The Financial Crisis resurrected the thinking of Hyman Minsky and his “financial instability hypothesis”. With the crisis, there was coined the term Minsky Moment, the time when financial markets collapse after a period of prosperity from the excessive speculation on financial assets. Unfortunately, his insightful views on financial instability never received the attention it deserved before the crisis. It was not structured in the current economic orthodoxy of formal mathematical modeling.
Minsky focused on how extended stability or prosperity leads to excessive risky lending which creates the environment for a crisis. He describes three levels of financing, hedging, speculation, and Ponzi-lending based on increasing levels of risk. Hedge financing is the safest and based on future cash. In speculative lending, firms can generate cash flow for interest but must roll principal. Ponzi financing is based on lending where cash flow will not be able to pay for interest or principal but needs the appreciation of financial assets to pay back loans.
Any decline in price will cause the house of cards for this type of lending to fall. Ponzi lending is more likely when there is an extended period of stability and low volatility of financial assets. Banks will take greater risks in a competitive but stable environment while borrowers believe their collateral will not suffer any downfalls.
While not a formal model, we believe that theories surrounding the impact of mixed Gaussian distributions which can generate negative skew in financial assets can help explain why periods of calm can actually create an environment of more downside risk. Skew in financial assets is generated when there is a mixed distribution of the underlying asset coupled with a distribution concerning a possible jump or regime change. The mixed distribution, when there are negative jumps, will create negative skew.
Research has found that if the underlying core asset distribution has lower volatility, the potential for negative skew increases. As the distribution spread narrows for the underlying asset, the impact of a jump will be more meaningful. In Minsky terms, a period of calm will sow the seeds for a potential downside event by increasing its impact on prices from the jump process. If more leverage is taken and financial markets are more susceptible to any negative jump, there will be more skew and downside risk.
Low volatility, a measure of calm, will also be periods when negative skew will be larger. The mixed distribution will show more downside risk that cannot be diversified away in the same way as hedging volatility. Low volatility with greater skew will result in a Minsky Moment being more likely. Minsky’s work may not have been put his hypothesis in these terms, but looking at the distribution of financial assets can tell us something about potential financial instability.