Minsky’s Financial Instability Hypothesis – Applications in Stress Testing?

One of the issues that we keep coming back to in stress testing is whether the financial system is inherently prone to instability and crisis or the system naturally tends towards equilibrium and instability is due to external shocks. Any stress scenario that we design, or that we are asked to model, will fall somewhere along this spectrum though I suspect most scenarios tend to be based on exogenous shocks. This touches on a long standing area of economic debate and hence not something that we can expect to resolve any time soon. I think it however useful to consider the question when conducting stress testing and evaluate the outcomes.

From roughly the early 1980’s until the GFC in 2008, the dominant economic paradigm has arguably been that the market forces, coupled with monetary and fiscal policy built on a sound understanding of how the economy works, meant that the business cycle was dead and that the primary challenge of policy was to engineer efficient capital allocations that maximised growth. The GFC obviously highlighted shortcomings with the conventional economic approach and drew attention to an alternative approach developed by Hyman Minsky which he labelled the Financial Instability Hypothesis.

Minsky’s Financial Instability Hypothesis (FIH)

Minsky focused on borrowing and lending with varying margins of safety as a fundamental property of all capitalist economies and identified three forms

  • “Hedge” financing under which cash flow covers the repayment of principal and interest
  • “Speculative” financing under which cash flow covers interest but the principal repayments must be continually refinanced
  • “Ponzi” financing under which cash flow is insufficient to cover either interest or principal and the borrower is betting that appreciation in the value of the asset being financed will be sufficient to repay loan principal plus capitalised interest and generate a profit

The terms that Minsky uses do not strictly conform to modern usage but his basic idea is clear; increasingly speculative lending tends to be associated with increasing fragility of borrowers and the financial system as a whole. Ponzi financing is particularly problematic because the system is vulnerable to external shocks that can result in restricted access to finance or which cause asset devaluation cycle as borrowers to sell their assets in order to reduce their leverage. The downward pressure on assets prices associated with the deleveraging process then puts further pressure on the capacity to repay the loans and so on.

The term “Minsky moment” has been used to describe the inflexion point where debt levels become unsustainable and asset prices fall as investors seek to deleverage. Investor psychology is obviously one of the primary drivers in this three stage cycle; investor optimism translates to a willingness to borrow and to pay more for assets, the higher asset valuations in turn allow lenders to lend more against set loan to valuation caps. Lenders can also be caught up in the mood of optimism and take on more risk (e.g. via higher Loan Valuation Ratio limits or higher debt service coverage ratios). Minsky stated that “the fundamental assertion of the financial instability hypothesis is that the financial structure evolves from being robust to being fragile over a period in which the economy does well” (Financial Crises: Systemic or Idiosyncratic by Hyman Minsky, April 1991, p16).

It should also be noted that a Minsky moment does not require an external shock, a simple change in investor outlook or risk tolerance could be sufficient to trigger the reversal. Minsky observed that the tendency of the endogenous process he described to lead to systemic fragility and instability is constrained by institutions and interventions that he described as “thwarting systems” (“Market Processes and Thwarting Systems” by P. Ferri and H. Minsky, November 1991, p2). However Minsky’s FIH also assumes that there is a longer term cycle in which these constraints are gradually wound back allowing more and more risk to accumulate in the system over successive business cycles.

What Minsky describes is similar to the idea of a long term “financial cycle” (25 years plus) being distinct from the shorter duration “business cycle” (typically 7-10 years) – refer this post “The financial cycle and macroeconomics: What have we learnt?” for more detail. An important feature of this longer term financial cycle is a process that gradually transforms the business institutions, decision-making conventions, and structures of market governance, including regulation, which contribute to the stability of capitalist economies.

The transformation process can be broken down into two components

  1. winding back of regulation and
  2. increased risk taking

which in combination increase both the supply of and demand for risk. The process of regulatory relaxation can take a number of forms:

  • One dimension is regulatory capture; whereby the institutions designed to regulate and reduce excessive risk-taking are captured and weakened
  • A second dimension is regulatory relapse; reduced regulation may be justified on the rationale that things are changed and regulation is no longer needed but there is often an ideological foundation typically based on economic theory (e.g. the “Great Moderation” or market discipline underpinning self-regulation).
  • A third dimension is regulatory escape; whereby the supply of risk is increased through financial innovation that escapes the regulatory net because the new financial products and practices were not conceived of when existing regulation was written.

Borrowers also take on more risk for a variety of reasons:

  • First, financial innovation provides new products that allow borrowers to take on more debt or which embed higher leverage inside the same nominal value of debt.
  • Second, market participants are also subject to gradual memory loss that increases their willingness to take on risk

The changing taste for risk is also evident in cultural developments which can help explain the propensity for investors to buy shares or property. A greater proportion of the population currently invest in shares than was the case for their parents or grandparents. These individual investors are actively engaged in share investing in a way that would be unimaginable for the generations that preceded them. Owning your own home and ideally an investment property as well is an important objective for many Australians but less important in say Germany.

These changes in risk appetite can also weaken market discipline based constraints against excessive risk-taking. A book titled “The Origin of Financial Crises” by George Cooper (April 2008) is worth reading if you are interested in the ideas outlined above. A collection of Minsky’s papers can also be found here  if you are interested in exploring his thinking more deeply.

I have been doing a bit of research lately both on the question of what exactly does Expected Loss “expect” and on the ways in which cycle downturns are defined. I may be missing something, but I find this distinction between endogenous and exogenous factors largely missing from the discussion papers that I have found so far and from stress testing itself. I would greatly appreciate some suggestions if anyone has come across any good material on the issue.

Tony

Author: From the Outside

After working in the Australian banking system for close to four decades, I am taking some time out to write and reflect on what I have learned. My primary area of expertise is bank capital management but this blog aims to offer a bank insider's outside perspective on banking, capital, economics, finance and risk.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s