Study shows low market volatility leads to banking crises

 
Jake Cordell
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Scenes Of Darwin
All calm at sea? You better watch out (Source: Getty)

Beware the calm before the storm.

A new report has found periods of low volatility in the financial markets increase the chance of a banking crisis.

Researchers from the London School of Economics (LSE), the University of Chile and the US Federal Reserve studied more than 200 years of economic history across 60 countries, finding spells of more predictable performance are one of the biggest signs of an impending crash.

The team, studying the relationship between volatility and financial crises concluded: "Low volatility leads to banking crises and both low and high volatility make stock market crises more likely."

The team suggests that low volatility, rather than instilling a sense of calm and composure to the financial markets, actually encourages excessive risk taking which can lead to bubbles and sharp corrections.

Read more: Have we seen the end of volatility in the currency markets?

"Low-risk environments are conducive to greater buildup of risk-taking ... Persistently low volatility for a prolonged period of time leads to a crisis, while higher volatility signals a pending crisis."

The group added: "The volatility-crisis relationship becomes stronger when financial markets are more prominent and less regulated".

In total, the group studied 262 banking crises, 419 stock market crashes and 540 currency crises across both the developed and emerging world over a 211 year spell. While volatility was higher in the emerging world on average, they noted in the two decades before the 2008 crisis, financial volatility spiked across the world.

Volatility has risen drastically as financial markets have become more sophisticated. Each line represents a different country.

The paper also shows how globalisation has created much more synchronisation in market movements around the world.

In the Bretton Woods era of post-war fixed exchange rates, the correlation between returns for investors in different developed markets was fairly weak, at just over 10 per cent. However, this correlation jumped to more than 40 per cent after the 1980s 'Big Bang' of financial deregulation with such strong links helping explain how and why the financial crisis spread across the US and Europe so quickly and with such intensity.

The report noted that while the relationship between volatility, stock market crashes and banking crises was strong, the same could not be said for currency crises, with volatility a weak indicator of how to read the foreign exchange markets.

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