Financial Crises Continue to Strike amid Accelerated Evolution of Risk Management

Dr. John Taskinsoy a

ABSTRACT

“History repeats itself” is not just an idiom, it is the naked truth; another agonizing fact is that humans
do not seem to have learned from past experiences throughout history. For instance, misleading or
policy error by the Fed (unwarranted tight-money policy stance in the 1920s) was argued to be one
of the contributing forces that triggered the 1929 US stock market crash, and the ensuing panic caused
the Great Depression of the 1930s – the severest shock in the history of humankind. Looking for a
scapegoat and responding to the public outcry for more rigorous regulations, the U.S. government
rushed to pass the Glass-Steagall Act (the Banking Act of 1933) which barred commercial banks from
engaging in investment and underwriting activities. Over a half century later, the Gramm-Leach-Bliley
Act of 1999 during the Clinton administration repealed the Banking Act of 1933 which allowed banks
to resume their speculative and highly risky investment activities of the past (i.e. predatory lending
practices and credit expansion into sub-prime), this combined with historically low interest rates and
another policy error by the Fed (this time around, accommodative – expansive policy stance in the
1990s created dollar glut) contributed to the Great Recession of 2008-09. Whenever there is a crisis
(financial, economic, and currency), pouring money into the market, as the Fed always does, should
not be an automatic first action because quantitative easing by central banks usually fosters the next
big crisis. Since the outbreak of WWI, the real problems that caused WWI and WWII have never been
resolved, therefore the vestiges from that era coupled with ill-advised strategies and policy actions
continue to create a new breed of crises, and the successor always promises to be more deadly and
more severe than the antecedent. We have choices, we can continue the way it is and face the day of
reckoning, or build better societies based on more humane principles.

Keywords: Value-at-Risk; Stress Testing; Financial Stability; Microprudential; Macroprudential

JEL classification: O31, G12, E42, C40, Q32, Q54, H23

 This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors.
a Corresponding author email address: johntaskinsoy@gmail.com
Faculty of Economics & Business – Universiti Malaysia Sarawak (Unimas), 94300 Kota Samarahan, Sarawak, Malaysia.

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1.0 Introduction

Every activity or decision by a person or a firm revolves around a degree of risk (high risk, potential
high rewards); however, even before the advent of risk management as part of the decision-making
process in the late 1950s, insurance was predominantly used to protect people and companies against
losses associated with natural disasters, accidents and work related injuries; nonetheless, insurable
risks at the time due to huge costs did not include pure financial risk arose from market risk, credit
risk, operational risk, and liquidity risk (see Allen & Carletti, 2006; Bernstein, 1996; BIS, 1994; Cline,
1984). The use of derivatives in the 1970s not only changed the risk-management landscape, but had
prompted companies to develop internal risk assessment models (Duffee & Zhou, 2001; Gibson, 2007;
Grima, 2012; Minton et al., 2008; Morrison, 2001). Notwithstanding economic theories, regulations,
analytical tools, enhanced techniques, and risk assessment/management models failed to prevent a
series of economic, financial and currency crises that began in the late 1990s.1

The global economy changed dramatically after the conclusion of World War I. Stories have often told
that the United States of America is the land of opportunities for brave entrepreneurs and inventors
who trust their visions and believe taking risks will lead to great returns. A speculative boom in the
1920s fueled growth in manufacturing activity in the U.S., this led to the utopia belief that the US stock
market was going to be the predominant beneficiary of the industrial boom. Furthermore, rising stock
prices in Wall Street enticed investors with the driving motive to invest more in equities through
barrowed money, however significant margin buying increased the counterparty risk. Monetarists
postulate that the Fed’s misguided/unjustified tight-money policy errors in the late 1920s resulted in
a substantial drop in the US money stock and the ensuing severe contraction led to the 1929 stock
market crash, recession, and the inevitable Great Depression (Bernanke & Gertler, 1995; Eichengreen,
2002; Bernanke, 2004; Friedman & Schwartz, 1963). Epstein and Ferguson (1984) defended the Fed’s
tight-money policy action, claiming the Fed’s main objective was to curtail speculation on Wall Street
in order to avoid stock market crash, but the Fed gravely failed and left the economy debilitated.

The Great Depression epoch (the 1930s), an economic and financial tsunami that the world had never
experienced before (the most severe2 crisis in the history of humankind), was triggered by numerous
causal effects (see Bernanke, 1983; Bernanke & James, 1991; Hamilton, 1987; Hall & Ferguson, 1998;

1 For a longer perspective and detailed discussions on this topic and other related topics, interested readers are welcome to
check out Taskinsoy (2012; 2013; 2018; 2019; 2020; 2021; 2022).
2 Between 1929 and 1933, about 2,000 banks failed annually (about 9,000 banks); nominal gross national product (GNP)

fell nearly 50% whereas the real output fell over 25%; wholesale and consumer prices plummeted, over 30% and 25%
respectively; unemployment skyrocketed over 20% (fell below 10% only after WWII); and real interest rate nearly tripled
(jumped from little over 4% to 11.50%). For further discussion, see Friedman and Schwartz (1963); Wheelock (1998).

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Meltzer, 1976; Temin, 1976; Wheelock, 1998); as such, the death of Benjamin Strong in 1928 (head
of the New York Federal Reserve Bank)3, the 1929 stock market crash (Black Tuesday), beggar-thy-
neighbor4 policies (Eichengreen & Irwin, 2010), the U.S. Smoot-Hawley tariff of 1930 (e.g. Irwin,
1998), the collapse of international trade (Eichengreen & Irwin, 1995), banking panic and crashes
(Kindleberger, 1978, 1986), a lack of gold reserves at the Fed (Epstein & Ferguson, 1984), Great
Britain’s decision in 1931 to leave the gold standard due to speculative attacks on the British pound
(Cooper, 1982), and finally the Glass-Steagall Act5 also known as the Banking Act of 1933 which
barred US commercial banks from investment banking activities (see Crawford, 2011; Lardner, 2009;
Mester, 1996). The dollar was devalued in 1934 as a defense by President Roosevelt to turn the
economic tide, the value of dollar to gold changed from $20.67/oz to $35/0z.

In the U.S., the dark and devious (Lardner, 2009) side of investment banking activities of commercial
banks made investors and the public lose trust in the whole American financial system; as a result,
the public outcry demanded more rigorous regulations with stringent supervision (Crawford, 2011;
Mester, 1996). To restore confidence, the Glass-Steagall Act (Banking Act of 1933) was drafted by
Senator Carter Glass and Representative Henry Steagall to bar commercial banks from underwriting
securities and investment activities; the Act also created an independent Federal Deposit Insurance
Corporation (FDIC). One positive upshot of the financial havoc in the 1930s was a realization (a wake-
up call) that the development of hedging and risk mitigation tools was necessary (Wheelock, 2007),
but this notion was interrupted by another warfare. Although WWI was described as “the war to end
all wars”, the unresolved problems of WWI (i.e. Germany’s - Adolf Hitler’s grievances to the very harsh
punishing clauses of the Treaty of Versailles) left the door wide open for the breakout of WWII.

The Great Depression was a more of a man-made phenomenon6 (miscalculated mistakes or ill-fated
policies) than an event that was driven by the market forces. The depression would have stayed as an
ordinary recession and not descended into the Great Depression status if the following three errors
were avoided (Eichengreen, 2003): 1) the gold-exchange rates after the gold standard resumed in
1920 failed to mirror the countries’ trades and were considerably inconsistent (i.e. utterly overvalued

3 Although the New York Federal Reserve Bank had no prior authority granted by the federal government, Benjamin Strong
allowed the bank to engage in the open market bond operations to keep the money supply stable despite volatility in gold
inflows and outflows. This meant bending the rules of banking rules which was not legal.
4 Countries passed protectionist policies to resolve their own economic problems at the expense of other nations.
5 As a reactionary response to drafted by Senator Carter Glass and Representative Henry Steagall
6 Extreme volatility in wheat price sent signals to investors that high volatility might cause the US stock market to falter;

increased ownership of stocks during the boom reversed, a panic selling at market downturn caused forced liquidation of
margin positions; the 1929 stock market crash and the ensuing Great Depression of the 1930s caused bank failures, mass
unemployment, and credit crunch; banking system collapsed due to feeble regulatory framework, inadequate capital
buffers, insufficient liquidity, and policy errors by the Fed.

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British pound); 2) the issue in the previous number made fixed exchange rates extremely vulnerable
to speculative attacks during economically challenging times (sluggish global economy), which forced
some countries to abandon the gold standard in the 1930s (the UK was first in 1931); 3) the passage
of the Smoot-Hawley tariff in the United States resulted in the "beggar-thy-neighbor"7 policies that
resulted in which was considered counterproductive and massively disruptive in international trade
activities (Bernanke, 2013). The cataclysmic collapse of the gold standard in the 1930s led to the
inauguration of the Bretton Woods system8 of fixed exchange rates, largely viewed as the beginning
of the US dollar supremacy. John Maynard Keynes (“Baron Keynes”), distinguished British economist
and the leader of the British delegation at the Bretton Woods Conference in 1944, made a compelling
argument against the use of a fixed exchange rate regime pegged to the U.S. dollar (USD), but his
proposal of a supranational currency along with creation of two watchdog institutions to monitor and
avoid significant global trade imbalances was rejected (Schumacher, 1943).

Before 1950, there were not whole a lot of risk types to be concerned; the world trade was dominated
by a few countries, financial markets (equity and bond) were in infancy stages (not deep and diverse
enough), and risky financial instruments such as derivatives only arose during the 1970s. In the post-
WWII era, trade volumes along with business models have grown in complexity; with the fast-pace
globalization and internationalization of finance (i.e. Asia as a new periphery after Germany and Japan
graduated to the center), risk management has evolved to adapt to fast-changing business models
(from transaction-based local perspective to aggregated portfolios with global complexity) and to the
new breed of risks such as market risk (i.e. highly adverse market conditions in an acute stress), credit
risk (i.e. the ability to meet debt obligations), liquidity risk (i.e. cash and cash equivalent liquid assets),
and operational risk (i.e. ROI, ROE, ROA9, revenue, default risk and company-specific issues).

Due to unrealistic promises combined with many overlooked issues (e.g. Siklos, 2013), the Bretton
Woods system was destined to fail. The foreseen collapse of the Bretton Woods system resulted in
significant volatility in major foreign exchange markets in the 1970s (see Mundell & Swoboda, 1969
for monetary problems). This quickly turned into a worldwide financial turmoil in the wake of two
other high-magnitude events causing enormous disruptions to the world trade and financial stability.
First was the Yom Kippur War (1973) and ensuing oil crisis (1974-78); the second event was the

7 One country tries to solve its own problems on the expense of other countries (i.e. what the U.S. is doing currently).
8 The aftermath of World War II gave the U.S. an opportunity to impose a new monetary order, an exchange rate regime
pegged to the US dollar. War-devastated and economically drained allies had no choice but sign the agreement at the United
Nations Monetary and Financial Conference. Also, two new organizations were created which began operations in 1945;
the International Bank for Reconstruction and Development (IBRD) which later became the World Bank and International
Monetary Fund (IMF). The US dollar became the reserve-fiat currency when President Nixon cut dollar’s link to gold
conversion in 1971 (for more detailed discussion, see e.g. Hudson, 2003; Eichengreen, 2004).
9 ROI: Return on investment; ROE: Return on equity; and ROA: Return on assets.

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closure and forced liquidation of Germany’s Cologne-based Bankhaus Herstatt (1974).10 These macro
events and their farfetched implications resulted in unprecedented spikes in commodity prices by the
mid-1970s during which the prices of both gold and oil broke records.11 Hazlitt (1984) argues that
the ever more instability episodes were the “…consequence of the inherently inflationary institutions
set up in 1944” (i.e. the IMF and the World Bank) and the Bretton Woods system “…not only permits
and encourages but almost compels world inflation”. Dooley et al. (2004) stress that “Bretton Woods
system does not evolve; it just occasionally reloads a periphery”.

Five seminal papers had instigated the evolution of risk management to accelerate at a remarkable
pace. Markowitz’s (1952, 1959) mean-variance criterion reduced risk through the ultimate portfolio
selection, primarily focusing on portfolio risk. Modigliani-Miller’s (1958) introduced unconventional
irrelevance and arbitrage-reasoning, arguing that a firm’s market value is irrelevant to its cost of
capital whether capitalized equity financing or debt financing. Sharpe’s (1964, 1990) Capital Asset
Pricing Model – CAPM was a paradigm-shifting development that introduced risk-based pricing. Black
and Scholes’ (1973) option pricing formula (futures trading) and the Merton’s (1973a, 1974) pricing
of corporate debt created a shift from risk-based pricing (i.e. CAPM) to arbitrage-based pricing
models. Since the 1980s, futures trading and foreign exchange (FX) grew at a record pace surpassing
daily volumes of stock and bond markets combined; billionaire Warren Buffet described derivatives
as “weapons of mass destruction” (for a longer discussion, see Adams & Wyatt, 1987; Cornell, 1981;
Diebold, 2012; Frankel & Froot, 1990; Hsieh, 1989; Glassman, 1987; Lyons, 1988).

Financial crises are inexorable outcomes of banking panics, often facilitated by stock market crashes,
bursting of bubbles, sovereign defaults (sovereign debt crisis), currency crises, pandemic (COVID-
19), and augmented geopolitical risks (terrorist attack, political turmoil, wars, etc.). The search for
quantitative models and the development of enhanced risk management frameworks accelerated
with the antecedent crises; as such, US stock market crash of 1987, the end of golden decade (1990s),
Asian crisis of 1997-98, subprime crises (mortgage debacle) of 2006-07, and global financial crisis of
2008. These high-magnitude events can provide a simpler explanation, after all, each of them faced
similar triggers; imbalances, excessive risk-taking, excessive on-and off-balance sheet leverage,
inadequate liquidity (both in quality and quantity), significant cross-border activities, asset liability
mismatch, shadow-banking (arbitrage), procyclical deleveraging, insufficient capital buffers held by
banks to absorb losses in an acute stress, and herd behavior (speculation and contagion).

10 The sudden bankruptcy of a small privately-owned Bankhaus Herstatt in June 1974 is a famous as well as a shocking
incident that clearly illustrated the settlement risk in foreign exchange payments, plus ignored regulatory issues.
11 OPEC sharply raised oil prices during 1973-74 to show its strong disapproval of the U.S. aid to Israel during the war. By

March 1974, the price of oil rose from $3/barrel to $12/barrel. The price of gold rose from $44/ounce in 1972 to $185 in
1975 (see Kindleberger & Alibar, 2005 for the reasons behind the huge spike).

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2.0 Literature Review

Risk management (i.e. detection, measurement, governance) was an arcane topic in the early 20th
century. The Great Depression was not caused by a single factor; on the contrary, the root cause of
the severest worldwide economic dislocation was a confluence of driving and contributing forces, i.e.
significant drop in money stock (“The Great Contraction”), Federal Reserve’s (the Fed’s) unwarranted
tight-money policy (monetary deflation), substantially reduced fiscal spending, debt deflation, stock
market crash of 1929, collapse of the gold standard, last but not the least, passage of the 1930 Smoot–
Hawley Tariff Act which played a crisis-intensifier role, otherwise this would have remained as an
ordinary recession (for longer discussions and a historical perspective, see Bernanke, 1983, 2004;
Bernanke & James, 1991; Eichengreen, 2003; Eichengreen & Irwin, 1995; Friedman & Schwartz, 1963,
2008; Hamilton, 1987; Irwin, 1998; Kindleberger, 1978, 1986; Meltzer, 1976; Temin, 1976).

Bernanke (2002) made the following sincere remarks at the Conference to Honor Milton Friedman at
University of Chicago “Let me end my talk by abusing slightly my status as an official representative
of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression, you're
right. We did it. We're very sorry. But thanks to you, we won't do it again”; last words of Bernanke’s
speech “we won’t do it again” was a promise on behalf of the Fed, but was not kept; less than a century
later, the Great Recession (GFC of 2008) stroke Americans like the A-bomb, leaving behind a financial
catastrophe of over $20 trillion (i.e. estimates range between $12 and $30 trillion, see Figure 1).

Source: Dallas Fed; AEI12

Figure 1: Output loss caused by the Great Depression

12 https://www.aei.org/economics/how-much-did-the-great-financial-crisis-cost-america-nearly-30-trillion/
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The Great Recession, caused by many of the same triggers that instigated the Great Depression, is a
naked truth that Bernanke (and the Fed) failed to keep a promise he made in a speech in memory of
the great monetarists Milton and Anna; as a reflection on the most unprecedented credit crisis in the
history of humankind, this paper is compelled to rephrase the last part of Bernanke’s speech;

Milton and Anna: Oops, we did it again. We're sorry, but this won’t change anything. Thanks to
you, but we will most likely do it again, again and again because this is what we do best.

Prior to the Great Depression, the US residential mortgage market was unevenly regulated with light
banking supervision and in short term nature (5-10 years) with variable interest rates (Blank, 1954;
Cho, 2004; Klaman, 1961). As urbanization grew rapidly in the U.S. between 1870 and 1930 (e.g. Gray
& Terborgh, 1929; Friedman & Schwartz, 1963), nonfarm housing starts soared, peaking at 930,000
in 1925 compared with just average 300,000 units per year between 1905 and 1916 (Snowden, 2014;
Diamond, 2004; Feldman, 2002). Despite the 1890 farm mortgage crisis, agricultural output in the
U.S. entered its “Golden Age” (1910-14); as a result, farmers increased their income substantially, but
the downside was, farmers’ total mortgage debt on their properties also increased over 50% during
1918-22 (Snowden, 2010; Wickens, 1937). With the onset of the Great Depression, property values
plummeted 50%, triggering a cascade of foreclosures – over 1 million homes went into foreclosure
between 1931 and 1935 (see Bodfish, 1931; Field, 1992; Foster & Wickens, 1937; Gottlieb, 1964). The
seeds of the 2008 global financial crisis were sowed when the US federal government has intervened
with a number of regulatory initiates (Table 1), which were (particularly, the creation of Fannie Mae
and Freddie Mac and the repeal13 of the 1933 Glass- Steagall Act) designed to stimulate the real estate
mortgage lending activity by banks and financial intermediaries (Behrens, 1952; Colean, 1950).

Table 1: Federal legislation timeline

1933 The Federal Deposit Insurance System and Home Owners Loan Corporation were established.
1936 The Federal Housing Administration was created.
1938 Fannie Mae was created to provide a secondary market by for FHA-insured loans.
1944 VA loan program was created as part of the Veterans Bill of Rights.
1948 Fannie Mae begins to purchase VA loans.
HUD and Ginnie Mae were created, and Fannie Mae became a shareholder-owned government-
1968
sponsored enterprise.
1970 Freddie Mac was created (the Federal Home Loan Mortgage Corporation Act).
1981 Savings & loans were allowed to invest in ARMs, and deposit ceilings were removed.
1982 Savings & loans securitize and sell off below-market-rate mortgages.
The Tax Reform Act of 1986 eliminated all interest-related personal deductions except for mortgages
1986
and home equity loans.
Freddie Mac was restructured as a publicly traded corporation, and the Federal Institution Reform
1989
Recovery and Enforcement Act passed.

Source: Green & Wachter (2005)

13 In 1999 (during Bill Clinton administration), the Gramm-Leach-Bliley Act of 1999 repealed the Glass-Steagall Act of 1933,
allowing non-bank institutions to participate in both commercial and investment activities.
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Table 2: List of economic crises and depressions

1st Century The Financial Panic of AD 33 (unsecured loans by main Roman banking houses).
3rd Century Crisis of the Third Century (Imperial crisis, Roman Empire nearly collapsed).
Coin exchange crisis of 692 (Byzantine emperor Justinian II refuses to accept tribute
7th Century from the Umayyad Caliphate with new Arab gold coins).
14th Century Banking crisis (the crash of the Peruzzi and the Bardi family in 1345).
Kipper und Wipper (1618–22) financial crisis at start of Thirty Years' War
17th Century Tulip mania (1637) an economic bubble that burst in 17th century Holland
The General Crisis (1640) Arguably the largest worldwide crisis in history
Great Tobacco Depression (1703) (British America)[2]
South Sea Bubble (1720) (UK)
Mississippi Company (1720) (France)
Crisis of 1763 – started in Amsterdam
Great East Indian Bengal Bubble Crash (1769) (India)
18th Century Crisis of 1772 – started in London and Amsterdam (collapse of the bankers)
War of American Independence Financing Crisis (1776) (United States)
Panic of 1785 – United States
Panic of 1792 – United States
Panic of 1796–1797 – Britain and United States
Danish state bankruptcy of 1813
Post-Napoleonic depression (post 1815) (England)
Panic of 1819, a U.S. recession with bank failures
Panic of 1825, a pervasive British recession in which many banks failed
Panic of 1837, a U.S. recession with bank failures, followed by a 5-year depression
Panic of 1847, started as a collapse of British financial markets
19th Century Panic of 1857, a U.S. recession with bank failures
Panic of 1866, was an international financial downturn
Great Depression of British Agriculture (1873–1896)
Long Depression (1873–1896)
Panic of 1873, a US recession with bank failures, followed by a four-year depression
Panic of 1884; Panic of 1890; Panic of 1893, a US recession with bank failures
Australian banking crisis of 1893; Panic of 1896

20th Century
Panic of 1901, a U.S. economic recession (control of the Northern Pacific Railway)
1900s Panic of 1907, a U.S. economic recession with bank failures
Depression of 1920–21, a U.S. economic recession following the end of WW1
1920s Wall Street Crash of 1929 and Great Depression (1929–1939) the worst depression
1970s energy crisis
OPEC oil price shock (1973)
1970s 1979 energy crisis (1979)
Secondary banking crisis of 1973–1975 in the UK
Latin American debt crisis (late 1970s, early 1980s) known as "lost decade"
Early 1980s Recession
Chilean crisis of 1982
Bank stock crisis (Israel 1983)
1980s Japanese asset price bubble (1986–1992)
Black Monday (1987) (1987) (US)
Savings and loan crisis, 1,043 out of the 3,234 S&Ls failed from 1986 to 1995 in the U.S
Special Period in Cuba (1990–1994); Early 1990s Recession; 1991 Indian economic
crisis; Finnish banking crisis (1990s) (1991–1993); Swedish banking crisis (1990s)
1990s Black Wednesday (1992); 1994 economic crisis in Mexico; 1997 Asian financial crisis
1998 Russian financial crisis; 1998–1999 Ecuador economic crisis; 1998–2002
Argentine great depression; Samba effect (1999) (Brazil)

Source: Wikipedia, https://en.wikipedia.org/wiki/List_of_economic_crises

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History repeats itself, which is evidenced in Table 2; conflict and crisis (i.e. political, war, economic,
financial, currency, etc.) as one of the potential outcome has been around since humans began living
in a communal life and interacting with each other socially and economically. In other words, this is
not the first time the world has faced the Great Recession and it won’t be the last; new strain of crises
will continue to strike as new and a higher order of civilizations are created and everything else to
sustain them. Table 2 is provided for informational purpose and as a testimony to the fact that history
really repeats itself, nevertheless the focus of this paper is the recurrent crises in the new millennium
(Table 3) and the failure of enhanced risk management tools (Garber,2000; Reinhart & Rogoff, 2009).

Table 3: List of economic crises

Argentine economic crisis (1999–2002)

Early 2000s recession
Dot-com bubble (2000–2002) (US)
2001 Turkish economic crisis
2001 September 11 Attacks
2002 Uruguay banking crisis
Venezuelan general strike of 2002–03
2007–2009 Financial Crisis
Late-2000s recession (worldwide)
2000s 2000s energy crisis (2003–2009) oil price bubble
Subprime mortgage crisis (US) (2007–2010)
United States housing bubble and market correction(2003–2011)
Automotive industry crisis of 2008–2010 (US)
2008–2012 Icelandic financial crisis
2008–2010 Irish banking crisis
Russian financial crisis of 2008–2009
2008 Latvian financial crisis
Venezuelan banking crisis of 2009–10
2008-16 Spanish financial crisis

European sovereign debt crisis (EU) (2009–2019)

Greek government-debt crisis (2009–2019)
2010–2014 Portuguese financial crisis
Crisis in Venezuela (2012-now)
Russo-Ukrainian War (2014-now)
2010s 2014 Russian financial crisis
2014-2017 Brazilian economic crisis
2015 Chinese stock market crash
Turkish currency and debt crisis, 2018
Argentine monetary crisis

COVID-19 recession / Economic impact of the COVID-19 (2020–present day)

2020 stock market crash (2020)
2020s Black Monday (9 March)
Black Thursday (12 March)
Lebanese liquidity crisis

Source: Wikipedia, https://en.wikipedia.org/wiki/List_of_economic_crises

The world financial history has never experienced a shortage of economic or/and financial shocks
associated with bank runs (the Bank of the United States in 1931 and the UK’s Northern Rock in 2007),
currency crises (Mexican peso crisis of 1994, Asian crisis of 1997-98, Russian ruble crisis of 1998,
etc.), debt crises (Latin American debt crisis of 1980s, Turkish currency and debt crisis of 2018), and
9
speculative bubbles (famous speculative bubbles in the 17th and 18th centuries, Dutch Tulipmania in
1634-38, Mississippi Bubble in 1719-20, and South Sea Bubble in 1720; and the new famous bubble
in the 21st century, internet bubble - dot.com crisis of 2001-02, lending bubble - subprime crisis of
2006, and housing bubble - global financial crisis of 2008). Whether old or new, all crises without an
exception had one or more of the following causal aspects (see Allen & Carletti, 2009; Beachy, 2012;
Bernanke, 2007; Birdsall, 2012; Cassidy, 2009); self-fulfilling prophecies (coordinating investment
activities according to expectations), excessive leverage by investors (margin buying) and banks
(overexposure), asset-liability mismatch (short-term debt is used for long-term investments), herd
behavior (irrational exuberance), regulatory failures (failure of banking regulation and supervision).

Source: Vanguard14
Figure 2: Consequences of the GFC of 2008

14 https://www.vanguard.com.au/adviser/en/article/markets-economy/the-global-financial-crisis
10
The Great Depression took place in the absence of risk assessment/measurement tools, during which,
the banking regulation and supervision was either feeble or hardly existed. Over six centuries later,
the Great Recession (GFC of 2008) occurred while the evolution of risk management was in full swing,
and this time around, there was an abundance of economic theories, tools, models, and enhanced
techniques available to banks, regulators, and the Fed to detect, gauge, and control risks in order to
prevent another Great Depression like financial havoc. Between the two events, striking similarities
exist; the Fed’s inability to prevent the recurrence of financial crises, jolted societies and dislocated
economies, heavy burden on tax payers, displaced millions and shattered dreams (Figure 2).

2.1 The Evolution of Risk Assessment and Risk Management

Still by the late 19th century, most countries were on a bimetallic standard (gold and silver); economic
growth was achieved under both silver and gold standards (e.g. Bernanke, 2005; Friedman, 1967;
Friedman & Schwartz, 1963). In a world where no risk detection, measurement, and governance tools
as we know today existed, risks (social, geopolitical, commerce, and financial) increased significantly
arising from five unprecedented macro events with farfetched global implications; as such, breakout
of WWI, US stock market crash of 1929, collapse of the gold standard, Great Depression of the 1930s,
and breakout of WWII. Among others, Eichengreen (2003), Bernanke and James (1991) argue that
Britain’s decision to leave gold standard in 1931 was a catalyst igniting the Great Depression.

To restore confidence and alleviate further escalation of risks, even before the conclusion of WWII,
the United States assumed the role of creating a new dollar-based monetary order at the 1944 Bretton
Woods Conference where 44 delegates from the wartime allies unanimously accepted Harry Dexter
White’s U.S. plan designed with only the American view in mind; moreover, same delegates agreed to
establish several watchdog institutions including the IMF, World Bank, and BIS to prevent the
occurrence of another Great Depression (Bordo, 1993; Bordo et al., 2017; Dooley et al., 2004; Garber,
1993; Hazlitt, 1984). As banking systems across the world have become increasingly intricate in the
post-WWII (increased manufacturing, trade, and investment activities), the need for enhanced risk
detection and measurement tools plus advanced supervision techniques became necessary.

Before 1950, pure financial risk was not covered under an insurance policy which was already very
expensive; moreover, efficient diversification of investment risks was an arcane topic until Markowitz
(1952, 1959) attacked the notion of risk relevant to the portfolio selection problem through the mean-
variance criterion, he assumed that investors were risk-averse who always considered minimizing
the variance and maximizing expected returns of their portfolios consisting of different investment
options with varying perceived risks. Markowitz argues that portfolio risk can be diversified away,

11
but not eliminated entirely. The latter remark is irrelevant because one of the underlying assumptions
of his portfolio theory states that risk inherent in each security should not be a concern to optimizing
investors (“efficient frontier”) who consider maximizing expected return while minimizing variance
of returns of the portfolio. Portfolio selection is based on mean-variance criterion, its optimization is
calculated by an algorithm through expected return, standard deviation, and correlation.

Markowitz claims that his theory differs from other theories in three ways; (i) the investor behavior
(utility functions) is a central focus as opposed to theories based on consumers or production firms;
(ii) agents of the economy act under uncertainty, and; (iii) the portfolio theory can be used by
practitioners in real-world applications (Markowitz, 1959). Tobin (1958), extending on Markowitz
(1952), shows that investors can actually create different portfolio combinations based on their risk
thresholds. Diversification is the key to portfolio selection, which promotes the concept that the risk
inherent in each security is irrelevant as long as each security’s contribution to the entire portfolio’s
variance (𝜎𝑃2 ) is acceptable; therefore, understanding of the variance of return of a portfolio and its
covariance is important (σ2P for security j = 1,2, … , m);

σ2P = ∑ xj2 σ2j + ∑ ∑ xj xk pjk σj σk

j j k#j

Where j and k denote securities and 𝜌𝑗𝑘 represents the correlation between the securities, 𝑥𝑗 is the
fraction value of the portfolio’s total value (Rubinstein, 2002).

Although the path-breaking Markowitz (1952) portfolio theory earned him the Nobel Prize in 1990
plus he has been called “...the father of modern portfolio theory (MPT)” (e.g. Rubinstein, 2002),
unfortunately for practitioners to use the theory in real-world applications, “it has been generalized
and refined in innumerable ways”. The theory is also criticized for its arduous data requirements,
which had been markedly simplified by Sharpe’s (1964) CAPM that simply focuses on two types of
risks; systematic and systemic (market risk and the residual) and idiosyncratic risk (company-
specific). Over the years, Markowitz’s portfolio theory has been subject to empirical and theoretical
objections; Merton (1973b) says that this was inevitable, attributable to the theory’s single-period
(discrete time) nature, it also assumes that investors have homogeneous expectations rather than
“myopic utility functions” and conform to the mean-variance criterion (Rubinstein, 2002).

Except the recessions of 1953 and 1958 in the United States, the post-World War II boom between
1945 and 1970 was considered as a calm period without a global-scale financial crisis or depression;
the former was caused by a sharp decline in consumer demand due to higher interest rates; and the
latter was triggered by a sharp drop in new car sales (i.e. worldwide severe economic downturn).

12
The second revolutionary development in the evolution of risk management was the M&M theorem
(Modigliani & Miller, 1958), which is based on irrelevance and arbitrage reasoning and assumes that
under certain conditions, a firm’s market value is irrelevant to its capital structure; in other words,
the average cost of capital to the firm is not determined by whether the firm is financed through equity
or bond issuance. Modigliani-Miller argue that switching to a lower cost of debt is offset by a higher
cost of equity as a consequence of the increased risk. The M&M theorem is structured around four
key assumptions: (i) taxes neutrality; (ii) capital markets are free of frictions and costs related to
transactional and bankruptcy; (iii) easy access to credit markets; (iv) changes in capital structure are
irrelevant to the firm’s market value.

Modigliani-Miller (1958) formulate their Propositions analytically:

X i (1), X i (2), … , X i (T) , assets of the ith firm generate a stream

, random variables are subject to the joint

X i = (Xi1 (1), X i (2), … , X i (T))
probability distribution.
T
1 , the return of the ith firm with a random variable
X i = lim ∑ X i (t)
T→∞ T 𝑋𝑖 and a probability distribution ∅𝑖 (𝑋𝑖 ).
t=1

The celebrated (and much criticized) Modigliani-Miller (1958) propositions were certainly viewed as
unorthodox with many controversies when they were first introduced (Durand, 1959). In response
to this, Miller (1988) says that the M&M theorem was “departing substantially from the then-
conventional views about capital structure”. On the contrary to a nearly perfect world (e.g., tax,
bankruptcy, and transaction) created by the theorem’s assumptions of “irrelevance”, the opponents
argue that the real world is imperfect with numerous costs and frictions; and just because of that, the
gearing matters; moreover, in the real world, investors with varying risk tolerance have asymmetry
of information and do not have an equal access to the capital markets. Also, there is a stark contrast
between the theoretical framework and the empirical results, the latter are poor.

Before the advent of the “mean-variance equilibrium model of exchange” (Merton, 1973a), commonly
referred to as the capital asset pricing model (CAPM), conditions of risk and the relationship between
risk valuation assets and expected return were not well-understood; nevertheless, capital markets
had operated in the absence of empirically proven microeconomic theories. Extending on Markowitz
(1952, 1959), the papers by Sharpe (1964) and Lintner (1965) marked the birth of the CAPM (also
exceptional contributions were provided by Mossin, 1966; and Treynor, 1962). Sharpe (1964) infers
that CAPM falls into “positive (descriptive)” theories, which assume that all economic agents operate

13
by the rules of Markowitz’s (1952) portfolio theory and make investment decisions accordingly. The
CAPM starts with “the investors’ preference function”, which assumes that the outcomes of future
investment opportunities are viewed with the use of probability distribution, and an investor is
willing and able to take an action on the basis of desired investment’s “expected value and standard
deviation” which are expressed by a total utility function:

U = f(Ew , σw ) , utility function.

dU / dEw > 0 , a higher Ew to a lower value is preferred.

dU / dσw < 0 , a lower value to a higher Ew is preferred.

Where 𝐸𝑤 denotes the expected future wealth, 𝜎𝑤 is the standard deviation. In the last two
assumptions, “...indifference curves relating 𝐸𝑤 and 𝜎𝑤 will be upward-sloping”. Next an investor
decides to commit a given fund (Wi ) from his existing wealth to investment; where Wt is his “terminal
wealth”, and R is the rate of return on investment (Sharpe, 1990):

R ≡ (Wt − Wi )/Wi , this formula can also be expressed as: Wt = RWi + Wi

Despite many theoretical and empirical issues, Merton (1973a, b) feels that the CAPM is one of the
most important developments in modern finance, earning William Sharpe along with Harry
Markowitz, Franco Modigliani and Merton Miller the Nobel Prize in 1990. Although the CAPM is used
both by financial and non-financial firms, and in spite of its revolutionary impact on financial
innovations and academic research, it has been subject to theoretical objections mainly caused by
empirical failures. The proponents defend the CAPM by arguing that the normal-functioning of the
capital markets is indicative that the CAPM’s assumptions were satisfied.

Prior to the development of the CAPM, the old view presupposed that the expected return on an asset
was relevant to the asset’s financing (risk was not factored in cost of capital calculation). According
to Merton (1973), the CAPM deduces that investors conform to the Markowitz (1952, 1959) mean-
variance criterion, this is the centerpiece of the criticism. Fama and French (2004) conclude that the
empirical test failures of the model suggest that most of its applications may be invalid. Black et al.
(1972) empirically invalidated the CAPM’s key assumption that the higher return from an asset is
proportional to the variance/covariance of the return. Their results indicated that CAPM under-or
over-predicts; low market beta (β) assets earn a higher yield and high β assets earn a lower yield than
what CAPM predicted. Sharpe (1964) and Lintner (1965) extend on the Markowitz (1952) by adding
two new assumptions; “complete agreement” and “borrowing and lending at a risk-free rate”.

14
Sharpe (1990) addresses one of the impediments related to the negative holding constraint in the
original CAPM (1964) that excluded short sales (a negative value for an asset can occur via borrowing
for the riskless asset or a short sale for a risky asset). As a major exodus from the original CAPM
(1964), Sharpe introduces a new condition that investors can hold positions in one or more assets
with negative values. Sharpe’s model assumes that every optimizing investor, under “a full investment
constraint”, wishes to maximize 𝑈𝑘 ; to do that, a portfolio consisting of securities with homogeneous
“marginal utility” must be selected; if this is not achieved, then the investor can do shifting from a
lower marginal utility security to a security with higher marginal utility.

Merton (1973a, b) develops his own version of the capital asset pricing model and calls it “An
Intertemporal Capital Asset Pricing Model”, and he emphasizes that the assumptions must be
“intertemporal” because “...the intertemporal nature of the model allows it to capture effects which
would never appear in a static model” such as the single-period CAPM. The extracted assumptions
that form the capital market as follow:

1) All assets have limited liability.

2) No transaction costs, taxes, or problems with indivisibilities of assets.
3) There are a sufficient number of investors with comparable wealth levels so that each investor
believes that he can buy and sell as much of an asset at the market price.
4) The capital market is always in equilibrium (e.g. no trading at non-equilibrium prices).
5) There exists an exchange market for borrowing and lending at the same rate of interest.
6) Short-sales of all assets, with full use of the proceeds, is allowed.
7) Trading in assets takes place continually in time.
8) The vector set of stochastic processes describing the opportunity set and its changes, is a time-
homogeneous (Markov process).
9) Only local changes in the state variables of the process are allowed.
10) For each asset in the opportunity set at each point in time t, the expected rate of return per unit
time, defined by:

α ≡ Et ((P(t + h) − P(t))/P(t))/h

The variance of the return per unit time is defined as:

σ2 = Et ((P(t + h) − P(t))/P(t) − ah)2 )/h

15
Where 𝑃(𝑡) represents the price of share, ℎ is the return on the asset over a horizon of time, 𝐸𝑡 is the
conditional expectation operator, 𝛼 is the instantaneous expected return, and 𝜎 2 (𝜎 2 > 0) is the
instantaneous variance of the return (Merton, 1973a).

Prior to Black and Scholes (1973) who developed the option pricing formula to calculate the prices of
European options, the earlier attempts of options valuations were based on warrants rather than
stocks (see Samuelson, 1965; Sprenkle, 1961). European options can only be exercised at maturity,
whereas the American option by Merton (1973b) can be exercised at any time before expiration.
Merton empirically proves that this gives an advantage to American put option over European put
option, and the value of the former will be greater than the value of the latter. An option gives the
holder the right to buy or sell an asset at a fixed price called the “strike price”. An option contract is
subject to pre-set terms and conditions within a specified time schedule.

Black and Scholes (1973) created a capital market environment with some “ideal conditions” for the
stock and for the option:

a) The short-term interest rate is known and is constant through time.

b) The stock price follows a random walk in continuous time with a variance rate proportional to the
square root of the stock price.
c) The stock pays no dividends or other distributions.
d) The option is “European”, it can only be exercised at maturity.
e) There are no transaction costs buying or selling the stock or the option.
f) Possible to borrow any fraction of the price of a security, buy or hold it at short-term interest rate.
g) There are no penalties to short selling.

Under these ideal conditions (assumptions), Black-Scholes say that “...the value of the option will
depend only on the price of the stock and time and on variables that are taken to be known constants”.
Their formula of the European options as follows:
∗
W(x, t) = xN(d1 ) − cer(t−t ) N(d2 )

1
lnx/c + (r + 2 v 2 )(t ∗ − t)
d1 =
v√(t ∗ − t)

1
lnx/c + (r − 2 v 2 )(t ∗ − t) d2 = d1 − σv √T
d2 =
v√(t ∗ − t)

16
Where 𝑤(𝑥, 𝑡) denotes the value of the option as a function of the stock price 𝑥 at time 𝑡, 𝑡 ∗ is the
maturity date, 𝑟 is the interest rate, c is the strike price, 𝑣 2 is the variance rate of the return on the
stock, and 𝑁(𝑑) is the cumulative normal density function (Black & Scholes, 1973).

Option pricing theories, including Black-Scholes and Merton, are based on restrictions which are
necessary assumptions or conditions to achieve consistency. Merton (1973b) says that his assumed
standard restrictions are insufficient to extend the Black and Scholes (1973) option pricing theory, so
he has introduced new assumptions to deal with specifically the effects of dividend payouts since the
European option is dividend protected. Also using the option pricing approach, Merton (1974)
develops a pricing theory for corporate bonds which are riskier with a higher default probability. The
value of corporate debt depends on provisions and restrictions imposed on them, but Merton (1974)
suggests that three of those are particularly important; (i) the riskless rate of return on government
bonds or high-rated corporate bonds; (ii) the indenture imposing provisions or restrictions; (iii) the
firm’s probability of default on its debt.

To develop his pricing theory of corporate liabilities, Merton makes several assumptions (the first
five is previously listed on p. 15, see Merton, 1974).

6. The Modigliani-Miller theorem states that the market value of a firm is invariant to its
capital structure options (whether financed via debt, equity, or hybrid).

7. The Term-Structure is "flat" and known with certainty (P(τ) = exp(−rτ));

Where r is the riskless rate of interest (constant), and the price of a riskless bond which promises a
payment of one dollar at time 𝜏 in the future.

8. The dynamics for the value of the firm, V, through time can be described by a diffusion-type
stochastic process with stochastic differential equation.

dV = (αV − C)dt + αVdz

Where α (and αy ) denotes the instantaneous expected rate of return on the firm per unit time,
C (and Cy ) is the total dollar payouts to its either shareholders or liabilities-holders, σ2 (and σ2y ) is the
instantaneous variance of return, and dz (and dzy ) is a standard Gauss-Wiener process.

Merton (1972) corrects the flaw of CAPM (risk-return tradeoff, in other words, investors select their
portfolios based on the relation between risk and expected return) by focusing on “risk-neutral
valuation” where the relation between risk and expected return is irrelevant, as Merton’s derivation
17
of the Black-Scholes formula is based on the arbitrage-based pricing instead of calculating the present
value of the option through the discounting method. Merton points out that, in continuous trading (as
opposed to intertemporal trading) involving no transaction costs and restrictions to short sales, “...the
existence of a dominated security would be equivalent to the existence of an arbitrage situation”,
termed as “symmetric market rationality”.

Altman (1968) developed the Z-score using six accounting and one market-based out of 22 variables
which are combined to produce five key financial ratios; a statistical technique known as the multiple
discriminant analysis (MDA) is used to classify or make default predictions. Although Altman’s model
predicts bankruptcy up to three years prior to the actual default, the prediction accuracy of his model
drops from 95% (one year) to 72% (two years), and the prediction accuracy deteriorates as the lead
time goes beyond two years (52% three years). Nevertheless, Altman (1968) considers his Z-score as
a very useful measure of risk with the ability of predicting defaults of distressed companies (Altman
& Hotchkiss, 2005). The Z-score was refined when Altman co-developed the “second generation ZETA”
(Altman et al., 1977). The ZETA model is more comprehensive than the Z-score and offers advantages
over a univariate study, but regression analysis is more popular. Through the discriminant coefficient
function, individual variables are transformed into a single Z value (overall index)

Z = V1 X1 + V2 X2 + ⋯ + Vn Xn ,

V1 , X2 , … Vn = discriminant coefficients, and

V1 , X2 , … Xn = independent variables

Z = 0.012X1 + 0.014X 2 + 0.033X3 + 0.006X4 + 0.999X5

Where Vi represents the discriminant coefficient and the X i values are independent, actual values. The
five variables (ratios) used in the study are: X1 = working capital / total assets; X 2 = retained
earnings / total assets; X 3 = earnings before interest and taxes / total assets; X 4 = market value
equity / book value of total debt; and X 5 = sales / total assets. To determine the discriminating power
of the model, Altman (1968) applies the F-value test, the output is a ratio describing the sums-of-
squares between groups and within groups, mathematically;

2 Ng
∑Gg=1 Ng (y̅g − y̅) 1
λ= N 2 , where y̅g = ∑ ypg
g
∑Gg=1 ∑p=1(ypg − y̅g ) Ng
p=1

18
Where G represents the number of groups, g is the group g, g = 1....G, Ng is the number of firms in
group g, 𝑦𝑝𝑔 is the firm p in group g, p = 1.... Ng, ẏ𝑔 is the group mean, and ẏ is the overall sample mean.
Altman (1968) concludes that a firm with a Z-score > 2.99 is non-bankrupt (insignificant PD), a Z-
score < 1.81 is considered bankrupt (or default is certain), and 1.81 < Z-score < 2.99 is in the “zone of
ignorance” or “gray area”.

The original Z-score needed refinements as risk has evolved considerably via fast-paced globalization,
financial innovations, and gradual integration (interconnectedness); this turn of events gave birth to
new risk types, triggering large corporate failures. As a result, Altman, Haldeman, and Narayanan
(1977) developed the new ZETA model which predicts defaults up to five years prior to the actual
bankruptcy event. Another improvement over the original Z-score is that the ZETA was tested on a
sample of manufacturing and retail firms, whereas the Z-score was developed for predicting
bankruptcies by manufacturers. The results of both Z-score and ZETA are similar for one year prior
to default; 93.9% and 96.2% respectively, but the accurate bankruptcy prediction of ZETA is
noticeably higher as the lead-time goes beyond two years (2.5 to 5 years); while the ZETA model
achieves around 70% accuracy at fifth year, the performance of Z-score for the same period is only
half of the ZETA (36%). Albeit criticism and statistical objections (e.g. narrow scope, old data, and
absent of extreme events), the Altman (1968) Z-score model has been used extensively to predict
firms facing distress and the resultant bankruptcies. However, one of the shortcomings of the Z-score
is that it only focused on some manufacturers and did not factor in asset volatility. Bemmann (2005)
asserts that although the Z-score’s bankruptcy prediction is strong for the first year, the accuracy
drops significantly in the long-term attributable to bias coefficients.

The cost of misclassification is avoided by setting the

q1 c1 cutoff score ZETA at zero, and calculated by the
ZETAc = ln
q 2 c11
formula on the left (Altman et al., 1977).

Where 𝑞1 denotes the prior probability of the bankrupt, 𝑞2 is the non-bankrupt, 𝑐1 is the cost of type
I and 𝑐11 type II errors. The efficiency of the ZETA bankruptcy classification can be compared with
other models through the use of the expected cost of ZETA shown below:

M12 M21
ECZETA = q1 ( ) C1 + q 2 ( )C
N1 N2 11

Where 𝑀12 , 𝑀21 represent bankruptcy classification misses (type I and II errors), 𝑁1 , 𝑁2 are the
number of observations in the bankrupt (N1) and non-bankrupt (N2) groups.

19
2.2 The Evolution of Risk Management Continues: More Enhanced Models

Business models in the world prior to the 1900s were based on agrarian societies and labor-intensive
agricultural output, therefore credit risk (trivial market risk) manifested within national borders; due
to geographic barriers in tandem with isolationist (beggar-thy-neighbor15) policies, banking activities
remained largely local and were mainly anchored in 5Cs (capital, collateral, character, conditions and
capacity), i.e. from capital aggregation (local depositors) to financial intermediation (allocation of
scarce resources from savers to local investors who enter into intertemporal contracts). The breakout
of WWII prompted the brutally battered world economy (thanks to Great Depression) to shift into
manufacturing underpinned by the development of other industries; as a result, United States became
a manufacturing powerhouse in the years between WWII and 1960.

After the conclusion of WWII, breakthrough developments in transportation (affordable cars, travel
by ship and airplane) forced businesses and banks to adapt to the fast-pace transformation; however,
transitioning from local to regional, and from that to national and to global meant that credit risk no
longer manifested locally (i.e. seeds of systemic risk were sowed). As geographic barriers gradually
disappeared (i.e. larger role of media, increased labor mobility, women in the workforce, reduced
restrictions of capital formation and capital flow, economic expansion, and increased consumerism),
existing risk exposures and the new strain of risks caused fractures in the US financial system and
those of developing countries and emerging market economies. During the years between WWII and
the mid-1970s, risk management evolved as well and was no longer confined to insurance policy and
Markowitz’s (1952) portfolio theory (diversification of risks) for loss prevention.

The unprecedented rise and the catastrophic fall (boom-and-bust) of the real estate industry in the
U.S. resulted in the Savings and Loan (S&L) debacle (Barth, 1991; FDIC, 1997), which was fostered by
changes in US tax laws (made more favorable), light regulation of the S&Ls (outside of main banking
regulation and supervision), and massive accumulation of capital by the S&Ls which invested capital
in real estate (Bernanke, 2005; Bracke & Fidora, 2008). While this was going on at home in the U.S.,
internationally active banks were pouring money into emerging market economies where elements
of 5Cs did not exist, and the upshot was the Latin American debt crisis in the early 1980s. After the
two lost decades (1970s: Yom Kippur War of 1973, OPEC retaliation of oil price shock in 1973 and
energy (oil) crisis in 1979, and the failure of Germany’s Cologne-based Bankhaus Herstatt in 1974;
1980s: US S&L crisis and Latin American debt crisis), a new risk-modelling tool called value-at-risk
(VaR) emerged following the 1987 US stock market crash and became mainstay in the late 1990s.

15 Countries passed protectionist policies to resolve their own economic problems at the expense of other nations.
20
In theory, VaR is not a new model, because it has been around for half a century since Baumol (1963)
introduced the concept in the early 1960s. When the US stock market crash of 1987 occurred, then
Chairman of JP Morgan asked his famous question “how much can we lose on our trading portfolio by
tomorrow’s close?” which became the basis for VaR models (Engle, 1982; Hendricks, 1996; Kupiec,
1995; Lopez & Walter, 2000; Nelson, 1991). One advantage of VaR is that it aggregates portfolio
related losses in a single number, arising from volatility triggered by changes in interest rates, equity
prices, or commodity prices. All VaR models practically provide a numeric value for the question of
the largest potential loss over a specified time horizon t at a given confidence interval p. The largest
value at risk can be written as 1 - p; meaning, the VaR on an asset is $1 million for a day at 99%
confidence, i.e. there is only 1% probability that the portfolio’s asset value will drop more than $1
million in any given day (99% of the times the portfolio’s value will drop less than $1 million).

However two key decisions were pivotal in VaR’s widespread adoption; first, JP Morgan created a
benchmark open architecture called RiskMetrics and provided public access to the compiled database
on the variances and covariance across different asset classes (JP Morgan, 1996); second, VaR became
the mainstay when the Basel Committee decided to allow banks to use VaR (at 99% confidence
interval for 10 days) internally while computing the capital adequacy and the capital requirements
(see BCBS, 1996a for market risk). VaR is calculated as shown below;

VaR = portfolio Value ∗ σ ∗ α ∗ √δt (e.g. Jorion, 1996;2001)

Where, 𝜎 denotes the daily volatility of the portfolio value, 𝛼 is the confidence level at which the
possibility of a loss is measured, 𝛿 is the time interval measured in days.

Even though many variations of VaR models exist today, none of the currently used VaR models is a
standalone tool to detect, gauge, and control complex and multidimensional risks under extreme but
plausible stress scenarios. Unless complemented by stress testing or other risk-modelling tools, VaR
is not a universally agreed best approach to measure market risk or bank-wide risks in an acute stress.
Therefore, it is suggested in the literature that either VaR models are incorporated with stress testing
or further research should be done on GARCH, IGARCH, EGARCH, and the quasi-maximum likelihood
GARCH (or QML GARCH) as alternative models.

Structural (e.g. Merton, 1974) and reduced form (e.g. Hull & White, 2000) models, derived from
Merton’s model on the pricing of corporate debt (bonds), are widely used to forecast probabilities of
default (PD) and distance-to-default (DtD). The DtD measures how many standard deviation a non-
financial firm is away from (distance to) a default risk (Black & Cox, 1976). The default point is when
the book-value of the debt exceeds the market value of assets, causing the firm a failure to service a
21
portion or all of its debt obligations; in this situation, the firm is considered to be in default. However,
it is not clear or well-understood what influences the DtD because the determinants of the DtD are
varied and multifaceted with linkages to the real economy.

In the Merton (1974), “the use of the term "risk" is restricted to the possible gains or losses to
bondholders as a result of (unanticipated) changes in the probability of default...”, and the distance-
to-default DDT over a horizon of T periods is given as;

V 1 The value of equity (E) can be written as:

ln D + (μ − 2 σ2 ) T
DDT = E = max(0, V – D)
σ√T
Where V denotes the value of the firm assets, D is the strike price (or default barrier), 𝜇 is the growth
value of firm’s assets, and 𝜎 is the asset volatility (Chan-Lau, 2006).

In the mentioned studies above, accounting-based and market-based data is used; in the market-
based, bond and equity prices provide information about default probabilities. Chan-Lau (2006)
calculates the probability of default of a zero-coupon (one unit value at maturity);

(1 − p) + pRR 1 − (1 + r)B
B= p=
1+r 1 − RR

Where B is the price of one unit zero-coupon bond, ρ is the default probability, RR is the recovery rate,
and r is the risk-free discount rate. Chan-Lau and Gravelle (2005) used the expected number of
defaults (END) to measure systemic risk in corporate, financial, and sovereign segments.

Chan-Lau (2006) states that knowing the asset value and asset volatility of the firm are prerequisites
to estimating the default probability of an equity in period t for a horizon of T years which is given by
the following formulas:
Vt
Et = Vt N(d1 ) − e−rT DN(d2 ) σE = N(d1 )
Et

Where N is the cumulative normal distribution, 𝑉𝑡 is the value of assets in period t, r is the risk-free
rate, and 𝜎𝐴 is the asset volatility.

V σ2
ln Dt + (r − 2A ) T
Pt = N (− ) d2 = d1 − σA √T
σA √T

22
Čihák (2007a) sees weaknesses in the earlier default-prediction measures and argues that a good
framework of financial stability needs to incorporate probabilities of default (PD) and loss given
default (LGD) of individual banks, and correlations of defaults (CD) across the entire financial system.
He also infers that the distribution of aggregate (systemic) loss as an early indicator provides a much
clearer picture of financial stability or instability compared to other only accounting-based measures
of risk. Čihák (2007a) uses elements of the credit portfolio risk theory (e.g. Saunders & Allen, 2002),
where he computes the distribution of systemic loss as;
n

Ls = ∑ Li
i=1

Where the financial system consists 𝓃 banks, Ls is the distribution of systemic loss, 𝔦 is the default
value of banks (when 𝔦 = 0, the bank is solvent; insolvent if Li > 0), and Li is a random variable with a
distribution from 0 to X i , and X i is the maximum loss of a bank. In the event of an acute financial
stress triggered by domestic, macroeconomic, or the confluence of both factors, Čihák (2007a)
concludes that bank 𝔦 may be in default when;
k

m√P + εi √1 − P ≤ Φ −1 (PD), where P = ∑ β2j

j=1

Φ−1 (PD) − m√P

εi
√1 − P

Where M (𝓂1 , 𝓂2 ...,𝓂𝑘 ) is the systemic factors affecting all banks in the financial system (but each
bank’s vulnerability exposure is varied), ℰi is the idiosyncratic shock, Ф is the cumulative normal
distribution of losses, PD is the probability of default. Next, for a given value of m, Čihák (2007a)
formulates the probability of bank 𝔦 to be in default:

Φ−1 (PDi ) − m√P

PDi |m ≤ Φ [ ]
√1 − P

To check whether the bank 𝔦 defaults or not, a standard normal variable ℰi is drawn and characterized
by the following indicator function:

Φ−1 (PDi ) − m√P 1 if true

I {εi ≤ }={ .
√1 − P 0 if false

Next, the loss to bank 𝔦 is calculated for a given state draw m, m(r), and ℰi , ℰi (r);
23
 Φ−1 (PDi ) − m√P
Lossi | m(r) = I {εi ≤ } X i Si
√1 − P

Finally, the expected loss is formulated as;

R
(LOSS)
1 Φ−1 (PDi ) − m√P
E |m = ∑. (I {εi (r) ≤ } X i Si )
R √1 − P
i=1

Extending on the Black-Scholes (1973) and Merton (1974) models, Vasicek (1984) assumes that the
total asset value (or value of the firm) follows a stochastic process;

dA = μAdt + Adz, t > 0

Where A represents the value of total assets, μ and 𝜎 2 are the instantaneous mean and variance
respectively, and dz is a standard Gauss-Wiener process. Vasicek (1984) says that a short-term loan
will be in default if A(T) < DT + CT; where, T is the term to maturity of the loan, DT is the value of the
short-term debt, CT is the amount due at maturity, and F is the combined dividend and interest
payments. Next, the probability of default (𝑝) is formulated below; N denotes the cumulative normal
distribution function (Vasicek, 1984).

p = P(A(T) < DT + CT |A(0)) = A

p = P(log A(T) < log(DT + CT ) | A(0) = A)

1
log(DT + CT ) − log(A − F) − μT + 2 σ2 T
p=N ( )
σ√T

Knowing default probabilities is of importance to firms, lenders, and counterparties; however,

computing the default rate of a firm is not an easy task; this is also evinced in the literature that the
relationship between stock returns and default probability is a complex one (e.g. Duffie & Singleton,
2003). Although the default rate of a firm with a rating of AAA in advanced countries is less than 2%
per annum, losses in the event of a default can be pretty significant. Crosbie and Bohn (2003) point
out that spreads tend to be higher to compensate higher risk surrounding PDs of volatile firms with
high leverage. Merton’s model computes spreads (Arora et al., 2005);

1 A
s=− log(Φ(d2 ) + exp (rT) Φ (−d1 )
T x
24
Where s is the spread, T is the default point in time, Ф is the cumulative normal distribution function,
A is the initial asset value (before default), X is the default threshold (or point of default), 𝜇 is the
deterioration in asset return, and 𝜎 is the asset return volatility.

2.3 The Failure of Risk Management Theories, Models, Tools, and Approaches

“During the past two decades, financial markets worldwide have become increasingly
interconnected. Financial globalization has brought considerable benefits to national
economies and to investors and savers, but it has also changed the structure of markets,
creating new risks and challenges for market participants and policymakers”6

Risks are both dynamic and multidimensional, which evolve, mutate, and transform over time. The
contemporaneous crises since the late 1990s serve a painful reminder that financial authorities (the
Fed, Bank of England, ECB, and Bank of Japan in particular), the supervisory community (BCBS, EBA,
BIS, etc.), and the multilateral organizations (IMF, World Bank, IIF, OECD, etc.) have gravely failed to
strengthen the global financial system in order to prevent the recurrence of banking, economic and
financial crises, to mitigate huge costs to economies worldwide, and to safeguard the global financial
stability. Various risk types have evolved, so did risk management; regardless, economic theories, risk
modelling tools, risk assessment/management frameworks, capital adequacy and liquidity measures
under Basel I, Basel II, country surveillance as part of the IMF’s FSAP, individual banks’ micro stress
testing for internal risk assessment, and macroprudential stress tests by supervisors and central
banks have contributed to further instability rather than stability in the global financial system. The
reasons why risk-management (especially since the 1990s) has failed to prevent costly crises:

 Financial analysis of publicly-listed companies through the use of accounting ratios is a popular
technique, however there are a number of limitations; 1) results of a ratio analysis represent past
(historical) company performance, when quarterly results are out, it may be already too late to
take appropriate actions; 2) inflationary effects, results are adjusted if inflation rises between each
release of quarterly statements (balance sheet, income statement, and statement of cash flow); 3)
changes in accounting policies will result in discrepancies in the reported results before and after
the change was made; 4) significant operational (or strategy) changes may lead to misleading or
manipulated conclusions, this in turn may send wrong signals to investors about the company’s
past performance and future prospects; 5) results may be interpreted falsely (lower or higher) due
to seasonal effects; 6) some greedy (and deceitful) managers may manipulate the results to inflate

6 See IMF, http://www.imf.org/external/pubs/ft/fandd/2002/03/hausler.htm

25
 the company’s earnings so that its share price goes up. All of these issues make the ratio analysis
less reliable. Investors lost billions of dollars as a result of accounting scandals by the high-profile
companies; Waste Management Scandal (1998), Enron Scandal (2001), WorldCom Scandal (2002),
Tyco Scandal (2002), HealthSouth Scandal (2003), Freddie Mac Scandal (2003), Lehman Brothers
Scandal (2008), and American International Group (AIG) Scandal (2005).

 Markowitz’s (1952) portfolio theory (mean-variance criterion) reduces the risk via the selection of
an ultimate portfolio. Investors have varying risk thresholds, and the theory has arduous data
requirements. The theory has been subject to many empirical and theoretical objections, this was
attributable to the theory’s single-period (discrete time) nature and assumption that investors
have homogeneous expectations rather than “myopic utility functions” and conform to the mean-
variance criterion. Fama and French (2004) conclude that the empirical test failures of the model
suggest that most of its applications may be invalid. Modern portfolio theory (MPT) has a number
of shortcomings; 1) portfolio theory does not model the market, its mathematical calculations do
not reflect the reality (actual numbers); 2) MPT does not factor in transaction costs as well as taxes
which negatively affect the performance of portfolios (profitability); 3) the theory assumes same
level of credibility for all investors, in reality, lending and borrowing activities are based on credit
scores of each investor; 4) another assumption of MPT, all investors have realistic expectations,
but in reality, men are irrational therefore have unrealistic expectations; 5) MPT assumes that all
investors are risk-averse who make rational decisions, this is not true, some decisions are made
based on emotions and may not be completely rational; 6) another wrong assumption is that no
investor makes impact on share prices, this is incorrect again, large institutional investors can have
impact on share prices, not all investors are price takers, some are price movers.

 Although CAPM (capital asset pricing model) was used both in financial and non-financial firms, it
had been subject to theoretical objections mainly caused by empirical failures. Proponents defend
the CAPM by arguing that the normal-functioning of the capital markets was indicative that the
CAPM’s assumptions were satisfied (Sharpe, 1964; Lintner, 1965; Mossin, 1966; Treynor, 1962).
CAPM deduced Markowitz’s mean-variance criterion, and this was the centerpiece of the criticism
(e.g. Merton, 1973a; Markowitz, 1952, 1959). Another criticism about the CAPM is that it under-or
over-predicts risk exposures, i.e. low market beta (𝛽) assets earn a higher yield and high 𝛽 assets
earn a lower yield than what CAPM predicted. Same Markowitz’s portfolio theory failed to assess
risks under highly adverse market conditions, CAPM falls into “positive (descriptive)” theories
which assume that all economic agents operate by the rules of Markowitz’ portfolio theory and
make investment decisions accordingly (Sharpe, 1990). CAPM failed to validate its measure of risk

26
 as well as linkages between risk and expected return, ally due to simplistic assumptions,
theoretical issues, and implementation challenges in testing the model (Fama & French, 2004).

 Merton did not envisage the growth potential of options and derivatives market (a derivative’s
value is derived from an underlying asset), he elaborated “...options are specialized and relatively
unimportant financial securities, the amount of time and space devoted to the development of a
pricing theory might be questioned”. The global derivatives market leading to the 2008 global
financial crisis (GFC) was five times larger than equity and bond markets (BIS, 2008), and the
exponential growth of derivatives is blamed for causing the GFC (Black & Scholes, 1973; Merton,
1973b). Throughout the 1990s and early 2000s, derivative related risk exposures were a key
destabilizing factor in the US origin crises such as the dot.com, mortgage debacle (subprime), and
the GFC of 2008 (BCBS, 2010a, b). Over the Counter (OTC) derivatives markets in the U.S. were
outside of the heavily regulated traditional banking system and subject to light or no regulation;
the exponential growth of derivatives since the 1990s coupled with ever more interconnectedness
due to fast-paced globalization and internationalization of finance has accelerated the buildup of
systemic risk that amplified the GFC’s aggregate loss. Banks along with the supervisory community
failed to identify and capture massive on- and off-balance sheet risks which were deeply
entrenched in securitized and re-securitized derivatives. Billionaire Warren Buffet described
derivatives as the “weapons of mass destruction.” The global savings glut (Bernanke, 2005; thanks
to the Fed’s accommodative expansive monetary policy) and the resultant easy (lax) credit (cheap
dollar) environment created a malaise in most advanced economies, and the side effect of which
was an illusory perception that unconventional risks related to structured products, securitization,
and derivatives were the new normal”. Since the inception of derivatives and securitization of
structured finance products, financial markets have become progressively more complex and
increasingly vulnerable; as a result, crises have become more disruptive, prolonged, and costly.

 Securitization of debt is regarded as vital for creating opportunities of new funding sources and
much needed liquidity in the financial system (Shin, 2009); however, financial and technological
innovations such as mortgage-backed securities (MBSs), collateralized debt obligations (CDOs),
and asset-backed commercial paper (ABCP) created a new breed of hard-to-detect risk exposures.
Financial innovation and related instruments added a new twist to risk assessment/management;
banks’ narrow focused risk management approaches failed to detect these new risk types which
were deeply embedded in securitized derivatives and structured finance products such as SIV
(structured investment vehicle) and SPE (special purpose entity) Securitization is also criticized
for enabling repeated issuances of liabilities (bad potatoes) in the form of SPVs and SPEs (Jobst et
al., 2013) which are set up as legal entities that can make business decisions.
27
 Following the 1987 US stock market crash, Chairman of JP Morgan asked his famous question “how
much can we lose on our trading portfolio by tomorrow’s close?” which became the basis for Value-
at-Risk (VaR) models. The accuracy of numeric VaR outputs depends on previously set variance
and covariance, without them the results are literally meaningless. Although VaR quickly became
a universally accepted standard measure to quantify market risk in a single number, nonetheless
it is not a standalone tool and the numeric values of a VaR model under extreme but plausible
scenarios are less reliable, therefore must be validated (complemented) by another statistical tool
such as stress testing (Jorion, 2001). Due to amplified risks in the 1980s and 1990s, the Basel
committee on Banking Supervision (BCBS) required banks to employ a VaR model (at 99%
confidence interval for 10 days) internally while computing the capital adequacy and the minimum
capital requirements (BCBS, 1996a). Virtually all VaR models (through variance-covariance,
historical, and Monte Carlo simulations) focus on tail-risk ignoring other risk types. Historical
simulation takes much longer time to process and it is only good with a moderate data size,
meaning not reliable for larger data size, but the distinctive advantage of this approach is its ability
to time market crashes. The variance covariance method is the fastest of the three, but its quick
results are less reliable involving options and bonds; the major weakness here is the heavy reliance
on assumptions. The Monte Carlo simulation is the slowest compared to its peers, but has the
capability of processing both private and historical data; as a result, it is a popular tool among
banks and supervisors (e.g. Benninga & Wiener, 1998). The accuracy of VaR outputs depends on
previously set variances and covariance; all VaR models focus on downside risks, ignoring liquidity
and systemic risks; the conditional normal distribution of returns is a prerequisite (ineffective in
heterogeneous distributions with many outliers or negative returns); linearity is a requirement,
but the payoff of an option is not linear; stationarity and non-stationarity may cause a breakdown
in VaR computations (Fallon, 1996; Hendricks, 1996). VaR models have been dissected under the
microscope as the GFC of 2008 revealed severe flaws; for instance, VaR has been blamed for being
“blind to true risk” (i.e. securitization and pipeline risks) under highly adverse market conditions.

 Prior to the establishment of the Basel Committee on Banking Supervision in 1974, large banks
had a constant propensity to circumvent banking regulation and supervision through inventing
loopholes such as skirting, race to the bottom, de facto versus de jure and cherry picking. In July
1988, the Basel Committee released Basel I (“International Convergence of Capital Measurement
and Capital Standards”) to banks within G-10, and had envisaged that the Basel I standard in the
long-run would make the global banking system more resilient; instead, arbitrary risk categories
and arbitrary risk buckets under Basel I ushered greater risk-taking (Table 4), making the global
financial system become more susceptible to costly and longer lasting systemic crises. Ferguson

28
 (2003), former Federal Reserve Vice Chairman, elaborated in a speech that “Basel I Accord is too
simplistic to adequately address the activities of the most complex banking institutions”. Basel I
also failed in its founding objectives “to strengthen the soundness and stability of the international
banking system” and “to reduce competitive inequalities” (BCBS, 1988). Another shortcoming of
Basel I is that it did not achieve a level of playing field by requiring all banks within G-10 to comply
with the one-size-fits-all capital adequacy rules. Risk-insensitiveness rules of Basel I primarily
focused on credit risk while ignoring other important risk types such as securitization risk, market
risk, liquidity risk (funding freeze), and procyclical deleveraging. Simplistic Basel I rules not only
enabled banks to hoard more capital via disintermediation (credit crunch in the 1990s), but caused
significant distortions in cross-border lending, and resulted in massive capital arbitrage. The Basel
Committee acknowledged that Basel I played a role in creating the East Asian crisis of 1997-98.
Basel I created incentives for gaming the system, this enabled banks to move higher-risk assets
between on-balance and off-balance sheets via securitization; this in turn created a new bank type
called shadow banking. Another deficiency of Basel I was that Securitization was used as a method
to disperse risk; conversely, this enabled the inherent risks from complex securitized instruments
(CDO, MBS, and CDS) to be deeply entrenched in the whole financial system, making it extremely
challenging for the financial authorities to assess whether or not each bank in the financial system
had both adequate capital and sufficient capital buffers to absorb losses in an acute stress.

Table 4: Arbitrary risk categories and risk weights under Basel I

Cash claims on OECD governments and loans either collateralized or and
1. 0%
guaranteed by them, claims on non-government domestic entities.
Claims on multilateral development banks incorporated within OECD and loans
2. 20% guaranteed by such entities, cash in collection, claims on OECD banks and short-
term loans (less than one year).
Fully secured mortgage loans on residential properties either occupied by the
3. 50%
borrower or rented out.
Claims on private sector, non-OECD banks (maturity of over one year),
4. 100% commercial firms owned by public entities, non-OECD governments, real estate,
and equity issued by banks.

Source: BCBS (1988)

 The systemic Asian crisis in the late 1990s prompted the Basel Committee to overhaul Basel I, the
outcome was a revised framework known as Basel II (Table 5; see BCBS, 2004). Despite Basel II’s
increased sensitivity to risks and the hype generated by the Basel Committee, Basel II still failed to
strengthen the global banking resilience; quite the opposite, Basel II rules raised procyclicality and
turned the too-big-to-fail banks into bigger-and harder-to-fail banks. The largest damage of Basel
II was that it made banks overly rely on ratings provided by external credit assessment institutions
(ECAIs) for even decisions on dividend payouts, audit frequency, and deposit rates; consequently,
29
 both large and systemically important banks felt the least urgency to strengthen their existing risk-
management frameworks or develop far better ones. Basel II has been criticized for amplifying
cyclical lending, this in turn reduced capital inflows to emerging market economies and developing
countries. Saurina and Trucharte (2007) emphasized that Basel II rules increased procyclicality
substantially, exacerbated boom-bust cycles, and led to deleveraging; as a result, contagion and
counterparty risk triggered a noticeable surge in defaults. Gordy (2003) argued that a single global
risk factor of Basel II to capture firm defaults increased the likelihood of large capital shortfalls.
Blundell-Wignall et al (2014) assert that Basel II raises procyclicality. The Basel Committee
admitted that the overreliance on external ratings provided by the ECAIs under Basel II caused
“cliff effects” in capital requirements and promoted banks to overreact to the GFC of 2008. The
Basel Committee had observed that important risks (securitization, short-term funding, liquidity,
contagion and counterparty default) were not detected and covered sufficiently under Basel II.

Table 5: Revised risk weights and credit assessments under Basel II

Option 1: Sovereigns

AAA A+ BBB+ BB+ Below

Credit Assessment Unrated
to AA- to A- to BBB- to B- B-

Risk Weight 20% 50% 100% 100% 150% 100%

Option 2: Banks & Corporations

AAA A+ BBB+ BB+ Below

Credit Assessment Unrated
to AA- to A- to BBB- to B- B-

Risk Weight 20% 50% 50% 100% 150% 50%

Short-term Risk
20% 20% 20% 50% 150% 20%
Weight

Corporate 20% 50% 100% 100% 150% 100%

ECA Risk Scores 0-1 2 3 4-6 7

Risk Weights 0% 20% 50% 100% 150%

Source: BCBS (2004)

 The inherent flaws (deficiencies) of VaR models prompted the Basel Committee to encourage the
development of an enhanced statistical tool to complement (not supplant) VaR. Prior to the Asian
crisis of 1997-98, the Basel Committee internally developed backtesting to confirm the accuracy
of VaR outputs; however, it was not settled on a single method. Backtesting was later replaced by
stress testing due to its deficiencies and imperfect signals (BCBS, 1996b; Campbell, 2005). Earlier
microprudential stress tests conducted by individual banks were bank-wide (not system-wide),
narrow in scope, portfolio-focused, and produced results by design (i.e. light and predictable stress
30
 scenarios). Banks mainly used stress testing to gauge risk exposures for internal purposes while
calculating capital adequacy and determining capital allocation. The supervisory community used
micro stress tests to assess the health of banks and the soundness of banking sectors.

Source: Author; BCBS (2004)

Figure 3: Pillar Structure of Basel II

 Micro stress tests under Basel II were used to assess bank-specific risks, calculate capital adequacy
taking into account credit risk, operational risk, market risk, liquidity risk, and interbank contagion
risk (Figure 3). However, banks are not left on their own in this process, designing of banks’ stress
testing frameworks along with their results are subject to rigorous oversight as part of Supervisory
Review Process under Basel II and III, defined by the Basel Committee as principles-based approach
that covers all risks. Micro stress tests conducted by supervisors collect data from banks in order
to assess the soundness of banks and to ensure that each bank meets the preset capital adequacy
ratio (CAR) and holds sufficient capital buffers (liquidity). However, very complex nature of the
supervisory stress tests is criticized for being resource intensive and costly; banks that fail to meet
CAR are mandated to change their lending and capital planning behavior, and raise fresh capital if
necessary to comply with capital and liquidity requirements. Some economists blamed Basel II for
the GFC, however Basel II implementation was interrupted by the subprime debacle in 2006-07.
31
 Source: Author; Pruski (2012)
Figure 4: IMF financial sector assessment program (FSAP)

 Amplified financial turmoil in the 1990s prompted the IMF and the World Bank to jointly establish
the Financial Sector Assessment Program (FSAP) in 1999 to assess financial sector soundness and
the stability of the IMF member-countries (Figure 4). Stress testing is an integral component of the
FSAP which, as part of its surveillance program known as Article IV Consultation, was created “...to
help countries enhance their resilience to crises and foster growth by promoting financial stability
and financial sector diversity” (IEO, 2006). A major criticism towards the FSAP is that participation
is voluntary and does not carry a legal force; proponents argue that this aspect of the FSAP exposes
the global financial system to systemic risk as some SIBs and their home countries may decide not
to participate in the program. The Financial Sector Assessment Program has failed to strengthen
the global financial stability because it is a very slow process (i.e. between 1 and 2 FSAP is
completed per month, between 17 and 19 per year); at this rate, it would take the IMF about 11

32
 years to complete FSAPs of 188 member countries. To improve the speed and the efficiency of the
program, the IMF has established the following prioritization criteria to select member-countries
to undergo FSAP; (i) systemic importance of the country; (ii) macroeconomic or financial
vulnerabilities; (iii) major reform programs; and (iv) monetary policy regimes and features of the
exchange rate that contribute to financial instability. Although the IMF’s FSAP has been initially
praised as a forward-looking process for making stress testing systematic and consistently applied
in IMF-member countries, but the misleading results of Iceland’s FSAP (IMF, 2008) caused not only
loss of credibility but left a long-lasting scuff on the unblemished reputation of the IMF and the
World Bank (for the lessons learned, see IMF & World Bank, 2003; 2005a; b).

 Macro stress testing (used by supervisors and central banks) is broad in scope, system focused (i.e.
health of an entire financial system is more vital than individual banks), systemic risk in check, and
is used as a crisis management tool by central banks only. To restore confidence, calm the state of
panic, and mitigate further losses, the Fed introduced the SCAP (Supervisory Capital Assessment
Program) in 2009. The widely perceived success of the SCAP spurred worldwide implementations,
but the success rate was varied and disparate across the globe. The SCAP was informative and the
Fed’s publishing of methodology along with the results was received well by the financial markets
(stock prices rose). The Committee of European Banking Supervisors (CEBS) followed the Fed’s
footsteps, but the first two EU-wide stress tests were bungled up. Macro stress tests designed and
conducted by the CEBS (2010) and the successor EBA (2011) contributed to financial instability
in Europe rather than restoring investor confidence as it was the case in the U.S. In stark contrast
to the Fed’s SCAP, the EU version of the stress tests were perceived uninformative due to a partial
disclosure of the results by the CEBS; consequently, stress conditions were deepened across the
EU and the upshot was a severe credit crunch, which ultimately led to the European sovereign debt
crisis during 2010-12 (see Blinder, 2013 for steps to restore confidence; FCIC, 2011 for causes;
Dewatripont et al., 2010 for lessons learned; and Nissanke, 2010 for impact on EMEs). Also, earlier
EU-wide stress testing programs have contrasted with the U.S. SCAP in terms of macro financial
parameters used and risk factors assumed. Cardinali and Nordmark (2011), Ellahie (2012), and
Petrella and Resti (2013) suggest that the CEBS (2010a) stress test was uninformative; as a result,
non-disclosure of the test results caused a decline in European equity markets.

 The failure of both Basel I and Basel II to strengthen the global financial system prompted the Basel
Committee to introduce a set of more stringent capital and liquidity regulation in December 2010
known as Basel III, fully effective by January 2019. Despite an initial cost burden on banks for the
implementation, Basel III is argued to be a major improvement over Basel I and Basel II in terms
of capital definition and the regulatory capital minima along with capital buffers. The vagueness
33
 of capital under Basel I and II was resolved by clearly defining deductions from the Common Equity
Tier 1 (CET1), Tier 2 capital was tightened and the Tier 3 capital was found unnecessary, therefore
eliminated permanently (Table 6). Same with the antecedent Basel standards the introduction of
Basel III was a reactionary response to a financial crisis, the GFC of 2008 (i.e. Basel I was introduced
after the US S&L crisis and Latin American debt crisis; the introduction of Basel II – Revised
Framework followed the breakout of the East Asian crisis of 1997-98).

Table 6: Basel III phase-in arrangements

Shading in grey indicates transition periods – all dates are as of January 1st

2013 2014 2015 2016 2017 2018 2019

Parallel run 2013 – 2017 Migration to

Leverage ratio
Disclosure starts 2015 Pillar 1 (2018)

Minimum CET1 ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%

Capital buffer 0.625% 1.25% 1.825% 2.5%

0 to
Countercyclical buffer Phase-in
2.5%
1.0 to
G-SIB surcharge Phase-in
2.5%
Minimum common
3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%
equity + capital buffer

Phase-in deductions
20% 40% 60% 80% 100% 100%
from CET1

Minimum Tier 1 capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%

Minimum total capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%

Minimum total capital

8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5%
+ conservation buffer

Capital instruments that

Phased out over 10-year horizon beginning 2013
no longer Tier 1 or Tier 2

Liquidity coverage ratio Observation

Introduce minimum standard by 2015
LCR ≥ 100 (short-term) Begins 2011

Net stable funding ratio Observation Introduce minimum

NSFR ≥ 100 (long-term) Begins 2011 Standard by 2018

Source: BCBS (2010a, b)

Notes: The minimum capital requirement increased significantly (4.5% Tier 1 + 2.5% capital buffers). Two new
liquidity standards (LCR > 100% and NSFR > 100%) and a leverage ratio (3%) have been introduced. Further, new
charges (2.5% G-SIB surcharge) and a 2.5% countercyclical buffer apply. When the minimum capital requirements,
capital buffers, and surcharges are added; banks may have as much as 13% capital charge.

 Banks have kept complaining about higher capital ratios, capital charges, and a tighter liquidity
regulation under Basel III. Carmassi and Micossi (2012) assert that the global banking system will
become more susceptible to shocks due to the rigorous capital and tighter liquidity rules under

34
 Basel III, which may potentially reduce the amount of capital for banks to invest while increasing
banks’ leverage. A number of measures was introduced under Basel III to correct all fundamental
deficiencies of the antecedent Basel standards (Basel I and II). Going forward, the assessments of
credit and market risks are no longer based on simplistic historical statistical correlations; the
rigorous Basel III rules are designed to address mark-to-market counterparty credit risk, credit
valuation adjustments and wrong-way risk (BCBS, 2010a; b). Since the Great Recession (the GFC
of 2008-09), the world has not yet experienced another GFC-like financial catastrophe, therefore
the next severe financial shock at same magnitude or higher than the GFC will attest whether Basel
III rules, contrary to the previous frameworks (Basel I and II), have been able to make the global
financial system more resilient to withstand shocks in an acute financial stress.

3.0 Concluding Remarks

“History repeats itself” is not just an idiom, it is the naked truth; another agonizing fact is that humans
do not seem to have learned from past experiences throughout history. For instance, misleading or
policy error by the Fed (unwarranted tight-money policy stance in the 1920s) was argued to be one
of the contributing forces that triggered the 1929 US stock market crash, and the ensuing panic caused
the Great Depression of the 1930s – the severest shock in the history of humankind. Looking for a
scapegoat and responding to the public outcry for more rigorous regulations, the U.S. government
rushed to pass the Glass-Steagall Act (the Banking Act of 1933) which barred commercial banks from
engaging in investment and underwriting activities. Over a half century later, the Gramm-Leach-Bliley
Act of 1999 during the Clinton administration repealed the Banking Act of 1933 which allowed banks
to resume their speculative and highly risky investment activities of the past (i.e. predatory lending
practices and credit expansion into sub-prime), this combined with historically low interest rates and
another policy error by the Fed (this time around, accommodative – expansive policy stance in the
1990s created dollar glut) contributed to the Great Recession of 2008-09.

Banks (and non-bank financial institutions) are at the epicenter of financial intermediation, and there
is no perfect substitute for banks in the capital markets; furthermore, banks are an inextricable part
of any sustainable economic growth because they allocate scarce and limited resources from savers
to investors who enter into intertemporal contracts. Risks are both dynamic and multidimensional
which evolve, mutate, and transform over time; consequently, banks have a regular and in ongoing
basis have the task of coping with a constant inventory of operational risks such as imperfect market
frictions, asymmetry of information, and transaction costs. For the past four decades, a financial crisis
has occurred in every decade, i.e. US stock market crash of 1987, Asian crisis of 1997-98, subprime

35
crisis of 2006, global financial crisis 0f 2007-08 and the subsequent European sovereign debt crisis
of 2009-12, and great global health crisis (COVID-19) of 2019-present. These repeated crises serve a
painful reminder that the influential financial authorities (Fed and ECB in particular), the supervisory
community (BCBS, EBA, BIS, etc.), and the multilateral organizations (IMF, World Bank, IIF, OECD,
etc.) have grossly failed to strengthen the global financial system by preventing the recurrence of
banking, financial, economic and currency crises, mitigating their massive costs to economies, and
safeguarding the global financial stability. Consequently, various risk detection and risk management
tools alongside capital adequacy and liquidity measures under Basel I, Basel II, FSAP, and individual
banks’ inadequate microprudential stress tests contributed to further instability rather than stability
in the global financial system. Macroprudential stress testing as a crisis-management tool has resulted
in positive outcomes in advanced economies, but the next high-magnitude future financial crisis will
show to what extent banks have improved their capital positions (both in quality and quantity) and
development enhanced risk assessment frameworks for internal risk measurement purposes.

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