Wednesday, 28 May 2008

Minsky, Ponzi and Procyclicality

More on my reading backlog: I've been tackling Minsky's Cushions of Safety: Systemic Risk and the Crisis in the U.S. Subprime Mortgage Market which compares the old-style model of financial system fragility with the happenings in the subprime crisis. What I had not realised is that Minsky's notion of fragility is just a form of procyclicality:
Central to Minsky’s analysis of financial fragility was the concept of a cushion of safety...The “cushion” covers the margin of error in anticipated returns from an investment project...For example, the margin of safety for a banker lending to a businessman for a particular project would be determined by the difference between the amount loaned and the amount required to finance the project...The idea of increasing financial fragility is built around the slow and imperceptible erosion of margins of safety during conditions of relative stability.
A good example is credit risk modeling: calibration of credit risk models to recent historical default rates during quiet conditions slowly erodes cushions of safety, leaving institutions more leveraged when a crisis hits. Minsky might have been one of the first to identify procyclicality via the lending decision, but there are plenty more examples of the phenomenon in modern banking. I don't think it is fair, as some commentators do, to call this a Ponzi scheme: rather I think it is a calibration error, but one firms and their regulators need to be aware of.

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