Integrated Markets led to ‘Shocking’ Instabilities

Prior to the Crisis, it was thought that diversification of counterparty networks would work to reduce systemic risk in the financial system.

European Central Bank: The element that had been more unexpected in the current crisis is the rigour with which systemic risk has been triggered by the collective behaviour of financial institutions and the ways in which they interact in financial markets. The crisis has highlighted the importance of improving our understanding of interconnectedness in the financial system, both via the direct links between financial institutions and the indirect ones created in financial markets. 

The crisis has taught us that major risks can emerge from within the financial system itself. It was not the real economy that threw the financial system into disarray, but the reverse.  Endogenous risks – risks that emerge from within the financial sector – can have many causes. They may arise, for example, because large parts of the system rely on the same sources of funding, or because they have similar exposures – to rising financial imbalances, to currency mismatches and to widespread mis-pricing of risk.  We have also seen that turbulence can arise from relatively modest initial shocks. The system is so interconnected that what looks stable can turn out to be “meta-stable”, which means potentially highly instable. … 

The meta-stability of a system is a complex concept, which calls for analysis of the interplay between diverse phenomena. In financial systems, these phenomena include herd behaviour, complex networks of relationships between counterparties, and contagion from common or correlated exposures to particular asset classes. They also include the undesirable pro-cyclical effects of prudential rules, of accounting rules, of credit rating agencies, and of compensation systems that put undue emphasis on short-term earnings.[1]