In this video I will talk about the financial fragility hypothesis, developed by the American economist Hyman Minsky. I will address its foundation, concept, main points and, mainly, how it is applied in current financial markets. Hello, welcome to the channel, I'm Rafael Disconzi.
If you're new here, on this channel I share content on Finance, Investments and Economics. Please subscribe, make your comments, suggestions and leave a “like” if you like this material. The starting point of the financial fragility model is the characterization of individual economic agents (individuals or legal entities) through their “balance sheet”.
According to Hyman Minsky, an American economist known for his studies on financial crises and their connection with the economic cycle, every economic agent, be it a person, a family, a company or the government itself, can be described by its balance sheet, in the sense that every agent assumes payment commitments (its liabilities), which, ideally, must be honored through the revenues derived from its rights (its assets). These agents, however, view their assets and liabilities differently. They recognize that the returns on their assets are uncertain, that is, they are surrounded by risks and may not materialize as expected when they were purchased.
But everyone sees their liabilities as certain, that is, they know that failure to fulfill the obligations assumed can have serious consequences, such as, ultimately, insolvency. In other words, whether or not you receive what you expected to receive for your assets, the person knows that they will have to honor their debts in the same way. This is the origin of one of the main characteristics of the Minsky model: the assumption that when deciding to constitute a “portfolio”, each decision unit must weigh not only the attractiveness of each asset class, but also the compatibility of expected returns with the obligations for the future that will have to be assumed to finance this purchase.
As returns are uncertain, but obligations are not, when formulating an accumulation strategy, each agent has to prepare a “plan B”, what to do in case expectations are disappointed, that is, how to guarantee their survival if cash inflows “cash” are not sufficient to cover the “cash” outflows defined by the obligations assumed. The main legacy of Keynes in Minsky's approach manifests itself in the need to hedge against the disappointment of expectations. The risks surrounding the future are not always calculable.
Often they are not even definable a priori. Many things that we cannot even imagine in the present can go wrong in the future and disappoint expectations. Investors can bet on the success of companies that are very advanced at present, but that will end up succumbing to competition from another company that has some fundamental innovation, for example.
How to predict such innovations and their impacts? Thus, in contrast to what practitioners of the efficient markets hypothesis assume, asset prices do not reflect stable “fundamentals” of the economy, but, on the contrary, they reflect expectations that are formed in a framework of fundamental uncertainty, in which the “ projected future cannot be more than one hypothesis among many. Two important implications arise from adopting this concept of uncertainty.
The first is the instability that surrounds these markets, as they are subject to drastic changes when agents become convinced that the scenarios assumed as probable for the future have not proven to be consistent with the developments experienced and change their behavior to adapt it to new developments. applicable scenarios. These changes can be abrupt and sudden.
The second, given that it is assumed not only that the future is uncertain, but, and even more importantly, that agents know that the future is uncertain and that their expectations can be disappointed by an unforeseen (and unpredictable) evolution of facts, it is that these same agents will take certain precautions when deciding what assets to acquire and what obligations to assume to minimize the costs of disappointment. This last insight leads to a fundamental concept for understanding the financial dynamics proposed by Minsky: the margin of safety. When deciding on your exposure to risks that may make it impossible to comply with obligations from the revenues obtained from acquired rights, the agent takes a certain number of precautions, such as always considering the worst estimate of expected returns as a basis for calculation, that is, examining whether even the worst conceivable case in terms of return would still allow compliance with the obligations assumed.
Another precaution is reflected in what Keynes called liquidity preference, the concern with maintaining liquid assets in the portfolio, including currency, to allow the settlement of obligations even if the paying assets do not perform adequately. The greater the uncertainty surrounding the future returns of assets, the greater the net reserve that the agent will maintain. These precautions are important, Minsky argued, because there are two important temptations that push the agent to expose themselves to risks.
The first is represented by the possibility of leverage, that is, the appeal to third-party resources to increase the return on its own capital whenever the interest rate on loans is lower than the expected rate of return on assets. The second is the possibility of mismatching maturities between assets and liabilities. Here, it’s about “playing” with the yield curve.
Under normal conditions, interest rates on shorter maturity contracts tend to be lower than the rates paid on longer maturity contracts. This opens up the possibility of borrowing at short maturities for investment in longer-maturity assets, pocketing the interest spread. But these factors that can increase the profitability of investments can also increase the risks of these investments.
Debt creates the possibility of insolvency, that is, the inability to honor the debts assumed. The mismatch of maturities creates the risk of illiquidity, that is, the inability to honor debts on the contracted dates. The difference between the two risk classes is subtle.
Insolvency is the ultimate inability to fulfill obligations, which means that the present value of assets is lower than the present value of liabilities in that decision unit. There is no point in letting time pass, because at any given moment cash inflows will be lower than outflows. Illiquidity is the inability to honor obligations temporarily, on some of the dates on which payments have to be made.
The present value of assets may be greater than that of liabilities, but at certain times contracted cash outflows may be greater than inflows. Insolvency can be avoided, however, in two ways: the use of accumulated liquid assets to cover these eventualities, that is, by establishing an adequate safety margin when the acquisition was made; the appeal for debt refinancing, that is, the persuasion of creditors that they have more to gain by refinancing the debt than by forcing the agent's insolvency. Of course, refinancing is only a solution if it can be done at terms compatible with the expected return on assets.
If interest rates rise significantly, for example, refinancing will not save the borrower from bankruptcy. All these factors, according to Minsky, are weighed when making decisions regarding the assets to buy and the bonds to issue. Margins of safety will serve to protect the ability to meet obligations in the face of disappointing expectations regarding asset returns.
The “width” of this margin will depend on the degree of uncertainty that surrounds the agents’ expectations at the time of implementing decisions. The greater the uncertainty surrounding the future, the greater the precautions to be taken, which can manifest themselves in several non-exclusive ways. In addition to considering expectations of return on assets “underneath”, leverage can be minimized , avoid “excessive” mismatching of maturities, build up reserves of liquid assets and currency, ensure the availability of refinancing sources at reasonable terms etc.
Naturally, all of these forms of protection (hedging) cost money, whether in terms of explicit costs or in terms of opportunity costs (for example, loss of the opportunity to earn more through debt when leverage is limited). The decisive factor , according to Minsky, is the confidence that return expectations will actually be confirmed. It is at this point that Minsky introduces one of the best-known elements of his “model”, and which has attracted the most attention from financial crisis analysts.
Minsky wrote that stability is destabilizing. The confidence of economic agents, more than their expectations per se, is a product of experience. As a given situation reproduces itself as expected, future uncertainties decrease and agents' confidence in the possibility of fine-tuning their investment strategies to better take advantage of perceived opportunities increases.
Thus, contrary to the automaticity of equilibrium situations (in the absence of exogenous shocks) assumed in the hypothesis of efficient markets, in Minsky's approach, equilibrium situations are overcome by the persistence of the equilibrium itself, without the need for external disturbances. Thus, if return expectations are confirmed by the evolution of facts, again and again, agents will inevitably ask themselves whether the precautions taken at the beginning of the process are not excessive, given the experience they have had of not needing them. It is important to remember that taking precautions involves explicit and opportunity costs.
If the precautions prove unnecessary, there is no reason to continue paying these costs. The consequence, therefore, of the experience of stability is to lead agents to behave in more and more risky ways, to increase their gains. The buffer of liquid assets (which pay little or nothing) is reduced, so that more paying assets can be purchased.
Leverage increases as the maturity mismatch increases. The balance sheet position of each agent becomes more and more fragile. If the process is not stopped (for example, by regulatory or economic policy restrictions on credit expansion, increased leverage, etc.
), the time will come when the margin of safety will be so narrow, i. e. the balance sheet position of agents will be so fragile that even shocks that would be relatively minor in other circumstances will end up collapsing the financial system, as was the case with subprime mortgage financing in the United States.
When the shock occurs, and the return of investments reduces the established narrow safety margin, it means that there is little or no space to absorb the loss. We are missing only one element of Minsky's approach: what happens when the balance sheet position of agents, exposed to illiquidity and insolvency and without liquidity buffers that can absorb losses or access to refinancing, is shaken by an adverse shock? If there is no external aid to the financial system, the result will be a crisis.
This may, however, only affect the most exposed agents if excessive financial fragility is not widespread. If, on the other hand, the weakening has affected an important part of the financial sector, there is a risk of what Minsky, borrowing from Irving Fisher, called debt deflation. If asset returns are not sufficient to honor obligations, there are no reserves or access to refinancing, there is only one way out: sell assets to pay debts.
Minsky called this, using market language, “selling position to make position”. If the difficulties are widespread, however, the sale of assets is not an effective alternative, as all it will do is worsen and spread the difficulties. If many agents try to liquidate assets at the same time, their prices will fall, not only making it impossible for those agents to pay their debts, but also infecting other holders of the same assets (or assets with similar characteristics).
Therefore, it is necessary to run more and more to stay in the same place: you sell more to obtain less revenue, because prices fall if there is a general excess of supply. As Fisher, before Minsky, had already shown, the “natural” limit of this process is the complete destruction of the system’s financial wealth and widespread insolvency. This process was associated, both by Fisher and Minsky, with depressions, such as that of the 1930s.
Debt deflation depends on two factors to occur. First, that fragility is, if not generalized, at least extensive enough that the volume of assets to be liquidated is significant. According to which no external intervention, by the government, for example, occurs to stop the fall in asset prices.
This approach made Hyman Minsky an author of mandatory citation in any work on the financial crisis, his analyzes exerted great influence, not only in academia, but also in financial circles. Thank you for watching, share your perception on this topic, I hope you enjoyed it, don't forget to subscribe to the channel, leave your “like” and we'll see you in the next video. Goodbye.
