Derivatives, financial fragility and systemic risk: lessons from Barings Bank, Long-Term Capital Management, Lehman Brothers and AIG

By Paula Marina Sarno, Norberto Montani Martins

PKES Working Paper 1812

October 2018

This paper aims at analysing the relationship among derivatives, financial fragility and systemic risk by discussing the role played by these financial instruments in the collapse or near-collapse of Barings Bank, Long-Term Capital Management (LTCM), Lehman Brothers and AIG. We investigate in which ways derivatives contributed to the build-up of systemic risks in these experiences according to a Post-Keynesian perspective, which is focused on the Minskyian concept of financial fragility and Cardim de Carvalho’s analysis of contagion and systemic risk. Our analysis points out that derivatives’ embedded leverage played a pivotal role in fragilizing the financial positions of Barings, LTCM and AIG, and a supporting role in Lehman’s failure, accelerating its financial debacle. While Barings’ failure did not cause contagion nor systemic consequences via derivative markets, in the case of Lehman derivatives worked as a major mechanism of contagion and contributed to the materialization of a systemic crisis. Yet, concerns on potential contagion effects via derivatives in the cases of LTCM (indirect) and AIG (direct) provided reasons for setting up the bailouts that avoided the collapse of these institutions. Finally, we highlight that, if speculative and Ponzi financing positions are widespread, instead of cushioning financial shocks, derivatives might fragilize even more financial institutions and disseminate difficulties among the financial system, therefore contributing to a systemic crisis to take place.

Keywords: Financial Crisis, Financial Fragility, Contagion, Systemic Risk, Derivatives, Barings Bank, LTCM, Lehmann Brothers, AIG

JEL classification: G01 G29 G30