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Financial Risk Management: Models, History, and Institutions by Allan M. Malz

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CHAPTER 14

Financial Crises

For financial market participants, financial crises are very difficult to anticipate and plan for, yet extremely destructive when they occur. From the standpoint of public policy, there is insufficient agreement on how to prevent or cope with crises. For researchers, financial crises remain a diffuse area, with poor problem definition, yet intense controversy. Crisis episodes present the most dramatic departures from the standard model of asset price behavior. The subprime crisis, by some measures, is the most severe financial crisis since the Great Depression of the 1930s, and will drastically change the financial system in ways not yet known.

Financial crises can be summarized as episodes displaying some or all of these symptoms or observable hallmarks:

Asset prices change sharply. The changes in asset prices are often a large multiple of the recently observed volatility, and thus would be judged extremely low-probability by the standard model.

Return moments change sharply. Volatility increases for almost all assets. Correlations “break down,” that is, change from previous values, drawing much closer to ±1, or to 0, or changing sign.

Aggregate credit shrinks drastically. Balance sheets shrink rapidly as assets lose value, lenders seek to reduce leverage, the credit intermediation mechanism is impaired, and borrowers are forced to curtail activity.

Market liquidity conditions deteriorate and liquidity impasses arise. Transaction volumes for many ...

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