The global financial crisis of 2007/8 has highlighted the intertwined nature of financial systems. The emergence of financial instruments in the form of credit default swaps, collateralized debt obligations, and other credit derivative products vastly increased the connectivity between financial institutions worldwide. The heavy reliance of many of these institutions on short-term wholesale funding markets resulted, moreover, in a dramatic increase in rollover risk at a system level. What initially began as a localized difficulty in the US sub-prime mortgage market rapidly escalated beyond the United States once some financial institutions were found to be in difficulty, investors became wary of lending to each other and interbank markets quickly froze, pushing many banks and other financial intermediaries into difficulty.
Figure 1 illustrates how the arrival of news of losses at troubled hedge funds, downgrades of structured financial products, and concerns about asset quality increased funding pressures on all banks. These changes was not gradual but abrupt and sharp. Before the crisis, banks required some 10 basis points of compensation for making one-month loans to each other. By September 2007, that compensation premium had risen to around 100 basis points. The ensuing collapse of the investment banks Bear Stearns and Lehman Brothers in 2008 resulted in the premium rising more than thirty-fold from pre-crisis levels.
Not with standing the subsequent large-scale public sector bailouts of the banking system in many countries, it has taken over 12 months since the troubles at Lehman Brothers for this premium to return to pre-crisis levels. The compensation premium for three and six month loans followed a similar pattern, spiking after the collapse of Lehman Brothers. However, their return to pre-crisis levels has been more prolonged.
The global scale of the breakdown in the interbank markets has been without precedent and poses challenges for our understanding of systemic risk. The rollover decision of banks in short-term debt markets is typically modeled as a coordination game between lenders involved with a single, risky, counterparty. As Morris and Shin (2003, 2008) point out, when market participants have imperfect common knowledge of fundamentals, strategic uncertainty about the actions of other participants can be more important than structural uncertainty concerning the soundness of balance sheets. In such global games, the arrival of bad news about a debtor’s balance sheet causes small seeds of doubt to reverberate across all lenders, leading potentially to a mass withdrawal of lending which forces the bank into early liquidation.
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Rollover risk, network structure and systemic financial crises
