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50 2 systemically important financial market

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Unformatted text preview: 50 2. Systemically important financial market utilities and payment, clearing, and settlement activities: If a firm operates or significantly owns a public utility function that participates in moving reserves (or any other financial claim that effectively serves the purpose of “money” such as money market deposits or repo contracts) around the economy, then its failure could cause a breakdown in economic activity. 3. Runs: Many financial institutions have fragile capital structures in that they hold assets with long-term duration or low liquidity but their liabilities are highly short-term in nature, exposing these firms to individual runs on their liabilities that could, with enough uncertainty and given commonality of asset exposures, lead to large-scale runs on similar institutions. 4. Fire sales: With respect to fire sales, consider the spillover risk – what economists like to call a “pecuniary externality” – that arises as one institution’s trouble leads to depressed asset prices and a hostile funding environment, pulling others down and thus leading to further price drops and funding problems, resulting in a “death spiral” in the financial sector. We now consider each of these in turn as it relates to Fannie and Freddie. Consistent with what our systemic risk rankings suggest, a valid economic argument can be made that no firm was systemically more important than the GSEs. 4.1.1 Interconnected to the Max According to the American Cancer Society, this year, approximately 550,000 Americans are expected to die of cancer, which accounts for almost one of every four deaths. Contrary to common opinion, the initial onset of cancer – abnormal tissue growth that is called a tumor – is not what causes death. It is the breaking away of cells from the tumor that enter the bloodstream or lymphatic system and spread throughout the body, resulting in new tumors in vital areas. In other words, a small cancer in one part of the body, especially if untreated, can lead to widespread cancer and eventual death. It is not much different in financial markets when one considers the failure of an interconnected financial institution. For example, consider the over-the-counter (OTC) derivatives market. The main reason for systemic risk in OTC markets is that individual institutions do not observe the totality of trades that are being done by their counterparties. The prime example in the current crisis is AIG, which built up $450 billion of one-sided credit default swap (CDS) exposure on the so-called AAA-tranches of securitized products. These positions were built up with no or little capital and collateral support. Because all of the trades were in the same direction, once the trades lost value, it meant that AIG’s failure would be 51 passed on throughout the financial system. For example, AIG’s failure could cause an AIG counterparty to fail, one consequence of which could result in a counterparty to AIG’s counterparty to fail even though that second firm has no direct relation to AIG, and so on. Like counterparty to fail even though that second firm has no direct relation to AIG, and so on....
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50 2 Systemically important financial market utilities and...

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