The subprime financial crisis of 2007-08, which originated in the U.S. but caused a systemic failure in the global financial system and the Great Recession (2008-12), is clearly one of the handful of extremely important events in the last 100 years of finance that teach us critical lessons for the future.
This global crisis is considered by many economists and finance experts as the worst financial crisis since the Great Depression of the 1930s. It resulted in the complete collapse of large financial institutions requiring their bailouts by national governments. It also triggered an extensive bear market in stocks worldwide. In many countries, the housing market also suffered, resulting in foreclosures and evictions. The crisis played a significant role in the failure of key enterprises such Lehman Brothers, declines in consumer wealth estimated in trillions of dollars, prolonged unemployment and a downturn in economic activity leading to the Great Recession of 2008–2012 global recession. All this also contributed to the European sovereign-debt crisis.
The inevitable bursting of the U.S. housing bubble, in 2006-07, caused the values of derivative securities tied to U.S. real estate to plunge, damaging and destabilizing financial institutions in the U.S. and abroad. The resultant financial crisis was triggered by a complex interplay of several factors: policies that encouraged home ownership at any cost, easier access to cheap loans for financially weak (i.e., subprime) borrowers, a “rosy” forecast of ever increasing real estate prices leading to an overvaluation of subprime mortgage tranches, questionable practices by ratings agencies and mortgage sellers, compensation structures that encouraged excessive risk taking as well as fraudulent practices, and a laissez faire regulatory environment. Most importantly, what was crucially lacking was a system-wide understanding of how all these interacted with one another and could play out.
Financial systems are built on interdependencies where funding flows, credit and counterparty relationships, and asset purchases and sales all occur in a complex network between institutions. Stresses to one part of the system can spread to others, in the extreme case resulting in a threat to financial stability as we witnessed recently. Failures from the recent economic crisis – the propagation of the fallout from the Lehman bankruptcy, the counterparty exposures laid bare in the face of the near-bankruptcy of AIG, and the more recent exposure of European banks to the risk of sovereign default – illustrate the critical need for a fundamental understanding of the structure, dynamics and stability of this network.
At CMSR, our collaborative projects involving researchers from the School of Engineering and the Business School (see below) are targeted towards gaining this fundamental understanding by adapting concepts, tools and techniques from systems engineering for financial systems. We also work on applying this understanding to improve the modeling, design, monitoring, analysis, regulation and management of financial systems to minimize systemic risk. The goal is not only to develop methodologies but also to implement them in software in order to provide tools that can be used by practioners for the better monitoring and management of systemic risk.