Hyun Song Shin and the Dynamics of Endogenous Risk
In the complex world of global finance, the stability of the system often depends less on external shocks and more on the internal behaviors of the participants. Hyun Song Shin has dedicated much of his research to understanding these internal mechanisms, challenging traditional views on how risk is measured and managed within the global economy.
Global Coordination Games and Game Theory
Shin's contributions to game theory gained significant momentum in 1998 through a collaborative article with Stephen Morris. Together, they explored global coordination games, focusing on a stylized model of currency crises. In this model, traders observe fundamental economic data accompanied by small amounts of noise.
Their research demonstrated that this environment leads to the selection of a unique equilibrium. This finding was pivotal because it stood in stark contrast to models based on complete information, which typically feature multiple equilibria, making the outcome of financial crises harder to predict.
The Concept of Endogenous Risk
One of Shin's most influential contributions, developed alongside co-author Jon Danielsson, is the coining of the term endogenous risk. To understand this, one must distinguish it from exogenous risk—shocks that originate from outside the financial system.
Endogenous risk refers to shocks that stem from the interactions between financial system participants. These interactions create internal mechanisms, such as feedback loops and forced fire sales, where the actions of one actor trigger a chain reaction among others.
In his 2010 book, Risk and Liquidity, Shin illustrates this concept using an analogy of London's Millennium Bridge. The bridge experienced synchronized oscillation not because of an external force, but because pedestrians instinctively adjusted their footing at the same time to avoid falling, thereby amplifying the instability. Similarly, in finance, when participants act in unison to manage risk, they can inadvertently create systemic instability.
Macroprudential Regulation and Financial Stability
Shin argues that financial firms systematically increase their risk-taking as asset prices rise. Because of this, he asserts that the vulnerability of the financial system cannot be accurately measured by price indicators, such as volatility or credit spreads.
Instead, Shin suggests that analysts should focus on quantity-based metrics, including:
- The total amount of assets held on intermediary balance sheets.
- Liquidity mismatches (the difference between the liquidity of assets and the liabilities used to fund them).
- Maturity mismatches between assets and liabilities.
These views informed his winning entry in the second Financial Times annual essay contest on banking regulation. Shin advocated for macroprudential regulations that "lean against the credit cycle" to increase stability across G-20 economies, specifically proposing a global tax on non-core banking liabilities as an effective tool to deflate asset bubbles.
Analyzing the Taper Tantrum
Shin's theories provide a framework for understanding real-world market volatility, such as the 2013 "taper tantrum." This event was a massive global overreaction to a hint from U.S. Federal Reserve Chair Ben Bernanke that the Fed might taper quantitative easing (the purchase of government securities to increase money supply).
Presenting his theory at the Federal Reserve Bank of San Francisco, Shin suggested that the tantrum was driven by excess global liquidity and a surge in demand for private-sector bonds in emerging economies, which left these markets hypersensitive to changes in U.S. monetary policy.
Key Facts
- Endogenous Risk: Risk generated internally by the interactions and feedback loops of financial participants.
- Coordination Games: Research with Stephen Morris showed that small noise in fundamentals can lead to a unique equilibrium in currency crises.
- Regulatory Proposal: Advocated for a global tax on non-core banking liabilities to curb asset bubbles.
- Taper Tantrum Theory: Attributed the 2013 market volatility to excess global liquidity and demand for emerging economy private bonds.
- Risk Measurement: Argues that balance sheet quantities and maturity mismatches are better indicators of risk than price-based indicators.
| Concept | Traditional View | Shin's Perspective |
|---|---|---|
| Risk Origin | Exogenous (External shocks) | Endogenous (Internal interactions) |
| Risk Indicators | Price-based (Volatility, Spreads) | Quantity-based (Balance sheets, Mismatches) |
| Equilibrium | Multiple equilibria (Complete info) | Unique equilibrium (Noise-based info) |
| Regulation | Reactive measures | Macroprudential (Leaning against the credit cycle) |
Frequently Asked Questions
What is the difference between endogenous and exogenous risk?
Exogenous risk comes from outside the system, such as a natural disaster. Endogenous risk is created within the system by the way participants interact, leading to feedback loops and systemic instability.
How does the Millennium Bridge analogy explain financial risk?
Just as pedestrians synchronized their movements to stay balanced, causing the bridge to sway, financial actors often take the same risk-management actions simultaneously, which can destabilize the entire financial system.
Why does Shin dislike using credit spreads to measure risk?
He believes price indicators like credit spreads fail to capture the true vulnerability of the system because firms take more risk as prices rise; therefore, the actual quantities on balance sheets are more telling.
What was the cause of the Taper Tantrum according to Shin?
Shin attributed the overreaction to the growth in demand for private-sector bonds in emerging economies and the resulting excess of global liquidity.
What is a macroprudential regulation that "leans against the credit cycle"?
It is a regulatory approach designed to limit excessive credit growth during booms to prevent the formation of bubbles, such as implementing a global tax on non-core banking liabilities.