What drives a financial crisis?

Lessons from the crisis of 1907 show that there are seven factors that can lead to a self-reinforcing system of financial failure. Are these factors at play in the current scenario?

Robert F Bruner

How did it come to this? The news from global credit markets has been discouraging for months. We have seen the sacking of CEOs of two financial behemoths (Merrill Lynch and Citigroup), a run on a bank (Northern Rock), and announcements of many billions in loan losses. To make sense of this drama, it helps to understand what drives financial crises. Sean Carr and I have used a detailed study of one crisis (the Panic of 1907) to offer a summary of seven prominent drivers.

Growth: Joseph Schumpeter argued that new inventions stimulate expansion, and eventually over-expansion. Sooner or later the markets will correct the mistakes that occurred during the expansions. These expansive periods are “hot markets”, incubators for financial crises. When markets are hot, there is a sharp increase in trading activity, talk of a “paradigm shift”, entry by inexperienced players rising prices, aggressive financing, and so on. During hot markets, decision-makers are prone to make bigger mistakes.

Complexity: This may be related to growth. But the macro economy evolves with more complexity that makes it hard for depositors and investors to know what is going on. Complexity is reflected in factors such as the expanding size and scope of the economy, technological change, and growing demographic diversity. The problem with complexity is asymmetric information, the imbalance within and among investors about what is known.

Inflexibility: Inflexibility refers to the absence of sufficient safety buffers or cushion against shocks. A systems engineer would call this “tight linkage”. Parts of a system are linked. Such linkage is “tight” where there are few firewalls or safety buffers. Trouble can spread rapidly. In financial systems, inflexibility could refer to the insufficiency of reserves of cash to meet the withdrawal demands of depositors or of capital to absorb loan losses.

Cognitive biases: Behavioural economists such as the Nobel prize-winner, Daniel Kahneman, have documented cognitive biases in markets, such as over-optimism, over-pessimism, deal frenzy, failure to ignore sunk costs, and so on. Cognitive biases prevent rational action and prevent leaders from being mentally prepared for trouble.

Adverse leadership: Leaders do things advertently or inadvertently in the advance of crises that elevate risk—they may say or do things to promote speculation, increase the uncertainty of investors, and/or amplify cognitive biases.

Economic shock: The sixth driver of crises is some kind of real economic shock that spooks depositors and investors. Each crisis has a trigger of some sort. Trouble breaks out and spreads rapidly—the trouble could be a natural disaster (such as a massive earthquake, 1906), a sovereign default (such as Russia, 1998), or the onset of a major war (1914). A “shock” must be real (not cosmetic), costly, unambiguous, and surprising.

Collective action: Seventh, the depth and duration of every crisis is affected by the quality of leadership in organizing collective action. People can behave in ways that promote individual welfare, but worsen societal welfare. The prime example would be the rush to withdraw funds from a bank during a panic—such behaviour, while individually sound, may produce a self-fulfilling prophecy of bank failure.

Inadequate collective action leads to inappropriate responses, for example: delay, overreaction (creating other problems), unethical behaviour (such as acting in one’s self-interest rather than in the interest of the community) and infighting (due to old operating rivalries, cultural differences, or misunderstandings).

These seven factors constitute a system of failure. Rapid growth, complexity, tight linkage, cognitive biases, and adverse leadership create a medium of confusion and propagation. A shock occurs, followed by poor response, poor results, more confusion, propagation of the problems, and so on. This is the pernicious self-reinforcing downward cycle.

The current financial crisis illustrates these factors:

1. Growth: Indeed, the global economy has been growing rapidly for years.

2. Growing complexity: Globalization creates more complexity, especially with the increase in sheer scale and scope of markets and players. And we have seen increasing complexity in financial markets, institutions, and instruments.

3. Tight linkage: The relatively high consumer indebtedness in the US, and the aggressive use of leverage by hedge funds, private equity firms, and specialized investment vehicles bespeak a reduction in the ability to absorb financial shocks.

4. Cognitive bias: Some analysts point to astonishing price increases in the US and elsewhere in real estate. Some analysts suggest that the dramatic increases in the equity indexes in India and China reveal a “bubble” of optimism.

5. Leaders elevate risk: The recent sackings of CEOs at UBS, Merrill Lynch, and Citigroup were associated with adventures into the risky subprime loan market. Alan Greenspan has been criticized in recent months for the expansive monetary policy pursued in the 2002-2005 period.

6. Real shock: The obvious candidate is the surprising rate of default on home mortgage loans in the US that emerged starting in late 2006.

7. Collective action: Central banks have shifted sharply from restrictive to expansionary monetary actions. One group of major banks is trying to organize a private market source of liquidity in subprime loans.

It seems likely that this crisis has longer to run. Any crisis will ricochet through the global financial system like a billiard ball on a table. Eventually it will come to rest, but until then will perturb other players and perhaps knock some into the pockets. Watch for active intervention by central banks. Watch for failures of institutions—those that are most highly-levered, are poorly diversified, and/or poorly managed are the most vulnerable. Watch for efforts at collective action by the central banks or private groups.

While we are in for a period of turbulence, ultimately I am cautiously optimistic. Financial crises tend to run their course within 12 to 18 months. Therefore, as long as you are invested in sound assets and can afford to be patient, the best advice is to wait out the crisis. Above all, whatever happens in the capital markets, don’t panic!

This article draws on insights developed in the book, ‘The Panic of 1907: Lessons Learned from the Market’s Perfect Storm’ by Robert F Bruner and Sean D Carr