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More banks could fail because of the ongoing turmoil in the financial markets, Nobel Laureate Myron Scholes, MBA ’64, PhD ’70, warned in this summer at a Global Leadership Series event at the GSB’s London campus.
He said the market shock in March triggered by the near-collapse of Bear Stearns “far exceeded” what he had anticipated.“This is not over yet. We will potentially see more failures,” he told an audience of some 300 GSB alumni and finance professionals June 23. “There are still a lot of consequences that have to be worked out.”
But, he pointed out, financial shocks forced people to find innovative solutions. “People are trying to work through it. That’s what competition does,” said Scholes, who won the Nobel Prize in 1997 for his contribution to the Black-Scholes options pricing model used around the world.
In a wide-ranging address, Scholes discussed how the price liquidity and risk transfer changes during a period of market turmoil and increased volatility. He said a key element in the credit crunch was a surge in the price of liquidity and a flight of buyers to more liquid instruments. In quiet times, speculators played a key role in creating the liquidity needed for smooth market operations, Scholes said; they act to “compress time” by taking on risk from those wishing to hedge risks or change positions in the markets. He offered the classic example in the area of commodities of a miller who wants to insure against the risk of an adverse move in the wheat price. In the financial sphere, this has led to innovative ways by which people share and shed risk. “This creates a greater efficiency of capital,” he said.
The problem, Scholes said, was that it is difficult to specify exactly the need for liquidity, making it difficult to buy the correct insurance. “Even worse, during a financial shock, investors want to sell at the same time when speculators don’t want to buy” he said. Uncertainty over when asset prices will bottom out discourages speculators.“When a shock occurs, speculators withdraw capital and need much higher returns to step in just at the time when demanders want more intermediation services.”
Asked about the economic outlook, he said the United States faced a twin threat. The first was a “deleveraging cascade,” meaning that as one bank sold assets to reduce risk, it pushed prices down, forcing other institutions to sell as well. “We will possibly see this cascade of deleveraging having a tremendous effect on the future of financial institutions. And it’s not over yet—there’s still deleveraging that’s necessary,” he said.
The second threat was a “Keynesian cascade.” As the credit crunch depresses consumer spending, unemployment rises, which in turn lead to a fall in consumer spending. “Taken together we have a multiplier effect,” he said. This multiplier effect is the core of Federal Reserve Chairman’s Bernecke’s academic work.
Looking forward, Scholes said innovation rather than regulation was the best medicine for averting further crises. He said financial shocks had a positive impact by forcing people to examine the failure of previous models. “From chaos comes a new learning. Innovation results from chaos,” he said. ”I’m pessimistic in the short run, but very optimistic going forward.”
—Phil Thornton