A1.1: The key distinguishing characteristic of a systemic risk event is the fact that the impact of such events spills over into the real economy.

A1.2: No. Systemic events have been occurring since at least the Middle Ages, with the most documented event dating back to the 1600s, called the “Dutch Tulip Crisis,” in which many European investors and regular citizens took significant losses, in many cases their life savings, by making concentrated bets on the price of tulip bulbs on the futures market.

A1.3: Inflation spikes; currency crashes; currency debasements; bursting of asset bubbles; banking crisis and sovereign defaults.

A1.4: The insolvency of hundreds of U.S. banks was at the center of both the Great Depression and the Credit Crisis.

A1.5: It is critical that in the future systemic risks are better anticipated and mitigated to minimize the negative costs of such events on both the financial services sector as well as society, which often bears the cost of government bailouts.

A2.1: An asset bubble can be described as a non-sustainable pattern of price changes or cashflows that eventually suffers a precipitous decline in a short period of time.

A2.2: Although not a precondition for an asset bubble, many popular economic theories hold that “easy credit” conditions provided by Central Banks usually exist in the years leading up to a bubble. These conditions allow investors to speculate on investments, driving up the prices to unsustainable levels.

A2.3: Bubbles in real estate and stock markets represent the most common forms of asset bubbles. The most recent example of the former is the Credit Crisis in which residential home prices rose dramatically in many regions of the United States before crashing over the 2008–2010 time period.

A2.4: In early stages of industrialization, a substantial amount of the stock market valuation consists of real estate companies and construction companies and firms in other industries that are closely associated with real estate, including banks. Individuals whose wealth has increased sharply because of the increase in real estate values want to keep their wealth diversified and so they buy stocks, which in turn often fuels a bubble in stock markets.

A2.5: Inflation and capital flows; exchange rate changes; securities price changes

A2.6: Spain and France have incurred the greatest number of combined defaults (36) on external debt dating back to 1300.

A2.7: (i) Napoleonic wars; (ii) 1820s–1840s; (iii) 1870s–1890s; (iv) Great Depression era: 1930s–early 1950s; (v) Emerging markets: 1980s–1990s.

A2.8: The gold standard refers to a monetary system in which the standard unit of currency is freely convertible into gold at a fixed rate.

A3.1: Although there is no official timeframe designated for the Credit Crisis, much of research and analysis post-Crisis use 2008–2009 as representing the peak years of this event, with most high-profile financial failures or takeovers occurring during 2008.

A3.2: While there are many underlying causes of the Credit Crisis that range from questionable U.S. policy toward homeownership, to lax regulatory oversight, the aggressive use of financial innovation by Wall Street, and so on, the growth and eventual bursting of the residential real estate sector and securities derived from this sector was the primary driver of the failure of hundreds of financial firms and the associated economic fallout that followed.

A3.3: Subprime mortgages were a sub-segment of residential mortgages that differentiated between the credit quality of individual mortgage loans and mortgage-backed securities with subprime referring to borrowers with below-average individual credit scores.

A3.4: There have been many theories put forward since the Credit Crisis about what fueled the so-called asset bubble in U.S. residential real estate. Some of these theories include (i) the so-called “easy credit” monetary policy that existed in the early 2000s, in which the Fed Funds target rate declined from 6.5% to 1% between 2000 and 2003, making mortgages much more accessible to millions of additional Americans, (ii) the introduction, starting back in the 1990s, of looser mortgage underwriting standards and riskier mortgage products that required little or no down payment by borrowers, and (iii) the incentives that both the GSEs and many Wall Street firms had to generate greater and greater volumes of mortgages to fuel what was a tremendously profitable mortgage securitization business.

A3.5: Synthetic CDOs represent structured investment vehicles created and sold by Wall Street firms that often used subprime mortgage loans as underlying collateral or reference securities. Many of these structures defaulted when the loss rates on such collateral far exceeded the tolerance levels set by the investment banks for each “tranche” of the CDO. Following the Credit Crisis both investment banks and the large U.S. rating agencies suffered great criticism for the reckless way many of these investments were structured, rated, and marketed.

A3.6: While it's widely believed that no single factor caused the Credit Crisis, one area that has been the subject of significant debate is the extent to which U.S. public policy toward homeownership helped plant the seeds of the crisis dating as far back as the mid-1990s. In 1995, President Bill Clinton announced an initiative to boost U.S. homeownership from 65.1% to 67.5% of families by 2000. Also in 1995, Clinton loosened housing rules by rewriting the Community Reinvestment Act, which put added pressure on banks to lend in low-income neighborhoods.

A3.7: Fannie Mae and Freddie Mac, the two largest U.S. GSEs, were major players in the Credit Crisis. While the GSEs did not originate any individual mortgage loans, the GSEs set the standards in the United States for what constituted a Fannie- or Freddie-eligible or conforming mortgage. The GSEs also were allowed to build up real estate portfolios and offer guarantees on RMBS securities that could not be supported by their extremely thin capitalization, ultimately leading to the need for the U.S. government to seize control of both entities to minimize further dislocations in the functioning of the U.S. mortgage market.

A3.8: Although the views expressed during the months leading up to the failure of Lehman Brothers by senior U.S. government officials such as Ben Bernanke and Henry Paulson, among others, revealed that they were fully aware of the potential systemic impact Lehman's failure would likely have on global markets and economies, they decided not to provide any extraordinary support to Lehman. This decision has come under significant scrutiny since 2008 for several reasons, one of which was an accusation of inconsistency given that the government assisted with the bailout of Bear Stearns, AIG, the GSEs, and other entities.

A3.9: Among many devastating and historic impacts, the Credit Crisis sent both the United States and Europe into deep recessions, and led to >30% average decline in U.S. home prices, a similar decline in U.S. equity markets, a spike in U.S. unemployment to over 10%, and a tremendous loss in personal household net worth.

A3.10: While the economic impact of the Credit Crisis was significant, the primary government bailout program, TARP, was eventually fully repaid by its recipients so individual taxpayers incurred no losses.

A4.1: A hedge borrower, who is able to service debt payments from current cash flows from investments; speculative borrowers, for whom cash flow from investments can service interest payments on debt but require refinancing to repay principle; Ponzi borrowers who rely solely on appreciation of the underlying asset value to avoid default.

A4.2: The Theory of Benign Neglect posits that crises should be left to work themselves out.

A4.3: The concept of Moral Hazard is that the speculative behavior that fueled many historical systemic events will only be further encouraged in the future if investors feel it is likely that they will be bailed out by the government.

A4.4: Under the Efficient Market Hypothesis market prices should fully reflect all available information about a particular asset or company up to that point in time, and informed investors and traders identify any deviations between current prices and fundamental value and achieve quick arbitrage profits.

A4.5: Behavioral theory challenges these EMH assumptions, including the idea that EMH cannot adequately explain the frequent market anomalies that occur and that the influence of arbitrage on keeping markets efficient is limited.

A4.6: Investors tend to anchor their views to their initial values or judgments and, therefore, even when presented with overwhelming evidence supporting a particular adjustment to such judgments, refuse to take rational actions.

A4.7: Under the Prospect Theory, investors tend to feel the negative impact of a loss more acutely than the pleasure of an equal-sized gain, and research shows that decision makers' reaction to changes in wealth are approximately twice as sensitive to perceived losses than gains. This theory may help explain why most investors did not take advantage of significantly lower asset prices during prior crises, despite unique opportunities to buy assets at historically low prices.

A4.8: Heterogeneous beliefs represents a theory whereby investors do not agree on the basic value or expected return of an asset; meanwhile, under most asset pricing models there is an assumption that all investors will have the same expectations and make the same choices given a set of circumstances.

A4.9: The amygdala region of the brain is the final place where the neuropathway for fear response circumvents the brain's higher capabilities, including those associated with rationality. This may help explain why so many investors have made seemingly irrational and speculative decisions throughout history related to investment and borrowing.

A5.1: Following the Credit Crisis it became clear that there were large gaps related to information about interconnections large U.S. financial firms had across the global financial system with thousands of other counterparties in numerous geographic jurisdictions.

A5.2: Macroprudential supervision is associated with monitoring of data on broad economic and financial data to identify the buildup of potential systemic threats, whereas microprudential supervision represents the oversight of individual firms.

A5.3: The Office of Financial Research was created by the Financial Stability Oversight Council, which in turn was created under the powers of Title 1—Financial Stability of the Dodd-Frank Act.

A5.4: Based on public annual reports of the 10 largest global banks, these institutions have on average 3,500 subsidiaries located in 80 countries. Additionally, in some cases the greatest systemic risk within a global institution may be located within its non–home country subsidiary. An example of the latter would be the significant deterioration in the financial condition of the U.S. branches of European banks during the Credit Crisis because of their substantial involvement in subprime real estate activities.

A5.5: The VIX Index is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, the VIX Index has been considered by many to be the world's premier barometer of investor sentiment and market volatility.

A5.6: Four of the 20 recommendations made in a joint report by the IMF and FSB on reducing financial data gaps include development of measures of system-wide macroprudential risk, such as aggregate leverage and maturity mismatches; development of a common data template for systemically important global financial institutions; enhancement of BIS-consolidated banking statistics; and development of a standardized template covering the international exposure of large non-bank financial institutions.

A5.7: Three of the top remaining data-related priorities cited by the Office of Financial Research include: (i) bilateral repo, (ii) securities lending, and (iii) swap and other derivatives data.

A5.8: The bankruptcy of Lehman Brothers Inc. is often cited as the main lesson learned in terms of the lack of transparency that existed before the Credit Crisis into the size and global scope of exposures many banks and investment banks maintained.

A6.1: Prior to the Credit Crisis many supervisory tools fell in the category of microprudential regulation or regulation at the individual firm level.

A6.2: A key lesson learned from the Credit Crisis is that regulators need new and better tools to provide early warnings of risk buildup across the financial system that can lead to systemic events, not just a focus on individual firms.

A6.3: Microprudential regulations tend to target individual institutions or components of the system on a stand-alone basis, regardless of the institution's impact on the financial system as a whole.

A6.4: Macroprudential policies are concerned with aggregate levels of capital and economic cycles, with the main goal of avoiding systemic risks from building up.

A6.5: While macroprudential policies are distinct from day-to-day risk management, many macroprudential tools are in effect microprudential instruments deployed with a systemic perspective in mind.

A6.6: Examples of commonly used categories of regulatory tools throughout most of modern financial history include underwriting standards, stock margin requirements, and reserve requirements.

A6.7: The four stages of macroprudential policy implementation are risk identification and assessment, instrument selection and calibration, policy implementation, and policy evaluation.

A7.1: See Table 7.1.

A7.2: The safety and soundness of financial institutions, mitigation of systemic risk, fairness and efficiency of markets, and the protection of customers and investors.

A7.3: Institutional approach, functional approach, integrated approach, and twin peaks approach.

A7.4: Three European Union supervisory authorities are the European Banking Authority (EBA), the European Securities and Market Authority (ESMA), and the European Insurance and Occupational Pensions Authority (EIOPA). The European Systemic Risk Board (ESRB) oversees the EU's financial system and works to mitigate systemic risk. The European System of Financial Supervision (ESFS) is a decentralized system consisting of European and national supervisors.

A7.5: See Table 7.3.

A7.6: To promote financial stability; to end “too big to fail”; to end bailouts; and to protect consumers from abusive financial services practices.

A7.7: See Table 7.4.

A7.8: See Table 7.5.

A8.1: An organization that works to promote international financial stability.

A8.2: The Standing Committee on Assessment of Vulnerabilities identifies financial systemic risks. The Standing Committee on Supervisory and Regulatory Cooperation generates policy responses. The Standing Committee on Standards Implementation monitors the execution of responses.

A8.3: See Table 8.1.

A8.4: Periodic peer reviews and the implementation of key standards for sound financial systems.

A8.5: Multinational accords that set minimum capital requirements for banks that were established by the Basel Committee.

A8.6: An EU entity that provides macroprudential oversight of the EU's financial system and works to mitigate systemic risk.

A8.7: See Table 8.3.

A8.8: Excessive credit growth and leverage, addressed through capital buffers and minimum loan-to-value and loan-to-income requirements; excessive maturity mismatch and market illiquidity, addressed through stable funding restrictions and liquidity charges; direct and indirect exposure concentration, addressed through large exposure restrictions; and misaligned incentives and moral hazard, addressed through capital surcharges for systemically risky institutions as well as a systemic risk buffer.

A8.9: Entities that facilitate the clearing, settlement, and recording of financial transactions.

A8.10: International standards for the management of financial market infrastructures.

A8.11: As 24 principles and five responsibilities, organized as general organization principles; credit and liquidity risk management principles; settlement principles; central securities depositories and exchange-of-value settlement systems principles; default management principles; general business and operational risk management principles; access principles; efficiency principles; and transparency principles; and responsibilities of central banks, market regulators, and other relevant authorities for financial market infrastructures.

A9.1: An entity whose failure would cause financial instability that would threaten the economy.

A9.2: Size, contagion, correlation, concentration, and conditions.

A9.3: To identify systemically important banks and nonbank financial companies and make recommendations regarding heightened prudential standards for such entities, and to identify systemically important financial market utilities and payment, clearing, and settlement activities.

A9.4: If the bank has at least $50 billion in assets.

A9.5: Extent of leverage; extent and nature of off-balance-sheet exposure; extent and nature of transactions and relationships with other significant entities; its importance as a source of credit and liquidity for the U.S. financial system; its importance as a source of credit for low-income, minority, or underserved communities; the extent to which assets are managed rather than owned and the diffusion of ownership of assets under management; the nature, scope, size, scale, concentration, interconnectedness, and mix of activities; the degree to which the company is already regulated; the amount and nature of the entity's assets; the amount and type of the entity's liabilities; and other risk-related factors.

A9.6: Monetary value of transactions; exposure to counterparties; relationships, interdependencies, or other interactions with other financial market utilities; the effect of the financial market utility's failure or disruption; other factors that the FSOC deem appropriate.

A9.7: A bank whose distress or failure would threaten the global financial system and harm the economies of multiple countries.

A9.8: Cross-jurisdictional activity, size, interconnectedness, substitutability/financial institution infrastructure, and complexity.

A9.9: According to the Financial Stability Board, “…to ensure that G-SIBs have the loss-absorbing and recapitalisation capacity necessary to help ensure that, in and immediately following a resolution, critical functions can be continued without taxpayers' funds (public funds) or financial stability being put at risk.”

A10.1: Section 619 of the Dodd-Frank Act, which prohibits banking entities from engaging in proprietary trading and from owning or sponsoring hedge funds and private equity funds, and sets limits and requirements for systemically risky nonbank financial companies engaged in these activities.

A10.2: To separate federal support for the banking system from a banking entity's speculative trading activity; to reduce potential conflicts of interest between a banking entity and its customers; and to reduce risk to banking entities and nonbank financial companies that are regulated by the Federal Reserve.

A10.3: The Glass-Steagall Act.

A10.4: Proprietary trading is when an entity acts as a principal in transactions for its own trading account. A “trading account” is an account used to generate short-term profits. A “banking entity” is an insured depository institution; a company that controls an insured depository institution, a bank holding company; or any such entity's affiliate or subsidiary.

A10.5: To ensure that banking entities do not use ownership or sponsorship of hedge funds and private equity funds to circumvent the proprietary trading prohibition; to limit the private fund activities of banking entities to providing customer-related services; and to eliminate the incentive and opportunity of banking entities to bail out a private fund that they own or sponsor.

A10.6: Trading of certain securities; trading in connection with underwriting, market making, risk-mitigating hedging, and for clients; certain investments; trading by a regulated insurance company directly engaged in the business of insurance; bona fide trust, fiduciary, or investment advisory services; proprietary trading outside of the United States by banking entities not controlled by a U.S. banking entity; ownership and sponsorship of a private fund outside of the United States by banking entities not controlled by a U.S. banking entity; and other activities as deemed by regulators to promote and protect the safety and soundness of the banking entity and U.S. financial stability.

A10.7: U.S. Treasury securities; Federal National Mortgage Association (Fannie Mae) securities; Federal Home Loan Mortgage Corporation (Freddie Mac) securities; Government National Mortgage Association (Ginnie Mae) securities; Federal Home Loan Bank securities; Federal Agricultural Mortgage Corporation securities; a security issued by a Farm Credit System institution; and Municipal securities.

A10.8: The OCC, the FDIC, the Fed, the SEC, and the CFTC.

A10.9: It fails to sufficiently take account of change in financial markets, as hedge funds may take over much of the activity from which banking entities are prohibited, and their activities can harm financial stability and banks that are exposed to the activities of hedge funds. The Volcker Rule may have a negative impact on market making and liquidity provision; may harm market-maker networks; may increase the cost of capital to borrowers; and may damage bank risk management.

A11.1: An agreement between two counterparties to transact in the future in which the counterparties' profit or loss is a function of the value of an underlying asset.

A11.2: An OTC derivatives agreement in which two counterparties agree to transact an underlying asset in the future for a price that is agreed upon at initiation.

A11.3: An exchange-traded version of a forward contract.

A11.4: An agreement in which two counterparties agree to transact an underlying asset in the future for a price that is agreed upon at initiation, in which one of the counterparties has the right and not the obligation to transact in the future.

A11.5: An option contract in which the long counterparty has the right to purchase the underlying asset for a fixed price in the future from the short counterparty.

A11.6: An option contract in which the long counterparty has the right to sell the underlying asset for a fixed price in the future to the short counterparty.

A11.7: An agreement between two counterparties to exchange cash flows over a number of periods of time in the future.

A11.8: A swap agreement in which two counterparties agree to exchange a fixed rate of interest for a floating rate of interest over a number of periods of time.

A11.9: A swap agreement in which two counterparties agree to exchange cash flows in distinct currencies over a number of periods of time.

A11.10: A swap agreement in which one of the counterparties agrees to make periodic payments and the second counterparty agrees to make a large payment to the first counterparty should a specified reference asset issued by a specified reference entity experience a credit event.

A11.11: To translate the rates associated with swaps into cash flows.

A11.12: As financial distress on the part of the liability counterparty will force the asset counterparty to write down the value of its asset.

A11.13: Through the use of collateral, netting, and central counterparties.

A11.14: Payment netting where payments are netted out and closeout netting where the gross assets and gross liabilities across all of the agreements are netted out should one of the counterparties to an agreement experience a termination event.

A11.15: A central counterparty clearinghouse that becomes the counterparty to both of the original counterparties to a derivative security.

A11.16: Lower counterparty credit risk and multilateral netting.

A11.17: The private bilateral nature of most OTC derivatives agreements pre-Crisis; limited understanding on the part of regulators of the nature of exposures; the low recovery values associated with insolvent financial institutions; poorly understood and difficult-to-evaluate products and strategies; and the off-balance-sheet nature of exposures.

A12.1: The actual cashflows associated with an OTC derivative security are typically a small proportion of the notional principal.

A12.2: It fails to take into account closeout netting.

A12.3: It fails to take into account collateral.

A12.4: The Commodities Exchange Act of 1936, the Swap Exemption of 1993, and the Commodities Futures Modernization Act of 2000.

A12.5: A swap refers to OTC derivatives based on broad-based indexes, interest rates, and currencies, among other underlying assets. A security-based swap refers to OTC derivatives based on a single security or a narrowly defined index. A mixed swap has characteristics of both.

A12.6: It makes the clearing of OTC derivatives through a CCP mandatory.

A12.7: It mandates that OTC derivatives trade through formal platforms, such as a designated contract market, a national securities exchange, or an execution facility.

A12.8: It mandates that data related to OTC derivatives agreements be reported to, and maintained by, a registered data repository.

A12.9: The Title VII provision that prohibits the U.S. federal government from bailing out, or providing any other financial assistance to, financial institutions that participate in an OTC derivatives market, effectively forcing financial institutions that wish to participate in OTC derivatives market to push out their OTC derivatives activities to an affiliate.

A12.10: The complexity and the costs associated with complying with its provisions, as well as the concentration of counterparty exposure against CCPs, effectively creating a new type of too-big-to-fail entity.

A13.1: The BIS's Basel Committee on Banking Supervision.

A13.2: To strengthen the soundness and stability of the international banking system, and to do so in a manner that is both fair and consistent so as to reduce competitive inequality.

A13.3: A bank will become insolvent if its assets drop below its liabilities or if does not have sufficient liquidity to make the payments associated with its obligations.

A13.4: Credit risk, market risk, operational risk, and liquidity risk.

A13.5: The highest quality capital, including permanent shareholders' equity and disclosed reserves.

A13.6: To require a larger capital cushion for riskier assets than for less-risky assets.

A13.7: Minimum capital requirements, supervisory review, and market discipline.

A13.8: The capital conservation buffer and the countercyclical buffer.

A13.9: A ratio of Tier 1 capital to assets where the assets are not risk-weighted.

A13.10: Through introducing two new liquidity ratios, the liquidity coverage ratio and the net stable funding ratio.

A14.1: The discretionary provision of liquidity to a financial institution (or the market as a whole) by the central bank in reaction to an adverse shock that causes an abnormal increase in demand for liquidity that cannot be met from an alternative source (direct quote from Freixas et al., 1999; see note 1 in Chapter 14).

A14.2: The existence of this safety net enhances the confidence that others have when lending to financial institutions.

A14.3: Emergency lending that occurs when a financial institution is illiquid but solvent, and risk capital support for insolvent financial institutions.

A14.4: As financial institutions will be more willing to engage in risky activities and counterparties will not monitor creditworthiness as carefully.

A14.5: Ambiguity surrounding the willingness of the lender of last resort to provide emergency lending.

A14.6: To protect the money stock, provide support to the entire financial system rather than individual institutions, to behave consistently, and pre-announce policy.

A14.7: Alternative views of the function of the lender of last resort focus exclusively on open market operations; provision of temporary assistance to insolvent banks; and a free banking approach that takes the view that there is no need for a government authority to act as the lender of last resort and instead advocates the removal of legal restrictions.

A14.8: Banking panics.

A14.9: No.

A14.10: The provision of liquidity to financial institutions; provision of liquidity directly to participants in key credit markets; and expansion of open market operations.