The wobble factor

May 17th 2007 From The Economist print edition

Regulators are doing their best to ensure financial stability, but they don't have all the answers

IN 2005 participants at the Kansas City Fed's annual shindig in Jackson Hole, Wyoming, were reminded of a sunny day in London in June 2000 when the queen opened the new Millennium Bridge. Thousands of people flocked to take part in the spectacle, but no sooner had they stepped on to the bridge than it started shaking violently, forcing them to hold on to the handrails. The bridge was immediately closed again and remained so for 18 months.
The speaker at Jackson Hole, Hyun Song Shin, a professor of economics at Princeton University, used that embarrassing wobble as a metaphor for potential instability in financial markets. He was discussing a paper entitled “Has Financial Development Made the World Riskier?”, and he equated the pedestrians on the bridge to people in financial markets, and the bridge itself to movements in prices.
As Mr Shin observed, soldiers are trained to break step before crossing bridges. The footfall of thousands of individuals should be entirely random in the first place. “Here is the catch,” he said. “When the bridge moves, everyone adjusts his or her stance at the same time. This synchronised movement pushes the bridge that the people are standing on, and makes it move even more. This, in turn, makes the people adjust their stance more drastically, and so on. In other words, the wobble of the bridge feeds on itself.”
Fears of a self-reinforcing downward spiral in prices have been around for as long as financial markets have, but regulators and central bankers are becoming more vocal about the danger. The proliferation of new instruments, such as credit derivatives, and new market participants, such as hedge funds, intermediated by a small number of large global investment banks, poses new questions about financial stability. The “professional pessimists”, as some bankers call regulators, concede that under benign economic conditions everything appears to be working remarkably well. But how bad will the wobble be when conditions get worse?
Maria Jeeves
It is clear that new forces are at work. The big investment banks' exposure to privately arranged credit derivatives is estimated to be nearly as large as to their more traditional forms of lending. Hedge funds early last year accounted for more than half of all credit-derivative transactions. Commercial banks have sold off loans and bought structured credit products instead.
These three factors have fed more liquidity into the capital markets, and credit spreads have fallen dramatically. The paradox, as Malcolm Knight, general manager of the BIS, put it in a speech in February to the Global Association of Risk Professionals, is that financial markets may be vulnerable to the same forces that triggered old-fashioned bank runs. And if there is a run, hedge funds, whose assets under management have tripled this decade to about $1.5 trillion, may drain liquidity rather than provide it.
Safety catches
The industry has tried to deal with these concerns. In 2005 some of the world's most senior bankers, led by Gerald Corrigan, a former head of the New York Fed now at Goldman Sachs, issued a comprehensive report that looked at financial stability from a private-sector perspective. This differentiated between “disturbances” (isolated problems) and “shocks” (systemic ones). It identified three “red zone” shocks: the emerging-markets debt crisis of the mid-1980s; the stockmarket crash of 1987; and the Asian and Russian crises culminating in the near-collapse of Long-Term Capital Management, a hugely over-leveraged hedge fund, in 1998.
To help prevent further shocks, the group produced guidelines on which regulators are still chewing today. The most important of these include identifying credit risk, liquidity risk, crowded trades, embedded leverage in complex instruments, the shortcomings of financial modelling techniques and unexpected “tail risks”.
The most basic rule, say regulators, is “know your counterparty”. Banks are being discouraged from doing business with hedge funds that reveal little about their exposures or risk-management systems, and to strengthen collateral requirements where there are doubts. This is especially important when hedge funds have exposure to many banks, so lenders are not sure where they stand in the repayment queue.
But even with the best checks and balances in place, collateral can be a double-edged sword. As Mr Geithner of the New York Fed puts it, in periods of stress, as firms move to hedge against future losses and to raise money for margin calls, “the brake becomes the accelerator.” It can exacerbate the wobble.
Banks should not be complacent about their financial models, either. Prices of new instruments, by definition, have short histories, which makes it hard to predict how they will react in a crisis. At the height of the troubles with subprime mortgages earlier this year the price of indices based on tranches of subprime loans went into free fall. Regulators are now asking whether that was modelled for.
Sorting out a crisis once it has occurred will also present new headaches. With risk held by so many new market participants, it is not clear how easily they could be corralled to deal with a large default. And even where banks know there are shortcomings in the market infrastructure for new assets, they may not do anything about it individually for fear of losing business to rivals. For example, the industry used to take a long time to settle CDS trades. It was only after regulators in New York and London twisted its arm that, collectively, it agreed to mend its ways.
Maria Jeeves
Regulators say the investment banks have got much better at dealing with the risks, though there is room for further improvement. Annette Nazareth, a commissioner at America's Securities and Exchange Commission (which supervises investment banks), says there are “rumblings” that non-American banks trying to build up their prime-brokerage arms, through which they supply hedge funds with credit and other facilities, may be offering lenient credit terms. John Dugan, head of the Office of the Comptroller of the Currency, which oversees the largest commercial banks in America, says there has been some slippage in the collateral demanded from hedge funds. But, he notes, “our banks owe them more money than they owe us. This is a function of financial-market conditions and credit terms, and because both of these variables can change we have to remain vigilant.”
Many hope that when the Basel 2 capital accord is introduced in Europe and (eventually) in America, it will further strengthen risk-management systems in respect of new instruments and trading partners. The accord updates the one-size-fits-all framework of Basel 1, dating back to 1988, when capital requirements were set on parameters now considered unsatisfactory. For example, banks had to post the same amount of capital against lending to IBM as to an internet start-up. Under Basel 2, capital requirements will depend on the rating of a borrower and the type of loan. Sometimes banks will also be able to use their own assessments of capital needs.
Some aspects of the new regime require extensive discussion between banks and their supervisors on how to assess complex credit exposures. Capital also has to be set aside against operating losses, which for large investment banks exposed to complex transactions may be onerous.
Not everybody agrees that Basel 2 has all the answers. Sheila Bair, chairman of America's Federal Deposit Insurance Corporation, which provides a safety net for bank depositors, worries that the models it uses to assess risk-weighted capital have been designed in a period of unprecedented prosperity for the banks. That may lead to insufficient levels of capital when the credit cycle deteriorates. “I'd rather maintain a constant cushion of capital in good times and bad,” she says.
The accord does maintain minimum capital requirements and allows plenty of scope for fine-tuning. But, as Ms Bair points out, with banks potentially holding much less capital during business expansions under the new rules, raising the capital they will need to withstand a recession could be painful and risk a credit crunch.
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