Volatility and financial crises

I just finished teaching a course titled, ‘Advanced Quantitative and Economic Analysis’ for students of the Master of Science Programme in Applied Finance at the Singapore Management University, on Friday. I had talked to them in the last two sessions about how long periods of stability breed instability through the risk-taking channel. This is the hypothesis of Hyman Minsky.

I was pleasantly surprised to find a paper published by the Federal Reserve Board in October 2016 on this topic. The paper is:

Danielsson, Jon, Marcela Valenzuela, and Ilknur Zer (2016). “Learning from
History: Volatility and Financial Crises,” Finance and Economics Discussion Series
2016-093. Washington: Board of Governors of the Federal Reserve System,

While the common view is that volatility directly affects the probability of a crisis, this has proven difficult to verify empirically. In what we believe is the first study to do so, we find direct empirical evidence that the level of volatility is not a good indicator of a crisis, but that relatively high or low volatility is. Low volatility increases the probability a banking crisis, both high and low volatility matter for stock market crises, whereas volatility{in any form{does not seem to explain currency crises.

We further use the credit-to-GDP gap as a proxy for risk-taking, and find that low
volatility significantly increases risk-taking. This is very much in line with what theory predicts and provides strong evidence for Minsky’s instability hypothesis and his famous statement that \stability is destabilizing”. Low volatility induces risk-taking, which leads to riskier investments. When those turn sour, a crisis follows.

Finally, we find that the relationship between volatility gap and the incidence of a crisis becomes stronger over time, consistent with the observation that stock markets have grown in importance over the 211 year sample.

What they say on page 6 about stock markets, low volatility and crises is very interesting:

Third, since our 211-year sample contains a variety of economic systems, market structures, and technological developments, it is of interest to examine the volatility-crisis relationship over key sub-periods of the sample. The relationship between financial market volatility and the incidence of a crisis becomes stronger over time – not surprising considering that prior to World War I, stock markets, and hence market volatility, played a much smaller role in the economy than they would later. The relationship weakened again during the Bretton Woods era when financial markets and capital flows were heavily regulated, and became especially strong since.

The emphasis above is mine. The policy implications are obvious. We need to regulate capital flows. Keynes was dead right in that respect. That is why it was both surprising and disappointing that Vijay Kelkar and Ajay Shah, in their advice to the government on managing the aftermath of demonetisation, batted for capital account convertibility. Not only was it unrelated to the issue of demonetisation but it is also counter to the mounting evidence that it does not add to but subtracts from economic welfare.

Indeed, India should consider not only retaining the short-term transaction tax in financial markets but think of expanding its scope and enhancing the rate of such taxation!


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