Learning From History: Volatility And Financial Crises

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Learning From History: Volatility And Financial Crises

Jon Danielsson
London School of Economics – Systemic Risk Centre

Marcela Valenzuela
University of Chile

Ilknur Zer
Federal Reserve Board

May 23, 2016


We study the effects of volatility on the probability of financial crises by constructing a cross-country database spanning 211 years. We find that volatility is not a significant predictor of crises whereas unusually high and low volatilities are. Low volatility leads to banking crises and both high and low volatilities make stock market crises more likely, while volatility in any form has little impact on currency crises. The volatility-crisis relationship becomes stronger when financial markets are more prominent and less regulated. Finally, low-risk environments are conducive to greater buildup of risk-taking, providing empirical support for the Minsky hypothesis.

Learning From History: Volatility And Financial Crises – Introduction

Volatility, both actual and expected, in markets is at low levels… to the
extent that low levels of volatility may induce risk-taking behavior … is a
concern to me and to the Committee.” – Federal Reserve Chair Janet Yellen, June 18, 2014.

Does unusual levels of financial market volatility imply an increased likelihood of a subsequent financial crisis? A common view maintains it does, pointing to the low volatility in the United States in the years prior to the 2008 crisis. This view is backed up by the theoretical literature, which finds clear channels for how volatility affects the likelihood of crises. However, to the best of our knowledge, it has not been conclusively empirically studied, which motivates our investigation into the link between financial market volatility, the real economy, and crises.

Market volatility is of clear interest to policymakers, with the above quotation by Chair Yellen just one example. Within the post-crisis macroprudential agenda, policymakers are actively searching for signals of future financial and economic instability and developing policy tools to mitigate the most unfortunate outcomes. Volatility is part of the macro-prudential toolkit. Unfortunately, in the absence of clear empirical guidance as how volatility affects future crises, it can be a difficult tool to wield.

Concerns about the relationship between the financial market and economic risk have a long history in the economic literature, notably Keynes (1936), Hayek (1960), and Minsky (1992) who argue that economic agents change their risk-taking behavior when financial market risk changes.

Thus, the theoretical literature suggests that financial market volatility affects economic decisions, especially when it deviates from what economic agents expect it to be. Relatively higher levels of volatility indicate higher uncertainty regarding future cash flows and discount rates, and hence, future economic conditions. Such high volatility can therefore be seen by forward-looking economic agents as a signal of the increased risk of adverse future outcomes and a pending crisis. We term this chain of events the high volatility channel.

Low volatility may also lead to a crisis, via what we denote the low volatility channel. Danielsson et al. (2012) propose a general equilibrium framework, whereby low risk induces economic agents to take more risk, which then endogenously affects the likelihood of future shocks. Similarly, Brunnermeier and Sannikov (2014), studying the volatility paradox, model how low fundamental risk leads to higher equilibrium leverage, and hence the buildup of systemic risk.

These arguments suggest that the high volatility channel is most important closer to a crisis, while the low channel is most important farther from a crisis. Low volatility induces risk-taking, which only materializes during a crisis, while high volatility is a signal of a pending crisis.

Volatility And Financial Crises

That leaves the question of how to quantify high and low volatility. Our empirical evidence indicates that volatility exhibits a slow-moving, non-linear trend. Borrowing terminology from the literature on output gap, we interpret this slow-run trend as the long-term volatility and calculate it using a one-sided Hodrick and Prescott (1997) filter. We then calculate the volatility gap”. Relatively high and low volatility (or high and low volatility in short) are defined as the deviations of volatility from above and below its trend, respectively. This implies four diffierent notions of volatility: the level of volatility, volatility trend, and high and low volatilities.

Several authors have examined the relationship between volatility and recessions and patterns in volatility during crises, almost exclusively focusing on the United States.1 However, to the best of our knowledge we are the first to formally examine how volatility may predict financial crises. While we do not know why the literature has not addressed the issue, we can advance two hypotheses. First, the presence of two simultaneous volatility channels is likely to frustrate empirical analysis solely focusing on volatility. Second, as we argue below, it is helpful to make use of long historical relationships. In an empirical exploration of the connection between volatility and crises we face two paths. We could focus on recent history with daily market activity measurements and ample economic and financial statistics. However, this would limit us to data from the past few decades at best. Since crises are rare events, the resulting sample size would be inevitably small. For instance, an OECD member country suffers a banking crisis every 35 years, on average. Alternatively, we could exploit long-term historical relationships over multiple decades and centuries, but at the expense of more limited data. We opted for the long-term historical view believing it to be the best way to obtain meaningful relationships between volatility and crises.

Volatility And Financial Crises

Volatility And Financial Crises

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