The
Financial Crisis resurrected the thinking of Hyman Minsky and his “financial
instability hypothesis”. With the crisis, there was coined the term Minsky
Moment, the time when financial markets collapse after a period of prosperity
from the excessive speculation on financial assets. Unfortunately, his
insightful views on financial instability never received the attention it
deserved before the crisis. It was not structured in the current economic
orthodoxy of formal mathematical modeling.
Minsky
focused on how extended stability or prosperity leads to excessive risky
lending which creates the environment for a crisis. He describes three levels
of financing, hedging, speculation, and Ponzi-lending based on increasing
levels of risk. Hedge financing is the
safest and based on future cash. In speculative lending, firms can generate
cash flow for interest but must roll principal. Ponzi financing is based on
lending where cash flow will not be able to pay for interest or principal but
needs the appreciation of financial assets to pay back loans.
Any
decline in price will cause the house of cards for this type of lending to
fall. Ponzi lending is more likely when there is an extended period of
stability and low volatility of financial assets. Banks will take greater risks
in a competitive but stable environment while borrowers believe their
collateral will not suffer any downfalls.
While not
a formal model, we believe that theories surrounding the impact of mixed
Gaussian distributions which can generate negative skew in financial assets can
help explain why periods of calm can actually create an environment of more
downside risk. Skew in financial assets is generated when there is a mixed
distribution of the underlying asset coupled with a distribution
concerning a possible jump or regime change. The mixed distribution, when there
are negative jumps, will create negative skew.
Research
has found that if the underlying core asset distribution has lower volatility,
the potential for negative skew increases. As the distribution spread narrows
for the underlying asset, the impact of a jump will be more meaningful. In
Minsky terms, a period of calm will sow the seeds for a potential downside
event by increasing its impact on prices from the jump process. If more
leverage is taken and financial markets are more susceptible to any negative
jump, there will be more skew and downside risk.
Low
volatility, a measure of calm, will also be periods when negative skew will be
larger. The mixed distribution will show more downside risk that cannot be
diversified away in the same way as hedging volatility. Low volatility with
greater skew will result in a Minsky Moment being more likely. Minsky’s work
may not have been put his hypothesis in these terms, but looking at the
distribution of financial assets can tell us something about potential
financial instability.
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