Financial crises happen episodically to varying degrees and extents within financial systems. The CDO (Collateralized Debt Obligation) induced liquidity crisis that began in early August 2007 led to the recession still gripping global economies five years later.
The financial system is susceptible to widespread disruptions because it contains many positive feedbacks. Institutions have adapted to protect against the disruptions they’ve experienced in the past, such as bank runs by depositors, however recent rapid changes in finance arising from globalization and product innovation have created linkages and feedbacks that are poorly understood and whose possible roles in initiating, amplifying, or stabilizing a crises have never been observed and are entirely uncertain.
In 2007, concern about default rates among sup-prime mortgages and uncertainty about the exposure created by the structured derivatives containing sub-prime mortgages led to a liquidity crisis whereby banks were reluctant to loan funds. This constriction influenced security markets, corporate bond markets, the value of the dollar, and required rapid and massive intervention by central banks to restore confidence in credit markets. We want to avoid such shocks from which recovery is difficult and fundamentally disruptive. This is especially challenging because protections against big crises should not encourage excessive risk-taking.