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Electronic copy available at: http://ssrn.com/abstract=2150987Electronic copy available at: http://ssrn.com/abstract=2150987
A brief history of financial risk and information
Mark D. Flood
This chapter presents the historical context for the current state of financial
information and risk management. In lieu of a comprehensive history, the
authors discuss several broad historical themes in risk and finance:
institutionalization, technology, globalization, and complexity, including the
rise of risk management professionals. Emblematic events are used to
illustrate the evolution of the financial markets and risk management.
financial history, risk management, institutionalization, technology,
Aug. 31, 2012
Forthcoming in the Handbook of Financial Data and Risk Information,
M. Brose, M. Flood, D. Krishna and W. Nichols, eds.,
Cambridge University Press, 2012.
Please do not circulate without permission
The author thanks Margarita Brose, Henry Gordon, Greg Feldberg, Jim
Lothian, Larry Neal, Jim Overdahl, Charles Taylor, and Dave Wheelock for
their helpful comments on drafts of this chapter. Any remaining errors are
the responsibility of the author alone.
Copyright 2012, Mark D. Flood
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Electronic copy available at: http://ssrn.com/abstract=2150987Electronic copy available at: http://ssrn.com/abstract=2150987
This chapter presents the historical context for the current state of financial
information and risk management. At any point in time, the institutions and
practices that constrain financial behavior are just the latest point in an
evolutionary process along a single historical path. Our basic understanding
of events is subject to this path dependence too. Keynes (1936, 383) notes
that, “Practical men, who believe themselves to be quite exempt from any
intellectual influences, are usually the slaves of some defunct economist.” In
tracing events over the longer term, the rhymes of history begin to emerge.
There are recurring dynamics and episodic patterns that make history
something more than mere chronology. Reinhart and Rogoff (2009), for
example, mock the perennial speculator's incantation that “this time is
different” with a sobering litany of financial over-enthusiasms that have
ended in tears.
On the other hand, the world has indeed changed over the long run. As we
write this, the global financial system is still emerging from the catastrophic
events of 2007-09. While one of our central goals is to demonstrate that
many of the features of the recent crisis have historical antecedents, events
that may appear to be defining characteristics of the latest trauma – such as
interconnectedness, technological sophistication, and worldwide impact – are
in fact the manifestations of broader historical trends that have been at work
for decades or centuries. This is clearly true of the four thematic dimensions
we emphasize below: institutionalization, globalization, technology, and
It is impossible to do justice to this rich history in such a brief space. Indeed,
entire books have been written on subsets of the topic.1 In lieu of a
comprehensive history, we range widely here, illustrating the broad historical
themes by identifying emblematic events while providing pointers to
additional resources for deeper research on specific topics. We compensate
for space constraints by decorating the discussion with recommendations for
further reading. This makes for a lengthy bibliography, which we hope the
reader will find useful.
1Examples include Goetzmann and Rouwenhorst's (2005) compendium on the history of
financial innovation, Bernstein's (1998) history of the intellectual enterprise of modeling
risk, Gleick's (2011) history of information theory, or the one-volume histories of various
aspects of economic and financial development in the Atlantic sphere, by Kindleberger
(1993), Neal (1990), Ferguson (2008), Grossman (2010), or O'Rourke and Williamson
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A. The institutionalization of financial services and regulation
History documents the gradual and piecemeal institutionalization of financial
markets. Starting with the Age of Exploration, new organizations begin to
emerge that are still familiar today. Developing and maintaining supply
routes that extended to the Far East and the Americas required more capital
and greater degrees of coordination than before. Hence, we see the
introduction of new forms of ownership and control, such as the limited
liability corporation, exemplified by the Dutch East India and British East
India companies, described below. In turn, these new firms required access
to deeper capital pools to fund their infrastructure; hence the creation of
stock exchanges in London and Amsterdam. Also important were
enhancements in risk management to spread the losses due to maritime
hazards; hence Lloyd's of London, also described below.
The institutionalization of commerce is mirrored by institutionalization of the
accompanying supervisory and regulatory superstructure.2 As noted, there is
a powerful historical path dependence that describes our current institutional
status quo. Institutional change typically accretes gradually, limited by legal
and bureaucratic inertia and frequently in concert with technological
advances. Major events occasionally disrupt this process. Calomiris and
Gorton (1991) note that the history of financial regulation can be written as a
chronology of traumatic events, linking each to the financial institutions
created in its wake. Table 1 provides a few examples. Even this brief
sampling should firmly establish the “crisis mechanism” as a means of
generating new institutions. The most recent such examples in the U.S. are
the Financial Stability Oversight Council (FSOC) and Office of Financial
Research (OFR), created through the Dodd-Frank Act, and which stand as
memorials to the market collapse of 2008. Whether created in reaction to a
crisis or to serve another financial purpose, such institutions tend to have
remarkable staying power. A few, such as the First and Second Banks of the
United States, have been dissolved, but many others, such as the Federal
Reserve (1913) or the U.S. National Banking System (1863) are still with us
long after the memories of the Panic of 1907 or Civil War financing have
2A more detailed chronology of the establishment of U.S. regulatory institutions appears in
chapter 3.3. A discussion of the current evolution of regulatory institutions in the
European Union is found in Chapter 3.5. The crisis of 2007 and its aftermath is discussed
in chapter 1.5.
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faded.3 The result, at any point in time, is a patchwork of official institutions,
each originated in response to a specific historical event or need.
Table 1: Some Crises and their Institutions
Crisis Institution(s) Created Reference
U.S. Civil War
National Banking System and Comptroller of
Panic of 1907 Federal Reserve Johnson (2010)
Federal Deposit Insurance Corporation (FDIC) Flood (1992)
Securities and Exchange Commission (SEC) Seligman (2003)
Federal Housing Administration (FHA),
Federal National Mortgage Association
(Fannie Mae), and Federal Home Loan Bank
Bank of Canada Bordo and Redish,
Securities Investor Protection Corporation
Basel Committee for Banking Supervision
Office of Thrift Supervision (OTS), and Federal
Housing Finance Board (FHFB)
Office of Financial Research (OFR), Financial
Stability Oversight Council (FSOC), Federal
Insurance Office (FIO), and Consumer
Financial Protection Bureau (CFPB)
Financial Policy Committee (proposed) of the
Bank of England
European Systemic Risk Board (ESRB) Nymand (this
Handbook, ch. 3.5)
3Bruner and Carr (2007) provide a readable and informative account of the Panic of 1907.
See Johnson (2010), Friedman and Schwartz (1971), and Markham (2002b) on the
founding of the Federal Reserve. Regarding the Bank of the United States and the
National Bank Act, see Hammond (1991) or Markham (2002a).
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A second theme that appears repeatedly over time is financial innovation as
a response to the inflexibility of official institutions. Kane (1977) posits a
“regulatory dialectic” of alternating innovations and countermanding rules
succeeding each other over time. For example, the three estates of church,
nobility, and commoners dominated the institutional structure in Europe
throughout the Middle Ages and up to the Industrial Revolution. In finance,
an important practical issue was the need to accommodate the Church's ban
on usury, taken from Deuteronomy (23:19-20). The ban was vigorously
debated and enforced for centuries, and it hampered a wide range of
economic activity, most notably the financing of military adventures. One
workaround was to delegate the business of money lending to Jews, who by
definition were not subject to excommunication. The economic segregation
of money lending facilitated economic activity, but unfortunately tended to
reinforce anti-Semitic attitudes by adding a profit motive for the recurring
pogroms that plagued the Jewish community.4 Munro (2003) documents a
number of more intricate circumventions of the rule, many of them variants
of perpetual annuities, known as rentes, that sufficiently disguised the
accrual of interest. These innovations expanded the range of financial
techniques, forming a foundation for a subsequent “financial revolution.”5
Few endeavors are riskier than war, and historically much of finance was
devoted to funding the imperial exploits of the European powers in their
high-stakes games. The voyage of Columbus was a precursor to several
centuries of conquest and settlement, with the potential for violent conflict
with indigenous locals or open warfare with national rivals. Large-scale
conflict is a speculative undertaking for both the participants and their
financiers. Historians sometimes refer to the “fiscal-military state” to
describe militaristic societies where much of economic life exists in service of
4Usury was the subject of a number of ecclesiastical rulings over the centuries, of which
the Third Lateran Council in 1179 is one of the more significant. Homer and Sylla (1986)
provide a useful and concise chronology (although they appear to neglect Lateran III).
Modern Christian teaching has largely relaxed prohibitions on usury. It remains an
important feature of Islamic finance: El-Gamal (2008) describes the Shari'a prohibitions
on usury (riba) and gambling (gharar), as well as techniques and ramifications of Shari'a
arbitrage. Most U.S. still states impose an explicit legal usury ceiling on interest rates; the
cap varies by jurisdiction.
5On rentes, see also Kindleberger (1993, ch. 12-14). The term “financial revolution” refers
to a nexus of activities, with a large increase in public borrowing being a notable
characteristic. The financial revolution occurred at different times in different places.
See, for example, Tracy (1985) and Wennerlind (2011).
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financing a large standing army and navy (see Knights, 2012). The European
powers in the fifteenth to eighteenth centuries fit this description. Frederick
the Great, who had to feed a famously effective standing army, advised, “A
financial system, handed over by father to son and constantly improved, can
change a government's position” Scott (2009, p. 23). It was especially in
Britain, however, that military funding needs supported the development of
financial markets. In contrast to absolutist monarchies, which might renege
on their debts, the invigorated powers of the British Parliament after the
Glorious Revolution of 1688 created a public counterweight that could hold
the crown to task for the repayment of debts (North and Weingast, 1989).
This credible threat brought lenders into the market, making large-scale
public borrowing possible and spurring the development of private financial
markets as well.
The stakes for fiscal-military states were indeed high: the arrival of bullion
(primarily silver) from Spain's New World colonies was a major contributor to
the so-called “price revolution” in Europe, a two-century inflationary episode
driven largely by mining discoveries and processing advances (see Braudel
and Spooner, 1967). Naturally, the producer of the precious metals was the
immediate beneficiary of this increase in purchasing power, at least when it
escaped the grasp of Dutch and English pirates. Spain ultimately dissipated
most of this windfall on the European wars of the Counter-Reformation (the
defeat of the Spanish Armada in 1588 is the most famous example) or
squandered it on royal extravagances like the Buen Retiro palace in Madrid.
Reinhart and Rogoff (2009) note that Spain was a “serial defaulter” on its
sovereign debt during the reigns of Philip II and his successors (roughly 1550
After the political revolutions of the eighteenth century, the fiscal-military
states gradually reoriented themselves. Industrialization created less painful
and less risky paths to enrichment for the ambitious and enterprising. Not
coincidentally, the Industrial Revolution, with its focus on capital-intensive
industries, coincides with the formalization of markets for equity shares: the
London Stock Exchange was formally organized in 1773, while the
Buttonwood Agreement creating the New York Stock Exchange (NYSE) was
signed in 1792.6 It is in the relatively peaceful nineteenth century that the
institutionalization of financial markets becomes pervasive.
6See Neal (1990) on the creation and expansion of exchanges in Europe and elsewhere.
Sylla (2005) focuses on the founding of the NYSE. The Amsterdam Stock Exchange is an
exception that proves the rule – it was founded in 1602 to support trading in shares of the
Dutch East India Company.
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The relatively peaceful 19th century was eventful in other ways. The Panic
of 1825 in London saw the first experiments with a lender of last resort (a
cornerstone of central banking), which led to a gradual restructuring of the
British financial system.7 In that episode, the Bank of England, then a
shareholder-owned public bank without lender-of-last-resort responsibilities,
stepped into the breach of a major liquidity crisis. By lending to other banks
at a discount (against good collateral), they enabled institutions to satisfy
withdrawals, thus stemming the panic. Posting collateral in a crisis to
liquidate assets without selling them addresses what is at root an information
problem, namely the inability of creditors to observe directly the quality of
the debtor firm's assets. The lesson learned by central bankers from the
1825 experience has become known as Bagehot's Rule: lend freely in a
crisis, on the basis of any acceptable collateral (“any good banking
securities”), but at a “very high rate of interest” (see Bagehot, p. 197). The
United States would suffer nearly a century of similar clearing crises before
founding the Federal Reserve in 1914. Unfortunately, while the existence of
a central bank should facilitate crisis response, it does not guarantee good
monetary policy, a point driven home after the 1929 crisis.8
The impact of new regulatory institutions is also important to the
development of financial markets. The newly regulated entities respond with
an institutionalization of their own as they comply with the new rule set. In
the 1950s, for example, U.S. banking in the aftermath of Depression-era
regulations and the newly revamped system of fixed exchange rates was
famously boring, inspiring the so-called 3-6-3 rule (i.e., borrow at 3%, lend at
6%, and be on the golf course by 3pm). Equally important, regulated entities
can push back, lobbying for repeal of the rules. To the extent that the
regulations constrain behavior and innovation (there is little point to rules
that never bind), financial activity will tend to migrate away from supervised
and regulated institutions to less supervised and encumbered markets.
Kaufman and Mote (1994), for example, document the decades-long
migration of financial assets away from traditional banking. They emphasize
that assets are a very inexact measure of financial activity, and that other
measures, such as employment and economic value added, paint a more
optimistic picture for banking. Nonetheless, by the 1990s, the share of
7See Bagehot (1873), Neal (1998) and Bordo (1998).
8On the 1929 crisis and Federal Reserve response, see Friedman and Schwartz (1971),
Galbraith (1955), and Ahamed (2009). There are more extreme examples as well,
including the German hyperinflation of 1922-23; see Kindleberger (1993, ch. 17) and
Eichengreen (1992, ch. 5).
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assets held at banks and thrifts had fallen to less than half of what it had
been in 1900.9
The essence of the “invisible hand” is the sufficiency of price information to
achieve the coordination of production and consumption activities across all
participants in the economy. However, for such a signaling mechanism to
work in practice, price information must be broadly observable. In other
words, an adequate communication technology is a prerequisite for
economic efficiency. Historically, this fundamental economic force has
created a strong tendency toward increasing availability and consistency of
prices. In international financial markets, this historical process is often
referred to as “capital market integration.”10 While timely knowledge of
foreign prices is in itself a valuable information source, full access to foreign
financial markets allows for actual diversification of investments and sharing
of risks internationally. Neal (1990, ch. 1-3) describes the emergence in the
late 17th century of a financial information network connecting the equity
markets of London and Amsterdam with each other and the rest of Europe.
Entrepreneurs in both cities began to publish weekly (or more frequent) stock
price lists reporting the “course of the exchange” locally, as well as in ports
as far-flung as Cadiz and Leghorn (i.e., Livorno). Prices were transmitted via
packet boat and stage coach.
It is unsurprising that these stock price lists developed prominently first in
the capitals of the two seafaring empires, since shipping requires both
financial capital to fund the cargoes and well developed insurance markets to
spread the risks of loss due to sinkings. Of course, international trade has
existed as long as there were nations. Truly global trade goes back at least
to the Age of Exploration, highlighted by the commencement of the spice
trade, the exploitation of American gold and silver resources, and the
development of the slave trade. From the start, trade and risk commingled.
9A more recent update by Feldman and Lueck (2007), reinforces this impression. After
adjusting for off-balance-sheet activities, they reveal a surge in the asset share held by
“other financial intermediaries” in the most recent two decades. Regulatory burdens are
only one example of transaction costs driving the long-term migration from traditional
financial intermediaries to securities markets and contracting – i.e., away from intra-
organization activities and toward inter-organization transactions. Coase (1990)
introduced transaction cost economics; Holmström and Roberts (1998) offer a survey.
10 See, for example, Obstfeld (1998), Lothian (2000) or Obstfeld and Taylor (2004).
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Motivated by international trade and the risks of venture capital, the Dutch
United East India Company pioneered two of the most important risk-
management innovations known, the implicit limited liability of shareholders
and a secondary market for equity shares on the Amsterdam Stock
Exchange.11 British Parliament similarly granted limited liability status to the
rival British East India Company in 1662. The limited liability provision
implied that owners could not lose anything beyond a fixed initial stake in
the company. This encouraged the investment of capital in ventures of
inherently high risk but potentially very high reward. Unfortunately, it also
encouraged leverage, which magnified the positive upside without increasing
the (zero) downside; the subsequent British South Sea Company, chartered
in 1710, was at the center of one the earliest systemic financial crises, the
South Sea Bubble of 1720.12
Until relatively recently, international trade overwhelmingly dominated
international investment. For centuries, the latter was dominated by various
forms of sovereign debt to finance wars, or to pay indemnities to the victors
afterward.13 Also prominent was financing for overseas investment in
infrastructure projects, such as railroads and canals. However, even today,
trade in goods and services is several multiples the level of investment
income as measured in current account statistics (see OECD, 2010). Given
the preeminence of trade, the challenges of payment and settlement were
the main focus of international finance. For much of recent history, this
meant the gold standard.
11 The Dutch East India Company is often known by its initials, VOC, an abbreviation for the
official name, Vereenigde Nederlandsche Geoctroyeerde Oostindische Compagnie. See
Neal (2005) for a good history of the early days of the VOC, which initially expanded
much more rapidly than the British East India Company; both firms were chartered in
1602. See Ferguson (2008, ch. 3) for a discussion of the limited liability provisions. Neal
(1990, ch. 3) traces the limited liability tradition to the earlier medieval shipping ventures
known as societas maris and commenda. The same chapter offers a good treatment of
the early days of financial trading in both London and Amsterdam.
12 Bordo, Eichengreen and Irwin (1999) provide a good summary of commercial and
financial globalization since the late nineteenth century. On the broader history of limited
liability corporations, see Baskin and Miranti (1997). Reinhart and Rogoff (2009),
Kindleberger (1993, ch. 15) and Kindleberger and Aliber (2005) discuss a range of
speculative manias and financial crises.
13 The borrowers and their underwriters were frequently very inventive in structuring these
deals, experimenting for example with the sale of a variety of retail life annuities known
as rentes, described above. Reinhart and Rogoff (2009) provide an authoritative overview
of the problem of default on sovereign debt (both external and internal).
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The gold standard grew in tandem with the globalization of trade, especially
in the Atlantic sphere (see O'Rourke and Williamson, 2001; and Lothian,
2000). By rigidly fixing certain key prices, the gold standard eliminated
exchange-rate uncertainty, thus playing an important informational role. By
propagating inflation and deflation across borders, it was central to economic
risks in the system. The gold standard did not spring forth fully formed, but
evolved gradually over several centuries.14 Silver coinage dominated in
Europe until the late Middle Ages. Following the introduction of gold coins in
thirteenth-century Italy, most of Europe subsequently evolved to a
complicated hodge-podge of gold, silver, and bimetallic standards.15 As
industrializing economies were discovering and exploiting enormous gains
from trade throughout the nineteenth century, the international gold
standard alleviated uncertainty about the value of payments exporters could
expect from importers. The chronology of the gold standard is punctuated by
three major wars, with the international monetary framework fundamentally
reorganized under new institutions after each. The first was the Franco-
Prussian War of 1870-71, during which most of Europe, except for Britain,
suspended convertibility.16 When Germany opted for a gold standard in
1873, using the French indemnity from the war to fund their new currency,
14 The gold standard is a commodity monetary standard. In an international context, if all
jurisdictions convert their circulating currencies to a common commodity base, then
international payment becomes straightforward. In a world with restricted and unreliable
communication networks, such a coordinated valuation system solves an important
problem of distributed information by removing exchange rate risk from the calculations,
as exchange rates are effectively fixed by the ratio of the relevant mint prices of bullion in
the local currencies. It is noteworthy that – in theory – any country can join the
international regime by committing domestically (i.e., unilaterally) to convert its own
currency to bullion at a fixed price. In so doing, it locks into a system of fixed exchange
rates as a matter of simple arithmetic, enforced by arbitrage. There is a degree of
arbitrariness in the choice of gold as the basis for a monetary system, Gold, silver and
copper all had long legacies, along with the practical advantages of being durable,
visually distinctive, and sufficiently rare that coins of useful denominations have a
15 Kindleberger (1993, ch. 4) highlights the operational burdens inherent in keeping a
bimetallic standard balanced. For example, Britain in 1717 unintentionally became the
first major economy to abandon bimetallism. Sir Isaac Newton, as Master of the Royal
Mint, undervalued silver (relative to gold) in the official mint exchange ratio – the rate at
which it would trade gold for silver. With ongoing mineral discoveries in the New World,
the correct ratio was uncertain. In typical Newtonian fashion, his intention was to monitor
market prices and adjust the mint ratio adaptively over time. However, the mint ratio
went untouched after his retirement, and Gresham's Law drove silver out of circulation.
16 It is standard practice to suspend convertibility during wartime, to protect bullion supplies
and facilitate potentially inflationary military spending needs.
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the rest of Europe followed, either officially or by committing to fix their
currency's exchange rate against the new German mark or the British pound.
The most famous of the postwar indemnities is the German reparations debt
under the terms of the Treaty of Versailles after World War I. The
unsustainable burden imposed on Germany by the Treaty contributed
significantly to a decade of political and economic turmoil there in the first
decade after the war, including the hyperinflation of 1923-24 (see
Eichengreen, 1992, ch. 5). In 1929, the the Young Plan to reduce the
reparations burden created the Bank for International Settlements (BIS) in
Basel to manage the payment flows (see Kindleberger, 1993, ch. 16).
Although the payments plan quickly fell apart in the aftermath of the 1929
stock market crash, the BIS is still with us as a key policy body for
coordinating international banking regulations.
The trauma of World War II provided an opportunity to restart international
monetary coordination. The crisis mechanism for creating new institutions
worked once again. Before the war was even over, the allies (44 nations in
all) met at the United Nations Monetary and Financial Conference in Bretton
Woods, New Hampshire, to negotiate creation of the International Monetary
Fund (IMF) to manage a reinstated system of fixed exchange rates, and the
International Bank for Reconstruction and Development (IBRD, later part of
the World Bank) to manage the rebuilding of Europe and Japan (see
Eichengreen, 1996, ch. 4). The United Nations (UN), General Agreement on
Tariffs and Trade (GATT), European Community (EC), and Organization for
European Economic Co-operation (OEEC) rounded out the complement of
major international economic institutions created in the wake of the war.17
The Bretton Woods framework was significantly more flexible than either the
interwar arrangements or the classical gold standard. The U.S. dollar was
pegged to gold, and other currencies pegged to the dollar, with provisions for
orderly (re-) devaluation when necessary.
U.S. deficit spending to support the Vietnam War and Great Society
ultimately created inflationary pressures, which the fixed exchange rates
tended to export to other countries. At the official parity of $35/oz., gold was
undervalued and flowed unrelentingly out of the U.S. In August 1971,
acknowledging that the U.S. had exhausted its reserves, the Nixon
administration suspended convertibility, effectively ending the gold standard
17 The OEEC received much of its funding through the Marshall Plan. It evolved into the
Organization for Economic Cooperation and Development (OECD).
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(see Eichengreen, 1996, ch. 4). The network of pegged exchange rates was
relaxed and finally abandoned in 1973.
As exchange rates began to float, trading in currencies expanded rapidly.
The need for coordinated international regulation was revealed by the failure
of Bank Herstatt in 1974. West German regulators closed Herstatt at the
close of business in Frankfurt June 24, 1974, after it had received Deutsche
marks, but before paying the corresponding U.S. dollars in New York (see
Becker, 1976). The resulting settlement crisis motivated the creation of the
Basel Committee on Banking Supervision (BCBS) within the BIS. The BCBS
provides a forum for regular cooperation on banking supervision among its
27 member countries, and is best known for its international coordinating
role on issues of bank supervision, especially its standards on capital
adequacy.18 Another example of global coordination is the Continuous Linked
Settlement Bank (CLS), created in the late 1990s by several large banks to
settle their currency trades. A key feature of CLS is multilateral netting to
reduce settlement risk.19
The expansion of credit that accompanied the breakdown of Bretton Woods
was the leading edge of a decades-long upswing in international financial
activity. Facilitated by advances in trading technology, and augmented by
“petrodollar recycling” of exporter revenues following the oil embargo of
1973-74, cross-border holdings of financial securities, especially bonds, grew
at double-digit rates through the 1980s (see Abken, 1991). An unhappy side-
effect was an overextension of credit, culminating in the Latin American debt
crisis of the 1980s.
The most recent episode in international monetary coordination is the Euro
Area (or Eurozone), the monetary union of the 17 countries sharing the Euro
as their legal tender currency within the European Union. Narrowly
construed, the Euro Area is an economic policy initiative, but because (like
the gold standard) it necessitates the coordination of fiscal and monetary
18 See BCBS (2009) and Goodhart (2011) on the history of the Basel Committee. Goodhart
clarifies that international supervisory coordination had begun informally within the EC as
early as 1972, well before Herstatt. This so-called Groupe de Contact was motivated
primarily by concerns around the burgeoning Eurodollar markets. The BCBS is discussed
in greater detail in Chapter 3.1 of this Handbook. For the statement of supervisory
principles, see BCBS (2011a). For various versions of the Basel capital standards, see
BCBS (1988, 1996, and 2011b).
19 CLS handles 94% of trading volume for 17 currencies; see Groenfeldt (2011). Aggregate
daily trading volume in the global foreign exchange market is on the order of $4 trillion;
see BIS (2010).
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policies across participating countries, it is an important political
commitment. The ongoing negotiations (as of early 2012) around the
possibility of a Greek sovereign default forcefully make this point. Indeed,
the 1992 Maastricht Treaty that launched the Euro project was itself a
powerful commitment to political unification, coming not coincidentally at the
end of the Cold War.
Global financial activity has continued to grow undeterred, facilitated by a
gradual transition from bank-based to market-based finance (see Lane and
Milesi-Ferretti, 2007). From the 1990s, the “Washington consensus” on
financial liberalization has encouraged the managed extension of credit to
under-capitalized and funding-constrained emerging economies.20 Once
again, there were some unhappy side-effects, including the Asian financial
crisis, precipitated by a speculative attack on the Thai baht in May 1997 (see
Woo, Sachs and Schwab, 2000, or Blustein, 2003).
Following upon the heels of the Asian crisis, the Russian sovereign debt
default in the fall of 1998 coincided with the expanding role of hedge funds
to produce another systemic event. Long Term Capital Management (LTCM)
was founded in 1994 to implement trading strategies in the currency and
bond markets. Although LTCM was not heavily exposed to Russian debt
directly, it was highly leveraged and very sensitive to the drop in liquidity
that pervaded all markets after Russia unexpectedly defaulted in September
1998 (see Lowenstein, 2001). Fearing a possible chain reaction if LTCM were
to unwind its positions in an already fragile market, the Federal Reserve
engineered a bailout, with fourteen U.S. and European banks contributing a
total of $3.5 billion in exchange for an equity stake to refloat the firm.
The latest episode in this litany of global crises is the financial crisis of 2007-
08, the ramifications of which are still underway. What appeared to be a
“Great Moderation” in the economy turned out instead to be market
euphoria, as a housing bubble in the U.S. (and elsewhere) was financed
largely through a complex web of securitization vehicles. Related structures,
such as credit default swaps (CDSs), provided third-party credit
enhancement. Because the U.S. does not save enough to fund its
investments (including housing expenditures), much of the securitization
debt was placed abroad, ensnaring much of the developed world in a
complex web of now troubled financial claims. As Reinhart and Rogoff (2009)
emphasize in their sobering historical review, the surprising fact about
20 For a history of the Washington consensus, see Williamson (2004). For a reconsideration,
see Kose, Prasad, Rogoff and Wei (2009).
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financial crises whether domestic or global, is not that they occur, but that
they unfold so similarly from one instance to the next.
From the start, innovations in financial risk management have been
intricately linked with innovations in information technology. It is difficult to
distinguish cause and effect among emerging risks and new technologies to
manage them. Invention evolves over time, with episodes of mimicry,
inspiration, and unintended consequences tumbling over one another.21
One humble institution of modern deposit banking – the checking account –
had its origins among innovations in risk management and information
technology in medieval Europe.22 The main risk addressed was quite
immediate, namely the potential loss of valuable cargo, especially coin or
bullion, to shipwreck, piracy, or highway robbery.23 The innovation was the
bill of exchange, a remittance service provided by a “sedentary” merchant
who maintained a local presence in major trading centers, with a network of
couriers to deliver instructions and reports. Instead of accepting cash, an
itinerant trader would deliver goods to the sedentary merchant's local office
in exchange for a cambium per literas (bill of exchange). This was a written
payment instruction that the trader could transport safely and easily, and
that he could redeem on a specified future date at a distant market center.
The dates were calibrated against estimated travel times and a well known
calendar of major trading fairs. For our purposes, the most interesting
aspects of these arrangements are the early information technologies
supporting the risk management innovation. First, the sedentary merchant
maintained a transactional database journaling the bills of exchange issued
and the payments and deliveries made.24 The sedentary merchant also
maintained a communications network of couriers and agents for messaging.
21 For an instructive historical example involving the invention of double-entry bookkeeping,
see Heeffer (2010).
22 Usher (1934) is a classic history of the early development of banking in Europe.
Grossman (2010, ch. 2) offers a more recent account of the same epoch. Kohn (1999a)
focuses specifically on the details of the process of issuing bills of exchange, along with
related payment innovations. Ferguson (2008) highlights their importance to the rise of
the Medici dynasty in Italy.
23 We would classify these today as operational risks. Kohn (1999b) also describes
commonplace medieval market risk – namely the risk that a shipment would arrive in port
to discover that local prices for the cargo were lower than anticipated.
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Simultaneously and separately, the local sedentary merchant would send
along instructions (so-called avisas) to the destination that the bill of
exchange should be honored upon presentment. Message formats were
roughly standardized, and settlement procedures were well established and
enforceable in the courts. To ensure the resilience of the communications
network, the sedentary merchant would typically transmit multiple
redundant copies of the avisas (but not the bill of exchange) via different
A subsequent innovation, related to the bill of exchange, was the cambium
nauticum (maritime exchange contract), which first appeared in thirteenth-
century Europe, and ultimately evolved into modern marine insurance. The
cambium nauticum was very similar to a bill of exchange, with the important
difference that payment was contingent upon safe delivery of the collateral
cargo.25 Of course, proper insurance, as a business model, involves more
than a willingness to take a gamble: it requires that the insurer be able to
calculate odds and select risks. Merchants' record-keeping systems provided
a natural statistical data sample of ladings, sailings and sinkings, as well as
other partial losses of cargo. The obvious fact that most shipments arrived
intact made sea-borne trade enticing for both the shippers and their
captains. More interesting is that insurers were able, at least approximately,
to select risks. Insurance premiums varied according to the distance
shipped, the time of year, state of war or peace, the presence of pirates, and
the type of vessel.
Benefiting from a general interest in measurement, more sophisticated
insurance markets developed in tandem with the foundations of probability
theory during the sixteenth to eighteenth centuries.26 Daston (1988) argues
that the raw materials for probability theory – for example, experience with
games of chance, set theory, and insurance markets – remained essentially
unused for centuries before the path-breaking correspondence of Pierre de
Fermat and Blaise Pascal in 1654. As old cosmological certainties collapsed
in the wake of Columbus's explorations, the Renaissance witnessed an
invigorated focus on empirical measurement. This was epitomized by the
24 This was, of course, written out longhand; early on, the records typically used Roman
numerals. Roman numerals were also an information security measure, as the alternative
Arabic representation was seen as more susceptible to forgery; see Arlinghaus (2003).
25 See de Roover (1945) for a detailed discussion of this and related legal developments.
26 Bernstein (1998), Daston (1988), Hald (2003), Hacking (2006), and Devlin (2008) recount
the history of this period.
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astronomical observations of Copernicus, Galileo and Kepler in the sixteenth
and early seventeenth centuries (see Hald, 2003). Christiaan Huygens
formalized Fermat's and Pascal's ideas in 1657. Royal societies for science
were founded London and Paris in the 1660s, and both worked on the
measurement of longitude, a matter of vital strategic importance for the new
transoceanic empires. Meanwhile, Lloyd's of London, the maritime insurance
society, was growing steadily from its beginnings in the 1630s.
In 1662, essentially contemporaneous with the aforementioned seminal work
on probability theory, John Graunt published the first mortality table,
compiled from official records of births and deaths (the latter attributed to
various causes) in London over the period 1604-61.27 Within a decade of
Graunt's publication, governments were using the data to refine the pricing
of life annuities they sold to raise revenue. By the end of the century, the
first modern life insurance companies were beginning to form in London. The
new methodologies for compiling high-quality data enabled more accurate
risk assessment. An important refinement in data collection was the
inclusion, starting in 1728, of age at death in the official London Bills of
Mortality. A boom in insurance markets ensued throughout the eighteenth
century, alongside intensive development in probability theory. This period
also saw Abraham de Moivre's approximation formula for the binomial
coefficients, first published in 1738. A century later, Carl F. Gauss would
refine and formalize this approximation as the normal distribution, applying it
to the Law of Errors to describe the regular patterns in measurement errors
and manufacturing variances.
The nineteenth century also saw dramatic improvements in communication
technologies. This is important for the history of finance, as contracting and
payment (or physical delivery) processes rely on effective messaging to
initiate and complete transactions. The first commercial deployments of the
telegraph occurred in the 1830s. Prior to that, most long-range
communication required couriers or ordinary post, although the Rothschild
banking house famously used carrier pigeons to gain an advantage over
competitors.28 By the late 1840s, the telegraph was reducing
27 See Bernstein (1998), ch. 5, for a discussion of Graunt's contribution to insurance.
28 On Rothschild's use of pigeons, see Stephen (1885). Contrary to popular myth, the
pigeons were not a factor in the Rothschilds' profiting from the Battle of Waterloo;
Ferguson (2008) details the true story, which was more about financial fortitude and
much less about cleverness. Another inventive technology of the same era was Claude
Chappe's semaphore telegraph, implemented as a network of visual signal towers
throughout France in the 18th century; see Gleick (2011).
16 of 32
contemporaneous price discrepancies between New York and markets further
west (see Garbade and Silber, 1978). The first successful transatlantic cable
was laid in 1866.29 The initially high cost of messaging was justified by
reductions in the risk of pricing surprises caused by the timing delay of
shipments to a distant port or investments in overseas securities. On the
other hand, the cable also helped speculators in London to participate
actively in U.S. banking panics.
More recently, modern investment strategies and risk management methods
have emerged contemporaneously with advances in information
technologies. Investors have understood for centuries the benefits of
diversification for risky investments. Ancient traders dispersed their most
valuable cargoes across many ships in a fleet. Computation expands these
possibilities. The cornerstone of modern portfolio theory, namely Markowitz's
(1959) formal optimization methods for portfolio selection based on the
covariance matrix of observed returns, requires computers for practical
implementation. Similarly, the option-pricing models of Black and Scholes
(1973) and Merton (1973) are able to assign plausible and well understood
values to simple put and call options. However, this requires the evaluation
of a normal integral, which must be interpolated numerically. Soon after its
introduction, it was commonplace for option traders to have the Black-
Scholes-Merton formula literally at their fingertips on the trading floor,
programmed into pocket calculators.30
The basic insight of Fermat in 1654 was that one could describe – and assign
probabilities to – all possible future paths that might ensue in an unfinished
game of chance. This is the essence of Monte Carlo analysis, which
generates the data to describe a large number of possible future evolutions
of the system. One goal is to reveal the odds of the various payoff outcomes
for a complex security (see Glasserman, 2003). Because this approach
frequently involves brute-force recursive and iterative algorithms, it has
29 See Hoag, 2006. The telephone followed in the 1870s, and was quickly commercialized,
and the wireless radio arrived in the 1920s.
30 Although the pricing formula is relatively recent, exchange traded options have a much
longer history; see Gelderblom and Jonker (2005). The original paper by Black and
Scholes (1973) also introduced the insight that limited liability equity is effectively a call
option on the assets of the firm. Limited liability equity was first introduced for the Dutch
East India Company in 1602, mentioned above. A slightly modified version of the Black-
Scholes-Merton formula is the core of one popular approach to estimating corporate
default risk (see Saunders, 1999). The compendium by Field (2003) provides a good
survey of risk modeling and risk management innovations since the introduction of the
Black-Scholes-Merton model (up to 2003, of course).
17 of 32
benefited enormously from advances in computing power. Monte Carlo is
also able to calculate probabilities in many cases where more traditional
closed-form solutions like the Black-Scholes-Merton model are inapplicable
(e.g., the odds of a mortgage prepaying or defaulting). These probability
estimates enable valuation approximations that in turn allow new markets to
emerge in many complex products, such as structured mortgage-backed
Program trading is another data- and computation-intensive technology with
risk implications. In 1982, the Chicago Mercantile Exchange (CME)
introduced futures contracts on the S&P500 stock index, a value-weighted
average of the prices of the common stocks of 500 large firms. Upon
maturity, the futures contract pays the buyer a simple multiple of the value
of the index on that day. Index arbitrage is a program trading strategy that
watches for pricing discrepancies between the index futures and the
individual underlying stocks, buying stocks and selling futures when the
former are relatively undervalued (or vice versa when stocks are
overvalued). To implement this most effectively, the program must execute
large volumes of transaction orders nearly simultaneously. The tactic would
not be practical without network bandwidth and computing power to validate
data and process messages. An important side benefit is that it penalizes
deviations between the futures price and underlying stock prices, enforcing
consistency in the price signals in the marketplace. Portfolio insurance is a
related strategy that continuously rebalances a short position in index
futures to emulate a put option for a portfolio of stocks. Again, frequent
trading is required. Because it relies on continuous recalibration, abrupt
jumps in prices can expose the portfolio to unbalanced moments. Both index
arbitrage and portfolio insurance contributed prominently to the Black
Monday crash of 1987, the largest daily percentage loss (–22%) in the history
of the U.S. equities markets.31
Program trading is only one example of a broader trend toward automation
of all aspects of the trading process. In many cases, human brokers have
given way to electronic brokerage, algorithmic trading has replaced human
discretion in investment decisions, and electronic communication networks
(ECNs) have attracted execution volume away from traditional trading floors
(see Harris, 2002). Straight-through processing (STP) of transaction and
settlement details has come to dominate back offices (see Weiss, 2006).
There are obvious operational efficiencies to automating much of the
repetitive work in the trading process. At one extreme, high-frequency
31 See Brady (1998), SEC (1988), and Carlson (2007) for analysis of the event.
18 of 32
trading designs streamlined decision algorithms to speed throughput, and
co-locates them on machines at the exchange to minimize network latency.
The “arms race” in this domain has generated extremely large trading
volumes in recent years. On the other hand, while not the primary culprit,
high-frequency trading was a factor in the Flash Crash of May 2010 (see
CFTC/SEC, 2010). The same computing and trading power that monitors and
enforces price consistency continuously across thousands of securities also
has the potential to generate enormous operational events very quickly.
D. Complexity and Professionalization
It has become commonplace to observe that financial markets have become
more complex. “Complexity” is a multifaceted concept, with at least three
common usages: systems complexity, descriptional complexity, and
computational complexity. Although all three are relevant, we are interested
especially in the latter: the computational burdens complexity places on
participants in the financial system.32 These burdens may be multiplied by
the degree of interconnectedness among the participants. Financial
complexity appears in several interrelated forms in the financial markets,
visible at the level of the individual contract, at the level of the firm, and at
the level of the system as a whole.
At the contract level, the development of option pricing theory and rapid
expansion of derivatives markets starting in the 1970s marked a revolution
in the practice of finance. Options are a form of contingent claim, meaning
that the payoff to the option holder depends on whether a particular
contingency occurs. Traditional insurance typically pays out for well defined
physical transitions like the death of the policyholder or sinking of a ship. In
contrast, contingencies for financial derivatives are typically more abstract,
and this abstraction enables considerable flexibility and creativity in
designing these contracts.33 An important benefit of this flexibility is the
32 Simon (1962) provides an important early overview of complexity with an emphasis on
hierarchical dependencies. Mitchell (2011) also highlights the systems aspect,
emphasizing interconnectedness and decentralized decision-making and computation.
Arora and Barak (2009) focus on computational intricacy. A third definition is Kolmogorov
(a.k.a. “descriptional”) complexity: the length of the shortest description that can capture
the full detail of a given set of facts.
33 A “derivative” is a contract for which the contingencies in question are derived from the
properties (typically the price) some underlying financial security. For example, a call
option pays off if the price of an underlying security is above a threshold value on a
particular future date. Derivatives exist for a vast range of underlyings and
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increased ability to trade risks, allowing exposures to flow (for a price) to
those best able to bear them.
Of course, the seeming costless ease of this abstract creativity is partly a
mirage. There are complexity costs. By definition, contingent claims create
dependencies to be measured and managed among the values and payoffs
of different securities. Goetzmann, Ingersoll, Spiegel and Welch (2007), for
example, demonstrate that it is straightforward for investment managers to
use options contracts to manipulate standard portfolio performance metrics.
This is particularly significant for hedge funds and other managers who are
compensated based on reported performance. Securitization contracts are
an example of a useful innovation that manifests descriptional complexity as
a side-effect. The offering documents for a typical structured securitization
go on for many hundreds of pages, not counting the thousands of pages of
paperwork for the underlying mortgage loans. Arora, Barak, Brunnermeier,
and Ge (2011) demonstrate the possibility of hiding poorly performing loans
within a complex structured securitization so that it is computationally
infeasible to detect their presence.
The last four decades have also seen significant changes in market structure
leading to increased complexity within and across firms. In the U.S., the
relaxation of interstate branching restrictions in the 1990s led to a massive
consolidation of the banking industry. Mergers reduced the total number of
commercial banks in the U.S. from over 14,000 in the mid-1980s to less than
half that today (Mester, 2007), and the industry as a whole has shed assets
through securitizations into off-balance-sheet special purpose vehicles. At
the same time, the very largest banks have grown into institutions that are
now known to regulators as, “large complex financial institutions” (LCFIs).
Citigroup, for example, now has nearly 2500 subsidiaries.34 Complexity has
also increased at the systemic level, particularly through the growth of
securitization vehicles and related markets. As wholesale-funded LCFIs have
taken on a greater role, and as securitization and trading have increased in
prominence, unregulated sectors such as the “shadow banking” markets for
repurchase agreements have ballooned (Adrian and Shin, 2009). At the
same time, the hedge fund sector grew roughly tenfold just in the decade
from 1994-2004, not counting funds of funds, (see Fung, Hsieh, Naik,and
Ramadorai, 2008). The fact that securitization funding chains stretched
around the world, from U.S. mortgage borrowers, through mortgage-backed
contingencies. See Hull (2008) for details.
34 See Herring and Carmassi (2010) for an analysis of subsidiary counts for LCFIs. See
Group of Ten (2001) for a study of the recent history of consolidation.
20 of 32
securities (MBS) pools and tranches, through repo collateral in the shadow
banking sector, to pension fund investors in Europe and elsewhere meant
that the collapse triggered by the failure of Lehman Brothers in 2008
necessarily had significant systemic ramifications.
The increasing complexity of financial contracts and the corresponding
growth in the use of computational technologies have created a need for
professional risk managers. As with important legal and medical decisions,
where crucial inputs must be entrusted to technical experts, a certification
process has emerged to indicate subject-matter competence. For example,
the most recent supervisory proposals from the Basel Committee would
codify a requirement for a Chief Risk Officer in large banking firms, affirming
what has been standard practice for many years (see BCBS, 2011a, p. 43).
Separately, industry participants have evolved professional societies and
formal processes for certification in risk management, as described below.
Within the field of financial risk, this trail was blazed by the actuarial
profession in the late nineteenth century (see Hickman, 2004). The Institute
of Actuaries (IA) was founded in London in 1848, following a successful
experiment in pooling policy data across firms to better estimate mortality.
By 1900 both the IA and the U.S.-based Society of Actuaries were offering
formal credentials of professional competence. Other technical financial
specialties have also evolved to provide formal certification. In the U.S., the
Certified Public Accountant (CPA) credential similarly traces its roots back to
the late nineteenth century. Among other roles, accountants and actuaries
provided expertise to courts and creditors seeking an equitable distribution
of assets in bankruptcy. The Chartered Financial Analyst (CFA) designation
for experts in corporate securities research is more recent, with the first
certification issued in 1963.
The Example of Value at Risk
More recently, the development of value at risk (VaR) models provides a
useful case study of the expansion and evolution of a technical risk-
management tool to a standardized industry practice and regulatory
requirement. The Black-Scholes-Merton model for valuing derivatives
originated in academia before spreading decisively throughout industry in
the 1980s. By the early 1990s, derivatives markets had revolutionized
financial services, creating a need for more transparent reporting of risk
exposures. JPMorgan instituted the so-called “415 report” – a single page
delivered at 4:15pm daily to the CEO – to overcome the shortcomings of
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traditional accounting for risk measurement. The 415 report captured the
risk exposure of each trading desk in a single value-at-risk (VaR) number,
the estimated largest dollar loss that might occur within a 95% probability
window. VaR demonstrated new possibilities in risk accounting and
reporting, but implementing it on a firm-wide basis is a significant technical
challenge.35 While early VaR measures addressed market risk – the
possibility of losses due to short-term fluctuations in market prices – the
basic idea was soon extended to credit risk (the possibility of counterparty
or borrower default). The data required to calibrate market-risk models
primarily consist of various price histories. Credit risk, in contrast, deals
with highly asymmetric distributions, where there is a small chance of a very
large loss. Because interesting events are much rarer, calibrating these
models typically relies on information on counterparty characteristics to
augment actual loss histories.
Regulators quickly took note of the potential of the new VaR tools in the
mid-1990s. In 1988, the BCBS proposed its first capital accord, Basel I,
which required banks to hold a specific percentage of capital between 0 and
8% for every asset on the balance sheet, depending only on a broad
categorization of the asset type as a proxy measure of credit risk (see BCBS,
1998). The goal was to harmonize regulatory capital requirements across
countries, to prevent international competition in this dimension. In 1996,
with the ascendancy of VaR, the BCBS amended Basel I to include VaR-
based measures of market risk. By the end of the century, the shortcomings
of the simplifications in Basel I were becoming clear. A major revision,
Basel II, was proposed in 2004. It reached final regulatory approval in the
U.S. just before the crisis struck in 2008. By the end of 2009, Basel III was
under discussion, and by 2011, the BCBS had begun to propose the details
(see Chapter 3.4 of this Handbook and BCBS, 2011b).
Under the most recent Basel III proposals (BCBS 2011b), the practical reality
of the CRO will become a regulatory requirement for many firms. In 1996,
the Global Association of Risk Professionals (GARP) was formed and began to
offer certification exams for risk managers. In 2002, a controversy over
GARP's governance led to a schism, and the Professional Risk Managers
International Association (PRMIA) split off. In addition, the older Risk
Management Association (RMA), which traces its history to 1914, now offers
35 Finger, et al, (1996) is the technical document JPMorgan provided to its clients. Laubsch
(2000) offers one approach to the reporting of enterprise risks in a VaR context.
22 of 32
certification for competence in credit risk. Today, GARP, PRMIA, and RMA all
exist as non-profit organizations offering training, conferences, and
certification examinations to risk professionals. The professional field of
quantitative risk management is here to stay.
In tracing the evolution of financial risk and information over time, we have
identified four fundamental trends. Institutionalization, technology,
globalization, and complexity, with its attendant rise of risk management
professionals, have all contributed to and been a part of the growth of
financial markets. Not coincidentally, these developments have occurred in
concert with the growth in human population and economic productivity.
Through all these striking changes, the system has remained susceptible to
financial crises, information-driven risk events of the first order. Plus ça
change, plus c'est la meme chose.
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