Stability and vulnerability in financial markets

In a globalised economy, as financial institutions around the world have become more connected, the financial system itself has become simultaneously both more stable and more vulnerable, Nobel Prize-winning economist Robert Merton said in a recent public lecture at NUS Business School.

“As they get more connected that’s not necessarily bad, but it tells us potentially that there is a greater vulnerability”, he said at the event organised by the Centre for Asset Management Research and Investments (CAMRI).

“It’s just common sense to say that if there is a shock that it may be a little more stable because we are interconnected but often that means that the shock can propagate through the system in unintended ways.”

Dr. Merton won the Nobel Prize in economics in 1997 with Myron Scholes for their work on stock options.

Watch Dr Robert Merton’s full talk on managing macrofinancial risksNow the Distinguished Professor of Finance at MIT Sloan School of Management and Resident Scientist at Dimensional Fund Advisors, he and his partners have been working on research to measure the connectedness of financial institutions and the impact that has on the financial markets and economic systems.

He told the NUS audience that the financial system globally is increasingly connected, demonstrating this by explaining how intertwined banks and sovereign governments have become.

“The connections between all these institutions are definitely stronger,” Dr. Merton said. He noted that while before the 2008 financial crisis, the connectedness was much denser, those connections still remain very strong.

In many cases, that interconnectedness means that there are fewer risks, but the interdependence also means that when one part of the system gets hit there are ripples almost everywhere.

It doesn’t necessarily mean the entire system is weak but it may mean that the system is more vulnerable.

Dr. Merton says that this is particularly true in the relationship between governments – which he calls sovereigns – and the banks they oversee.

merton280“When a bank holds the sovereign’s debt and the sovereign guarantees the banks, you have the guarantor guaranteeing and being guaranteed by the guarantor”, he said.

These relationships are meant to offer stability and give people confidence but sometimes there are shocks in the system in unintended ways. And, he says, some shocks are big enough that there is no safe harbour.

Over time, these connections and the intensity of these connections can also change. For example, Greece’s financial woes were for many months very interconnected with the rest of the world and even threatened to bring down the Euro. Now, however,  Europe is less worried about the severe austerity problems in Greece.

For regulators and governments, this interconnectedness makes it difficult to avoid some crises, just as Europe was drawn into the problems in Greece.

“It’s a little bit like if you know you have a hurricane coming,” Dr. Merton said. “You could ask the question is there anything we can do to stop the hurricane? I think most of us would say today, ‘no’. But there are things we could do, knowing that it may be coming and that we are vulnerable to it, and to try to protect ourselves.”

While the financial system is exposed to global risks, he believes that regardless of regulations, a lot of institutions have changed the way they operate and have dealt with some of the excesses on their own.

Dr. Merton told NUS he is concerned about the impact of long term low interest rates on pensions.

Regulators have lowered interest rates to boost economic growth and in many countries that has spurred expansion. However, low interest rates have dramatically cut returns on pensions around the world.

“This is hurting the pension industry and a generation of pensioners,” he said. This has made economies vulnerable. Yet, if interest rates go up, that will dramatically raise the cost of US debt by tens of billions of dollars.

Sign up to our newsletter