising trading or investment strategies. Once bubbles burst, portfolio insurance strategies in the event of falling prices - or dynamic hedging might heighten the downward spiral. Particularly in earlier episodes of equity-driven financial instability, such as the 1987 stock exchange crash, the initial wave of the sale of equity futures appears to have resulted in an accelerated decline in stock prices. However, the jury is still out on the role of tools such as portfolio insurance or automatic trading rules in exacerbating aggregate financial risk.
When thinking about the major challenges for maintaining financial stability I find it useful to first look at the notion of how the “real world” deviates from the “frictionless” ideal world of academic textbooks. In order to organise my reasoning, this can serve as a useful starting point, since in the ideal world there is no such thing as financial instability. Indeed, most of the concerns over financial stability actually stem from the fact that our “real world” financial markets have frictions or - in other words market imperfections. A fundamental friction is that financial market participants very often have imperfect information. When information is not perfect - or when markets are not fully transparent - investors’ decisions may be constantly subject to reassessment, which can lead to inevitable volatility in market prices. This does not necessarily mean that there is an inherent threat to financial stability. On the contrary, the very existence of some level of volatility indicates that markets are serving the function they are supposed to deliver - that they are an efficient exchange mechanism among economic agents. Nevertheless, some recent episodes of extreme volatility have drawn our attention to more accurately delineating the boundary between “normal” and what could be called “harmful” volatility. The second source of friction is that we also fall short of the ideal of having complete markets.