The gods strike back - vixek.com

A special report on financial risk l February 13th 2010

The gods strike back

RISkindd 1 2210 130802

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The Economist February 13th 2010 A special report on nancial risk 1

Financial risk got ahead of the worldrsquos ability to manage it Matthew Valencia asks if it can be tamed again

ed by larger balance sheets and greater leshyverage (borrowing) risk was being cappedby a technological shift

There was something selfshyservingabout this The more that risk could be calishybrated the greater the opportunity to turndebt into securities that could be sold orheld in trading books with lower capitalcharges than regular loans Regulators acshycepted this arguing that the great modershyation had subdued macroeconomic danshygers and that securitisation had choppedup individual rmsrsquo risks into manageablelumps This faith in the new technologyshydriven order was reected in the Basel 2bankshycapital rules which relied heavily onthe banksrsquo internal models

There were bumps along the way suchas the nearshycollapse of LongshyTerm CapitalManagement (LTCM) a hedge fund andthe dotcom bust but each time markets reshycovered relatively quickly Banks grewcocky But that sense of security was deshystroyed by the meltdown of 2007shy09which as much as anything was a crisis ofmodern metricsshybased risk managementThe idea that markets can be left to policethemselves turned out to be the worldrsquosmost expensive mistake requiring $15 trilshylion in capital injections and other formsof support It has cost a lot to learn how litshytle we really knew says a senior centralbanker Another lesson was that managingrisk is as much about judgment as aboutnumbers Trying ever harder to capture


THE revolutionary idea that denesthe boundary between modern

times and the past is the mastery of riskthe notion that the future is more than awhim of the gods and that men and womshyen are not passive before nature So wrotePeter Bernstein in his seminal history ofrisk Against the Gods published in 1996And so it seemed to all but a few Cassanshydras for much of the decade that followedFinance enjoyed a golden period with lowinterest rates low volatility and high reshyturns Risk seemed to have been reducedto a permanently lower level

This purported new paradigm hingedin large part on three closely linked develshyopments the huge growth of derivativesthe decomposition and distribution ofcredit risk through securitisation and theformidable combination of mathematicsand computing power in risk managementthat had its roots in academic work of themidshy20th century It blossomed in the1990s at rms such as Bankers Trust andJPMorgan which developed valueshyatshyrisk (VAR) a way for banks to calculatehow much they could expect to lose whenthings got really rough

Suddenly it seemed possible for any shynancial risk to be measured to ve decimalplaces and for expected returns to be adshyjusted accordingly Banks hired hordes ofPhDshywielding quants to neshytune evermore complex risk models The belief tookhold that even as prots were being boostshy

An audio interview with the author is at

Economistcomaudiovideo

A list of sources is at

Economistcomspecialreports

Numbershycrunchers crunchedThe uses and abuses of mathematical models Page 3

Cinderellarsquos momentRisk managers to the fore Page 6

A matter of principleWhy some banks did much better than others Page 7

When the river runs dryThe perils of a sudden evaporation of liquidityPage 8

Fingers in the dikeWhat regulators should do now Page 10

Blocking out the sirensrsquo songMoneymen need saving from themselvesPage 13

Also in this section

AcknowledgmentsIn addition to those mentioned in the text the authorwould like to thank the following for their help inpreparing this report Madelyn Antoncic Scott BaretRichard Bookstaber Kevin Buehler Jan BrockmeijerStephen Cecchetti Mark Chauvin John Cochrane JoseacuteCorral Wilson Ervin Dan Fields Chris Finger BennettGolub John Hogan Henry Hu Simon Johnson RobertKaplan Steven Kaplan Anil Kashyap James Lam BrianLeach Robert Le Blanc Mark Levonian Tim Long BlytheMasters Michael Mendelson Robert Merton Jorge MinaMary Frances Monroe Lubos Pastor Henry RistucciaBrian Robertson Daniel Sigrist Pietro Veronesi JimWiener Paul Wright and Luigi Zingales

1

2 A special report on nancial risk The Economist February 13th 2010

2

1

risk in mathematical formulae can becounterproductive if such a degree of acshycuracy is intrinsically unattainable

For now the hubris of spurious precishysion has given way to humility It turns outthat in nancial markets black swans orextreme events occur much more oftenthan the usual probability models suggestWorse nance is becoming more fragilethese days blowshyups are twice as frequentas they were before the rst world war acshycording to Barry Eichengreen of the Unishyversity of California at Berkeley and Mishychael Bordo of Rutgers University BenoitMandelbrot the father of fractal theoryand a pioneer in the study of marketswings argues that nance is prone to awild randomness not usually seen in nashyture In markets rare big changes can bemore signicant than the sum of manysmall changes he says If nancial marshykets followed the normal bellshyshaped disshytribution curve in which meltdowns arevery rare the stockmarket crash of 1987 theinterestshyrate turmoil of 1992 and the 2008crash would each be expected only once inthe lifetime of the universe

This is changing the way many nanshycial rms think about risk says Greg Casechief executive of Aon an insurance broshyker Before the crisis they were looking atthings like pandemics cybershysecurity andterrorism as possible causes of blackswans Now they are turning to risks fromwithin the system and how they can beshycome amplied in combination

Cheap as chips and just as bad for youIt would though be simplistic to blamethe crisis solely or even mainly on sloppyrisk managers or wildshyeyed quants Cheapmoney led to the wholesale underpricingof risk America ran negative real interestrates in 2002shy05 even though consumershyprice ination was quiescent Plenty ofeconomists disagree with the recent assershytion by Ben Bernanke chairman of theFederal Reserve that the crisis had more todo with lax regulation of mortgage proshyducts than loose monetary policy

Equally damaging were policies to proshymote home ownership in America usingFannie Mae and Freddie Mac the counshytryrsquos two mortgage giants They led the duoto binge on securities backed by shoddilyunderwritten loans

In the absence of strict limits higher leshyverage followed naturally from low intershyest rates The debt of Americarsquos nancialrms ballooned relative to the overalleconomy (see chart 1) At the peak of themadness the median large bank had borshy

rowings of 37 times its equity meaning itcould be wiped out by a loss of just 2shy3 ofits assets Borrowed money allowed invesshytors to fake alpha or aboveshymarket reshyturns says Benn Steil of the Council onForeign Relations

The agony was compounded by theproliferation of shortshyterm debt to supportilliquid longshyterm assets much of it issuedbeneath the regulatory radar in highly leshyveraged shadow banks such as strucshytured investment vehicles When marketsfroze sponsoring entities usually banksfelt morally obliged to absorb their lossesReputation risk was shown to have a veryreal nancial price says Doug Roeder ofthe Oce of the Comptroller of the Curshyrency an American regulator

Everywhere you looked moreover inshycentives were misaligned Firms deemedtoo big to fail nestled under implicit guarshyantees Sensitivity to risk was dulled by theGreenspan put a belief that AmericarsquosFederal Reserve would ride to the rescuewith lower rates and liquidity support ifneeded Scrutiny of borrowers was deleshygated to rating agencies who were paid bythe debtshyissuers Some products were socomplex and the chains from borrower toendshyinvestor so long that thorough due dishyligence was impossible A proper undershystanding of a typical collateralised debt obshyligation (CDO) a structured bundle of debtsecurities would have required reading30000 pages of documentation

Fees for securitisers were paid largelyupfront increasing the temptation to origishynate og and forget The problems withbankersrsquo pay went much wider meaningthat it was much better to be an employeethan a shareholder (or eventually a taxshypayer picking up the bailshyout tab) The roleof top executivesrsquo pay has been overshyblown Top brass at Lehman Brothers andAmerican International Group (AIG) sufshy

fered massive losses when share pricestumbled A recent study found that bankswhere chief executives had more of theirwealth tied up in the rm performedworse not better than those with apparshyently less strong incentives One explanashytion is that they took risks they thoughtwere in shareholdersrsquo best interests butwere proved wrong Motives lower downthe chain were more suspect It was tooeasy for traders to cash in on shortshytermgains and skirt responsibility for any timeshybombs they had set ticking

Asymmetries wreaked havoc in thevast overshytheshycounter derivatives markettoo where even large dealing rms lackedthe information to determine the conseshyquences of others failing Losses on conshytracts linked to Lehman turned out to bemodest but nobody knew that when itcollapsed in September 2008 causing panshyic Likewise it was hard to gauge the exposhysures to tail risks built up by sellers ofswaps on CDOs such as AIG and bond inshysurers These were essentially put optionswith limited upside and a low but realprobability of catastrophic losses

Another factor in the buildshyup of excesshysive risk was what Andy Haldane head ofnancial stability at the Bank of Englandhas described as disaster myopia Likedrivers who slow down after seeing acrash but soon speed up again investorsexercise greater caution after a disaster butthese days it takes less than a decade tomake them reckless again Not having seena debtshymarket crash since 1998 investorspiled into ever riskier securities in 2003shy07to maintain yield at a time of low interestrates Riskshymanagement models reinshyforced this myopia by relying too heavilyon recent data samples with a narrow disshytribution of outcomes especially in subshyprime mortgages

A further hazard was summed up bythe assertion in 2007 by Chuck Prince thenCitigrouprsquos boss that as long as the musicis playing yoursquove got to get up and dancePerformance is usually judged relative torivals or to an industry benchmark enshycouraging banks to mimic each otherrsquosriskshytaking even if in the long run it beneshyts no one In mortgages bad lendersdrove out good ones keeping up with agshygressive competitors for fear of losing marshyket share A few held back but it was noteasy when JPMorgan sacriced ve pershycentage points of return on equity in theshort run it was lambasted by shareshyholders who wanted it to catch up withzippiershylooking rivals

An overarching worry is that the comshy

1Borrowed time

Source Federal Reserve

US financial-industry debt as of GDP

0

20

40

60

80

100

120

1978 1988 1998 2008


2

1

plexity of todayrsquos global nancial networkmakes occasional catastrophic failure inshyevitable For example the market for creditderivatives galloped far ahead of its supshyporting infrastructure Only now are serishyous moves being made to push these conshytracts through central clearingshyhouseswhich ensure that trades are properly colshylateralised and guarantee their completionif one party defaults

Network overloadThe push to allocate capital ever more eshyciently over the past 20 years created whatTill Guldimann the father of VAR andviceshychairman of SunGard a technologyrm calls capitalism on steroids Banksgot to depend on the modelling of prices inesoteric markets to gauge risks and becameadept at gaming the rules As a result capishytal was not being spread around as eshyciently as everyone believed

Big banks had also grown increasinglyinterdependent through the boom in deshyrivatives computershydriven equities tradshying and so on Another bond was crossshyownership at the start of the crisis nanshycial rms held big dollops of each otherrsquoscommon and hybrid equity Such tightcoupling of components increases thedanger of nonshylinear outcomes where asmall change has a big impact Financialmarkets are not only vulnerable to blackswans but have become the perfect breedshying ground for them says Mr GuldimannIn such a network a rmrsquos troubles canhave an exaggerated eect on the pershyceived riskiness of its trading partnersWhen Lehmanrsquos creditshydefault spreads

rose to distressed levels AIGrsquos jumped bytwice what would have been expected onits own according to the InternationalMonetary Fund

Mr Haldane has suggested that theseknifeshyedge dynamics were caused not onlyby complexity but alsoparadoxicallybyhomogeneity Banks insurers hedge fundsand others bought smorgasbords of debtsecurities to try to reduce risk through dishyversication but the ingredients were simshyilar leveraged loans American mortgagesand the like From the individual rmrsquosperspective this looked sensible But forthe system as a whole it put everyonersquoseggs in the same few baskets as reected intheir returns (see chart 2)

Eorts are now under way to deal withthese risks The Financial Stability Boardan international group of regulators is tryshying to coshyordinate global reforms in areas

such as capital liquidity and mechanismsfor rescuing or dismantling troubledbanks Its biggest challenge will be to makethe system more resilient to the failure ofgiants There are deep divisions over howto set about this with some favouringtougher capital requirements othersbreakshyups still othersincluding Amerishycaa combination of remedies

In January President Barack Obamashocked big banks by proposing a tax ontheir liabilities and a plan to cap their sizeban proprietary trading and limit theirinvolvement in hedge funds and privateequity The proposals still need congressioshynal approval They were seen as energisingthe debate about how to tackle dangerousshyly large rms though the reaction in Eushyrope was mixed

Regulators are also inching towards amore systemic approach to risk The oldsupervisory framework assumed that ifthe 100 largest banks were individuallysafe then the system was too But the crisisshowed that even wellshymanaged rmsacting prudently in a downturn can unshydermine the strength of all

The banks themselves will have to nda middle ground in risk managementsomewhere between gut feeling and numshyber fetishism Much of the progress madein quantitative nance was real enoughbut a rm that does not understand theaws in its models is destined for troubleThis special report will argue that ruleswill have to be both tightened and betterenforced to avoid future crisesbut that allthe reforms in the world will never guaranshytee total safety 7

2In lockstep

Source ldquoBanking on the Staterdquo by Andrew Haldane andPiergiorgio Alessandri Bank for International Settlements

Weighted average cumulative total returns

2000 01 02 03 04 05 06 07 08 0950

0

50

100

150

200

+

ndash

Large complexfinancialinstitutions

Banks

Insurers

Hedge funds

IT PUT noses out of joint but it changedmarkets for good In the midshy1970s a few

progressive occupants of Chicagorsquos opshytions pits started trading with the aid ofsheets of theoretical prices derived from amodel and sold by an economist calledFisher Black Rivals used to relying on theirwits were unimpressed One modelshybased trader complained of having his pashypers snatched away and being told totrade like a man But the strings of numshybers caught on and soon derivatives exshychanges hailed the BlackshyScholes modelwhich used share and bond prices to calcushy

late the value of derivatives for helping tolegitimise a market that had been deridedas a gambling den

Thanks to BlackshyScholes options pricshying no longer had to rely on educatedguesses Derivatives trading got a hugeboost and quants poured into the industryBy 2005 they accounted for 5 of all shynance jobs against 12 in 1980 says Thomshyas Philippon of New York Universityandprobably a much higher proportion of payBy 2007 nance was attracting a quarter ofall graduates from the California Instituteof Technology

These eggheads are now in the dockalong with their probabilistic models InAmerica a congressional panel is investishygating the modelsrsquo role in the crash Wireda publication that can hardly be accused oftechnophobia has described defaultshyprobshyability models as the formula that killedWall Street Longshystanding critics of riskshymodelling such as Nassim Nicholas Talebauthor of The Black Swan and Paul Wilshymott a mathematician turned nancialeducator are now hailed as seers Modelsincreased risk exposure instead of limitshying it says Mr Taleb They can be worse

Numbershycrunchers crunched

The uses and abuses of mathematical models


2

1

than nothing the equivalent of a dangershyous operation on a patient who wouldstand a better chance if left untreated

Not all models were useless Those forinterest rates and foreign exchange pershyformed roughly as they were meant toHowever in debt markets they failed abshyjectly to take account of lowshyprobabilitybut highshyimpact events such as the gutshywrenching fall in house prices

The models went particularly awrywhen clusters of mortgageshybacked securishyties were further packaged into collateralshyised debt obligations (CDOs) In traditionalproducts such as corporate debt ratingagencies employ basic credit analysis andjudgment CDOs were so complex thatthey had to be assessed using specially deshysigned models which had various faultsEach CDO is a unique mix of assets but theassumptions about future defaults andmortgage rates were not closely tailored tothat mix nor did they factor in the tendenshycy of assets to move together in a crisis

The problem was exacerbated by thecredit ratersrsquo incentive to accommodatethe issuers who paid them Most nancialrms happily relied on the models eventhough the expected return on AAAshyratedtranches was suspiciously high for suchapparently safe securities At some banksrisk managers who questioned the ratingagenciesrsquo models were given short shriftMoodyrsquos and Standard amp Poorrsquos were asshysumed to know best For people paid acshycording to that yearrsquos revenue this was unshyderstandable A lifetime of wealth wasonly one model away sneers an Amerishycan regulator

Moreover heavy use of models mayhave changed the markets they were supshyposed to map thus undermining the validshyity of their own predictions says DonaldMacKenzie an economic sociologist at theUniversity of Edinburgh This feedbackprocess is known as countershyperformativshyity and had been noted before for instancewith BlackshyScholes With CDOs the modshyelsrsquo popularity boosted demand whichlowered the quality of the assetshybacked seshycurities that formed the poolsrsquo raw materishyal and widened the gap between expectedand actual defaults (see chart 3)

A related problem was the similarity ofrisk models Banks thought they were divshyersied only to nd that many others heldcomparable positions based on similarmodels that had been built to comply withthe Basel 2 standards and everyone wastrying to unwind the same positions at thesame time The breakdown of the modelswhich had been the only basis for pricing

the more exotic types of security turnedrisk into fullshyblown uncertainty (and thusextreme volatility)

For some the crisis has shattered faithin the precision of models and their inputsThey failed Keynesrsquos test that it is better tobe roughly right than exactly wrong Onenumber coming under renewed scrutiny isvalueshyatshyrisk (VAR) used by banks tomeasure the risk of loss in a portfolio of shynancial assets and by regulators to calcushylate banksrsquo capital buers Invented by eggshyheads at JPMorgan in the late 1980s VAR

has grown steadily in popularity It is thesubject of more than 200 books Whatmakes it so appealing is that its complexformulae distil the range of potential dailyprots or losses into a single dollar gure

Only so far with VARFrustratingly banks introduce their ownquirks into VAR calculations making comshyparison dicult For example MorganStanleyrsquos VAR for the rst quarter of 2009by its own reckoning was $115m but usingGoldman Sachsrsquos method it would havebeen $158m The bigger problem though isthat VAR works only for liquid securitiesover short periods in normal marketsand it does not cover catastrophic outshycomes If you have $30m of twoshyweek 1VAR for instance that means there is a 99chance that you will not lose more thanthat amount over the next fortnight Butthere may be a huge and unacknowledgedthreat lurking in that 1 tail

So chief executives would be foolish torely solely or even primarily on VAR tomanage risk Yet many managers andboards continue to pay close attention to itwithout fully understanding the caveats

the equivalent of someone who cannotswim feeling condent of crossing a riverhaving been told that it is on average fourfeet deep says Jaidev Iyer of the Global Asshysociation of Risk Professionals

Regulators are encouraging banks tolook beyond VAR One way is to use CoshyVAR (Conditional VAR) a measure thataims to capture spillover eects in troushybled markets such as losses due to the disshytress of others This greatly increases somebanksrsquo value at risk Banks are developingtheir own enhancements Morgan Stanleyfor instance uses stress VAR which facshytors in very tight liquidity constraints

Like its peers Morgan Stanley is also reshyviewing its stress testing which is used toconsider extreme situations The worst sceshynario envisaged by the rm turned out tobe less than half as bad as what actuallyhappened in the markets JPMorganChasersquos debtshymarket stress tests foresaw a40 increase in corporate spreads buthighshyyield spreads in 2007shy09 increasedmany times over Others fell similarlyshort Most banksrsquo tests were based on hisshytorical crises but this assumes that the fushyture will be similar to the past A repeat ofany specic market event such as 1987 or1998 is unlikely to be the way that a futurecrisis will unfold says Ken deRegt Morshygan Stanleyrsquos chief risk ocer

Faced with either random (and thereshyfore not very believable) scenarios or simshyplistic models that neglect fatshytail risksmany nd themselves in a noshymanrsquosshyland between the two says Andrew Freeshyman of Deloitte (and formerly a journalistat The Economist) Nevertheless he viewsscenario planning as a useful tool A rmthat had thought about say the mutationof default risk into liquidity risk wouldhave had a head start over its competitorsin 2008 even if it had not predicted preshycisely how this would happen

To some stress testing will always seemmaddeningly fuzzy It has so far been seenas the acupunctureshyandshyherbalshyremediescorner of risk management though pershyceptions are changing says Riccardo Rebshyonato of Royal Bank of Scotland who iswriting a book on the subject It is notmeant to be a predictive tool but a meansof considering possible outcomes to allowrms to react more nimbly to unexpecteddevelopments he argues Hedge funds arebetter at this than banks Some hadthought about the possibility of a largebrokershydealer going bust At least oneAQR had asked its lawyers to grill thefundrsquos prime brokers about the fate of itsassets in the event of their demise

3Never mind the quality

Source Donald MacKenzie University of Edinburgh

CDOs of subprime-mortgage-backed securitiesIssued in 2005-07

Estimated Actual 3-year default default rate rate

AAA 0001 010

AA+ 001 168

AA 004 816

AA- 005 1203

A+ 006 2096

A 009 2921

A- 012 3665

BBB+ 034 4873

BBB 049 5610

BBB- 088 6667


2 Some of the blame lies with bank regushylators who were just as blind to the danshygers ahead as the rms they oversawSometimes even more so after the rescueof Bear Stearns in March 2008 but beforeLehmanrsquos collapse Morgan Stanley was reshyportedly told by supervisors at the FederalReserve that its doomsday scenario wastoo bearish

The regulators have since becometougher In America for instance bankshave been told to run stress tests with sceshynarios that include a huge leap in interestrates A supervisorsrsquo report last Octoberngered some banks for windowshydressshying their tests Ocials are now asking forreverse stress testing in which a rmimagines it has failed and works backshywards to determine which vulnerabilitiescaused the hypothetical collapse Britainhas made this mandatory Bankers are dishyvided over its usefulness

Slicing the EmmentalThese changes point towards greater use ofjudgment and less reliance on numbers infuture But it would be unfair to tar all modshyels with the same brush The CDO ascowas an egregious and relatively rare caseof an instrument getting way ahead of theability to map it mathematically Modelswere an accessory to the crime not theperpetrator says Michael Mauboussin ofLegg Mason a money manager

As for VAR it may be hopeless at signalshyling rare severe losses but the process bywhich it is produced adds enormously tothe understanding of everyday risk whichcan be just as deadly as tail risk says AaronBrown a risk manager at AQR Craig Broshyderick chief risk ocer at Goldman Sachssees it as one of several measures whichalthough of limited use individually toshygether can provide a helpful picture Like aslice of Swiss cheese each number hasholes but put several of them together andyou get something solid

Modelling is not going away indeednumbershycrunchers who are devising newways to protect investors from outlying fatshytail risks are gaining inuence Pimco forinstance oers fatshytail hedging proshygrammes for mutualshyfund clients usingcocktails of options and other instrushyments These are built on specic risk facshytors rather than on the broader and inshycreasingly uid division of assets betweenequities currencies commodities and soon The relationships between asset classshyes have become less stable says Moshyhamed ElshyErian Pimcorsquos chief executiveAssetshyclass diversication remains desirshy

able but is not sucientNot surprisingly more investors are

now willing to give up some upside for thepromise of protection against catastrophiclosses Pimcorsquos clients are paying up to 1of the value of managed assets for thehedgingeven though as the recent crisisshowed there is a risk that insurers willnot be able to pay out Lisa Goldberg ofMSCI Barra reports keen interest in the anshyalytics rmrsquos extremeshyrisk model fromhedge funds investment banks and penshysion plans

In some areas the need may be for morecomputing power not less Financial rmsalready spend more than any other indusshytry on information technology (IT) some$500 billion in 2009 according to Gartnera consultancy Yet the quality of informashytion ltering through to senior managers isoften inadequate

A report by bank supervisors last Octoshyber pointed to poor risk aggregationmany large banks simply do not have thesystems to present an upshytoshydate picture oftheir rmshywide links to borrowers andtrading partners Twoshythirds of the bankssurveyed said they were only partiallyable (in other words unable) to aggregatetheir credit risks The Federal Reserve leadshying stress tests on American banks lastspring was shocked to nd that some ofthem needed days to calculate their exposhy

sure to derivatives counterpartiesTo be fair totting up counterparty risk is

not easy For each trading partner the calshyculations can involve many dierent typesof contract and hundreds of legal entitiesBut banks will have to learn fast undernew international proposals they will forthe rst time face capital charges on thecreditworthiness of swap counterparties

The banks with the most dysfunctionalsystems are generally those such as Citishygroup that have been through multiplemarriages and ended up with dozens oflegacy systems that cannot easily comshymunicate with each other That may exshyplain why some Citi units continued topile into subprime mortgages even as othshyers pulled back

In the depths of the crisis some bankswere unaware that dierent business unitswere marking the same assets at dierentprices The industry is working to sort thisout Banks are coming under pressure toappoint chief data ocers who can policethe integrity of the numbers separate fromchief information ocers who concenshytrate on system design and output

Some worry that the good work will becast aside As markets recover the biggesttemptation will be to abandon or scaleback IT projects allowing product develshyopment to get ahead of the supportingtechnology infrastructure just as it did inthe last boom

The way forward is not to reject highshytech nance but to be honest about its limishytations says Emanuel Derman a professorat New Yorkrsquos Columbia University and aformer quant at Goldman Sachs Modelsshould be seen as metaphors that can enshylighten but do not describe the world pershyfectly Messrs Derman and Wilmott havedrawn up a modellerrsquos Hippocratic oathwhich pledges among other things I willremember that I didnrsquot make the worldand it doesnrsquot satisfy my equations and Iwill never sacrice reality for elegancewithout explaining why I have done soOften the problem is not complex nancebut the people who practise it says Mr Wilshymott Because of their love of puzzlesquants lean towards technically brilliantrather than sensible solutions and tend toovershyengineer You may need a plumberbut you get a professor of uid dynamics

One way to deal with that problem is toselfshyinsure JPMorgan Chase holds $3 bilshylion of modelshyuncertainty reserves tocover mishaps caused by quants who havebeen too clever by half If you can makeprovisions for bad loans why not badmaths too 7


1

IN A speech delivered to a bankingshyindusshytry conference in Geneva in December

2006 Madelyn Antoncic issued a warningand then oered some reassurance Withvolatility low corporate credit spreadsgrowing ever tighter and markets all but igshynoring bad news there was she said aseemingly overwhelming sense of comshyplacency Nevertheless she insisted thatthe rm she served as chief risk ocerLehman Brothers was well placed to rideout any turbulence thanks to a keenawareness of emerging threats and a rockshysolid analytical framework

Behind the scenes all was not well MsAntoncic a respected risk manager withan economics PhD had expressed uneaseat the rmrsquos heavy exposure to commershycial property and was being sidelined bitby bit by the rmrsquos autocratic boss DickFuld Less than two months after herspeech she was pushed aside

Lehmanrsquos story ended particularly badshyly but this sort of lapse in risk governancewas alarmingly common during theboom So much for the notion generallyaccepted back then that the quality ofbanksrsquo risk regimes had like car composhynents converged around a high standardThe variance turned out to be shockingsays Jamie Dimon chief executive ofJPMorgan Chase

The banks that fared better includinghis own relied largely on giving their riskshymanaging roundheads equal status withthe riskshytaking cavaliers That was not easyIn happy times when risk seems low powshyer shifts from risk managers to tradersSalesshydriven cultures are the natural orderof things on Wall Street and in the City Disshycouraging transactions was frowned uponespecially at rms trying to push their wayup capitalshymarkets league tables Riskmanagers who said no put themselves ona collision course with the business headand often the chief executive too

At some large banks that subsequentlysuered big losses such as HBOS and Royshyal Bank of Scotland (RBS) credit commitshytees which vetted requests for big loanscould be formed on an ad hoc basis from apool of eligible members If the commitshyteersquos chairman typically a businessshylinehead encountered resistance from a risk

manager or other sceptic he could adjournthe meeting then reconstitute the commitshytee a week or two later with a more pliablemembership that would approve the loan

Another common trick was for a busishyness line to keep quiet about a proposal onwhich it had been working for weeks untila couple of hours before the meeting to apshyprove it so the risk team had no time tolodge convincing objections Exasperatedroundheads would occasionally resort topleading with regulators for help In theyears before the crash the Basel Commitshytee of bank supervisors reportedly reshyceived several requests from risk managersto scrutinise excessive riskshytaking at theirinstitutions that they felt powerless to stop

Many banksrsquo failings exposed the trishyumph of form over substance In recentyears it had become popular to appoint achief risk ocer to signal that the issue wasreceiving attention But according to LeoGrepin of McKinsey it was sometimes acase of management telling him lsquoyou tickthe boxes on risk and wersquoll worry aboutgenerating revenuersquo

Since 2007 banks have been scramshy

bling to convince markets and regulatorsthat they will continue to take risk seriousshyly once memories of the crisis fade Someare involving risk ocers in talks aboutnew products and strategic moves AtHSBC for instance they have had a biggerrole in vetting acquisitions since the bankrsquosAmerican retailshybanking subsidiarybought in 2003 suered heavy subprimeshymortgage losses Everyone should nowsee that the risk team needs to be just as inshyvolved on the returns side as on the riskside says Maureen Miskovic chief risk ofshycer at State Street an American bank

Glamming upMs Miskovic is one of an emerging breedof more powerful risk ocers They areseen as being on a par with the chief nanshycial ocer get a say in decisions on payand have the ear of the board whoseagreement is increasingly needed to reshymove them Some report directly to aboard committee as well asor occasionalshyly instead ofto the chief executive

For many the biggest task is to dismanshytle cumbersome silos says Ken Chalk of

Cinderellarsquos moment

Risk managers to the fore


2

1

Americarsquos Risk Management AssociationRisks were often stued into convenientbut misleading pigeonholes Banks wereslow to rene their approach even asgrowing market complexity led some ofthe risks to become interchangeable

Take the growth of traded credit proshyducts such as assetshybacked securities andCDOs made up of them Creditshyrisk deshypartments thought of them as market riskbecause they sat in the trading book Marshyketshyrisk teams saw them as credit instrushyments since the underlying assets wereloans This buckshypassing proved particushylarly costly at UBS which lost SFr36 billion($34 billion) on CDOs Many banks arenow combining their marketshy and creditshyrisk groups as HSBC did last year

For all the newshyfound authority of riskmanagers it can still be hard to attract talshyent to their ranks The job is said to havethe risk prole of a short option positionwith unlimited downside and limited upshysidesomething every good risk managershould avoid Moreover it lacks glamourPersuading a trader to move to risk can belike asking a trapeze artist to retrain as anaccountant says Barrie Wilkinson of Olishyver Wyman a consultancy

A question of cultureBesides there is more to establishing a solshyid risk culture than empowering risk oshycers Culture is a slippery concept but itmatters Whatever causes the next crisisit will be dierent so you need somethingthat can deal with the unexpected Thatrsquosculture says Colm Kelleher of MorganStanley One necessary ingredient is a trashydition of asking and repeating questionsuntil a clear answer emerges suggestsClayton Rose a banker who now teachesat Harvard Business School

The tone is set at the top for better orworse At the bestshyrun banks senior guresspend as much time fretting over risks asthey do salivating at opportunities (seebox) By contrast Lehmanrsquos Mr Fuld talkedof protecting mother but was drawn tothe glister of leveraged deals Stan OrsquoNealwho presided over giant losses at MerrillLynch was more empireshybuilder than riskmanager But imperial bosses and soundrisk cultures sometimes go together as atJPMorgan and Banco Santander

A softshytouch boss can be more dangershyous than a domineering one Under ChuckPrince who famously learned only in Sepshytember 2007 that Citigroup was sitting on$43 billion of toxic assets the lunatics wereable to take over the asylum Astonishingshyly the head of risk reported not to Mr

Prince or the board but to a newly hired exshyecutive with a background in corporateshygoshyvernance law not cuttingshyedge nance

Another lesson is that boards mattertoo Directorsrsquo lack of engagement or exshypertise played a big part in some of theworst slipshyups including Citirsquos The soshyciology of big banksrsquo boards also hadsomething to do with it says Ingo Walterof New Yorkrsquos Stern School of Business asthe members bonded dissidents felt presshysure to toe the line

Too few boards dened the parametersof risk oversight In a survey last year Deshy

loitte found that only seven of 30 largebanks had done so in any detail Everyoneagrees that boards have a critical role toplay in determining risk appetite but a reshycent report by a group of global regulatorsfound that many were reluctant to do this

Boards could also make a better job ofpolicing how (or even whether) banks adshyjust for risk in allocating capital internallyBefore the crisis some boards barelythought about this naively assuming thatprocedures for it were well honed A forshymer Lehman board member professeshimself astonished in retrospect at how

JPMORGAN CHASE managed to avoidbig losses largely thanks to the tone setby its boss Jamie Dimon A voracious

reader of internal reports he understandsnancial arcana and subjects sta to deshytailed questioning PowerPoint presentashytions are discouraged informal discusshysions of what is wrong or could gowrong encouraged These soft princishyples are supplemented by a hardshyheadedapproach to the allocation of capitalThough the bank suered painful lossesin leveraged loans it was not tripped upby CDOs or structured investment vehishycles (SIVs) even though it had been inshystrumental in developing both productsNor was it heavily exposed to AIG an inshysurance giant that got into trouble

This was not because it saw disastercoming says Bill Winters former coshyheadof the rmrsquos investment bank but beshycause it stuck by two basic principlesdonrsquot hold too much of anything andonly keep what you are sure will generatea decent riskshyadjusted return The bankjettisoned an SIV and $60 billion of CDOshyrelated risks because it saw them as toodicey at a time when others were stillkeen to snap them up It also closed 60credit lines for other SIVs and corporateclients when it realised that these couldbe simultaneously drawn down if thebankrsquos credit rating were cut And it took aconservative view of riskshymitigationHedging through bond insurers whose shynances grew shaky as the crisis spreadwas calculated twice once assuming thehedge would hold and again assuming itwas worthless

Goldman Sachsrsquos risk managementstood out toounlike the publicshyrelationsskills it subsequently displayed Steeredby its chief nancial ocer David Viniarthe rmrsquos traders began reducing their exshyposure to mortgage securities months beshy

fore subprime defaults began to explodeMore willing than rivals to take risksGoldman is also quicker to hedge themIn late 2006 it spent up to $150moneshyeighth of that quarterrsquos operating prothedging exposure to AIG

The rm promotes senior traders torisk positions making clear that suchmoves are a potential stepping stone tothe top Traders are encouraged to nurturethe risk manager in them Gary Cohn thermrsquos president rose to the top largely beshycause of his skill at hedging tail risksCrucially Goldman generally does notre its risk managers after a crisis allowshying them to learn from the experience Yetdespite everything it still needed governshyment help to survive

By contrast UBSrsquos risk culture was awshyful Its investment bank was free to betwith subsidised funds since transfersfrom the private bank were deeply undershypriced It confused itself by presentingrisk in a net and forget format Tradingdesks would estimate the maximum posshysible loss on risky assets hedge it andthen record the net risk as minimal inadshyvertently concealing huge tail risks in thegross exposure And it moved its best tradshyers to a hedge fund leaving the Bshyteam tomanage the bankrsquos positions

Publicly humbled by a frank report onits failings the bank has made a raft ofchanges Risk controllers have been handshyed more power Oswald Gruumlbel the chiefexecutive has said that if his newish riskchief Philip Lofts rejects a transaction hewill never overrule him If the two disshyagree Mr Lofts must inform the boardwhich no longer delegates risk issues to atrio of longshytime UBS employees A newindependent risk committee is bristlingwith risk experts Whether all thisamounts to a new paradigm as MrLofts claims remains to be seen

Why some banks did much better than others

A matter of principle


2

1

some of the risks in the companyrsquos propershyty investments were brushed aside whenassessing expected returns The survivorsare still struggling to create the sort ofjoinedshyup approach to risk adjustmentthat is common at large hedge funds adshymits one Wall Street executive

Board gamesRobert Pozen head of MFS InvestmentManagement an American asset managerthinks bank boards would be more eecshytive with fewer but more committed memshybers Cutting their size to 4shy8 rather thanthe 10shy18 typical now would foster morepersonal responsibility More nancialshyservices expertise would help too Afterthe passage of the SarbanesshyOxley act in2002 banks hired more independent direcshytors many of whom lacked relevant expeshyrience The former spymaster on Citirsquosboard and the theatrical impresario onLehmanrsquos may have been happy to askquestions but were they the right ones

Under regulatory pressure banks suchas Citi and Bank of America have hiredmore directors with strong nancialshysershy

vices backgrounds Mr Pozen suggests asshysembling a small cadre of nancially ushyent supershydirectors who would meetmore oftensay two or three days a monthrather than an average of six days a year asnowand may serve on only one otherboard to ensure they take the job seriously

That sounds sensible but the case foranother suggested reformcreating indeshypendent risk committees at board levelisless clear At some banks risk issues arehandled perfectly well by the audit comshymittee or the full board Nor is there a clearlink between the frequency of riskshyrelatedmeetings and a bankrsquos performance AtSpainrsquos Santander the relevant committeemet 102 times in 2008 Those of otherbanks that emerged relatively unscathedsuch as JPMorgan and Credit Suisse conshyvened much less often

Moreover some of the most importantriskshyrelated decisions of the next few yearswill come from another corner the comshypensation committee It is not just investshyment bankers and top executives whosepay structures need to be rethought In thepast risk managersrsquo pay was commonly

determined or heavily inuenced by themanagers of the trading desks they overshysaw or their bonus linked to the desksrsquo pershyformance says Richard Apostolik whoheads the Global Association of Risk Proshyfessionals (GARP) Boards need to elimishynate such conicts of interest

Meanwhile risk teams are being beefedup Morgan Stanley for instance is increasshying its complement to 450 nearly doublethe number it had in 2008 The GARP sawa 70 increase in riskshymanager certicashytions last year Risk is the busiest area for shynancial recruiters says Tim Holt of Heishydrick amp Struggles a rm of headhuntersWhen boards are looking for a new chiefexecutive they increasingly want someshyone who has been head of risk as well aschief nancial ocer which used to be thestandard requirement reckons MikeWoodrow of Risk Talent Associates anshyother headhunting rm

The big question is whether this intershyest in controlling risk will zzle out as econshyomies recover Experience suggests that itwill Bankers say this time is dierentbutthey always do 7

STAMPEDING crowds can generate presshysures of up to 4500 Newtons per square

metre enough to bend steel barriers Rushshyes for the exit in nancial markets can bejust as damaging Investors crowd intotrades to get the highest riskshyadjusted reshyturn in the same way that everyone wantstickets for the best concert When someoneshouts re their ight creates an endogshyenous risk of being trampled by fallingprices margin calls and vanishing capishytala negative externality that adds tooverall risk says Lasse Heje Pedersen ofNew York University

This played out dramatically in 2008Liquidity instantly drained from securitiesrms as clients abandoned anything witha whi of risk In three days in March BearStearns saw its pool of cash and liquid asshysets shrink by nearly 90 After the colshylapse of Lehman Brothers Morgan Stanleyhad $43 billion of withdrawals in a singleday mostly from hedge funds

Bob McDowall of Tower Group a conshysultancy explains that liquidity poses themost emotional of risks Its loss can prove

just as fatal as insolvency Many of thoseclobbered in the crisisincluding BearStearns Northern Rock and AIGwerestruck down by a sudden lack of cash orfunding sources not because they ran outof capital

Yet liquidity risk has been neglectedOver the past decade international regulashytors have paid more attention to capitalBanks ran liquidity stress tests and drewup contingency funding plans but oftenhalfshyheartedly With markets awash withcash and hedge funds privateshyequity rmsand sovereignshywealth funds all keen to inshyvest in assets there seemed little prospectof a liquidity crisis Academics such as MrPedersen Lubos Pastor at Chicagorsquos BoothSchool of Business and others were doingsolid work on liquidity shocks but practishytioners barely noticed

What makes liquidity so important isits binary quality one moment it is there inabundance the next it is gone This time itsevaporation was particularly abrupt beshycause markets had become so joined upThe panic to get out of levered mortgage inshy

vestments spilled quickly into interbankloan markets commercial paper primebrokerage securities lending (lendingshares to shortshysellers) and so on

As condence ebbed mortgageshybackedsecurities could no longer be used so easilyas collateral in repurchase or repo agreeshyments in which nancial rms borrowshortshyterm from investors with excesscash such as moneyshymarket funds Thiswas a big problem because securities rmshad become heavily reliant on this markettripling their repo borrowing in the veyears to 2008 Bear Stearns had $98 billionon its books compared with $72 billion oflongshyterm debt

Even the most liquid markets were afshyfected In August 2007 a wave of selling ofblueshychip shares forced by the need to covshyer losses on debt securities elsewherecaused sudden drops of up to 30 forsome computershydriven strategies popularwith hedge funds

Liquidity comes in two closely connectshyed forms asset liquidity or the ability tosell holdings easily at a decent price and

When the river runs dry

The perils of a sudden evaporation of liquidity


2

1

funding liquidity or the capacity to raise shynance and roll over old debts when needshyed without facing punitive haircuts oncollateral posted to back this borrowing

The years of excess saw a vast increasein the funding of longshyterm assets withshortshyterm (and thus cheaper) debt Shortshyterm borrowing has a good side the threatof lenders refusing to roll over can be asource of discipline Once they expectlosses though a run becomes inevitablethey rush for repayment to beat the crowdsetting o a panic that might hurt themeven more Financial crises are almost alshyways and everywhere about shortshytermdebt says Douglas Diamond of the BoothSchool of Business

Banks are founded on this maturitymismatch of longshy and shortshyterm debtbut they have deposit insurance which reshyduces the likelihood of runs However thistime much of the mismatched borrowingtook place in the uninsured shadowbanking network of investment banksstructured oshybalanceshysheet vehicles andthe like It was supported by seemingly inshygenious structures Auctionshyrate securitiesfor instance allowed the funding of stodgymunicipal bonds to be rolled over monthshyly with the interest rate reset each time

The past two years are littered with stoshyries of schools and hospitals that came acropper after dramatically shortening thetenure of their funding assuming that thesavings in interest costs small as theywere far outweighed the risk of market seishyzure Securities rms became equally comshyplacent as they watched asset values riseboosting the value of their holdings as colshylateral for repos Commercial banks inshycreased their reliance on wholesale fundshying and on ckle nonshycore deposits suchas those bought from brokers

Regulation did nothing to discouragethis treating banks that funded themshyselves with deposits and those borrowingovernight in wholesale markets exactlythe same Markets viewed the second cateshygory as more ecient Northern Rockwhich funded its mortgages largely in capishytal markets had a higher stockmarket ratshying than HSBC which relied more on conshyventional deposits The prevailing viewwas that risk was inherent in the asset notthe manner in which it was nanced

At the same time nancial rms builtup a host of liquidity obligations not all ofwhich they fully understood Banks wereexpected to support oshybalanceshysheet entishyties if clients wanted out Citigroup had totake back $58 billion of shortshyterm securishyties from structured vehicles it sponsored

AIG did not allow for the risk that the inshysurer would have to post more collateralagainst creditshydefault swaps if these fell invalue or its rating was cut

Now that the horse has bolted nanshycial rms are rushing to close the door forinstance by adding to liquidity buers (seechart 4) British banksrsquo holdings of sterlingliquid assets are at their highest for a deshycade Capitalshymarkets rms are courtingdeposits and shunning ighty wholesalefunding Deposits equity and longshytermdebt now make up almost twoshythirds ofMorgan Stanleyrsquos balanceshysheet liabilitiescompared with around 40 at the end of2007 Spending on liquidityshymanagementsystems is rising sharply with specialistsalmost able to name their price says onebanker Collateral management has beshycome a buzzword

Message from BaselRegulators too are trying to make up forlost time In a rst attempt to put numberson a nebulous concept in December theBasel Committee of central banks and sushypervisors from 27 countries proposed a

global liquidity standard for internationalshyly active banks Tougher requirementswould reverse a decadesshylong decline inbanksrsquo liquidity cushions

The new regime which could be adoptshyed as early as 2012 has two components acoverage ratio designed to ensure thatbanks have a big enough pool of highshyquality liquid assets to weather an acutestress scenario lasting for one month (inshycluding such inconveniences as a sharpratings downgrade and a wave of collatershyal calls) and a net stable funding ratioaimed at promoting longershyterm nancingof assets and thus limiting maturity misshymatches This will require a certain level offunding to be for a year or more

It remains to be seen how closely nashytional authorities follow the script Someseem intent on going even further In Switshyzerland UBS and Credit Suisse face a trishypling of the amount of cash and equivashylents they need to hold to 45 of depositsBritain will require all domestic entities tohave enough liquidity to stand alone unshysupported by their parent or other parts ofthe group Also controversial is the composhysition of the proposed liquidity cushionsSome countries want to restrict these togovernment debt deposits with centralbanks and the like The Basel proposals alshylow highshygrade corporate bonds too

Banks have countershyattacked arguingthat trapping liquidity in subsidiarieswould reduce their room for manoeuvre ina crisis and that the buer rules are too reshystrictive some unsurprisingly have calledfor bank debt to be eligible Under the Britshyish rules up to 8 of banksrsquo assets could betied up in cash and gilts (British governshyment bonds) that they are forced to holdreckons Simon Hills of the British BankersAssociation which could have a huge imshypact on business models That some arshy

75

4Filling the pool

Sources Federal Reserve Goldman Sachs

US banksrsquo cash assets $trn

0

025

050

075

100

125

1973 80 85 90 95 2000 05 09


2

1

gue is precisely the point of reformMuch can be done to reduce market

stresses without waiting for these reformsIn repo lendinga decadesshyold practicecritical to the smooth functioning of marshyketsthe Federal Reserve may soontoughen collateral requirements and forceborrowers to draw up contingency plansin case of a sudden freeze Banks that clearrepos will be expected to monitor the sizeand quality of big borrowersrsquo positionsmore closely The banks could live withthat but they worry about proposals toforce secured shortshyterm creditors to takean automatic loss if a bank fails

Another concern is prime brokeragebanksrsquo nancing of trading by hedgefunds When the market unravelled hedgefunds were unable to retrieve collateralthat their brokers had rehypothecatedor used to fund transactions of their ownbillions of such unsegregated money isstill trapped in Lehmanrsquos estate reducingdozens of its former clients to the status ofunsecured general creditors Brokers sufshyfered in turn as clients pulled whateverfunds they could from those they viewedas vulnerable Temporary bans on shortshyselling made things even worse playinghavoc with some hedge fundsrsquo strategiesand leaving them scrambling for cash Regshyulators are moving towards imposing limshyits on rehypothecation

Early reform could also come to the seshycuritiesshylending market in which institushy

tional investors lend shares from theirportfolios to shortshysellers for a fee Somelendersincluding notoriously AIGfound they were unable to repay cash colshylateral posted by borrowers because theyhad invested it in instruments that hadturned illiquid such as assetshybacked comshymercial paper Some have doubled theshare of their portfolios that they knowthey can sell overnight to as much as 50

Regulators might consider asking themto go further Bond markets unlike stockshymarkets revolve around quotes from dealshyers This creates a structural impediment tothe free ow of liquidity in strained timesargues Ken Froot of Harvard BusinessSchool because when dealers pull in theirhorns they are unable to function properlyas marketshymakers He suggests opening upaccess to trade data and competition toquote prices Some senior gures at the Fedlike the idea as do money managersthough predictably dealers are resisting

Twin realitiesThe other brutal lesson of the crisis conshycerns the way liquidity can aect solvencyIn a world of markshytoshymarket accounting asmall price movement on a large illiquidportfolio can quickly turn into cripplingpaper losses that eat into capital Highlyrated but hardshytoshyshift debt instrumentscan nish you o before losses on the unshyderlying loans have even begun to hurtyour cash ows If markets expect re

sales potential buyers will hold o for abetter price exacerbating fairshyvalue losses

In future banks will be more alert tothese dangers We were looking at thebonds we held focusing on the credit funshydamentals We lost sight of the capital hitfrom illiquidity and marking to marketthat can seriously hurt you in the meanshytime says Koos Timmermans chief riskocer at ING a large Dutch banking andinsurance group We now know that youhave to treat the accounting reality as ecoshynomic reality

Another lesson is the opportunity valshyue of staying liquid in good times saysAaron Brown a risk manager with AQR ahedge fund In an ecient market dollarbills are not left lying around But in the disshylocated markets of late 2008 there werelots of bargains to be had for the small mishynority of investors with dry powder

For some though bigger liquidity proshyblems may yet lie ahead Some $51 trillionof bank debt rated by Moodyrsquos is due tomature by 2012 This will have to be reshynanced at higher rates The rates could alsobe pushed up by an erosion of sovereigncredit quality given implicit state guaranshytees of bank liabilities And at some pointbanks face a reduction of cutshyprice liquidshyity support from central banksoered inreturn for often dodgy collateralwhichhas buoyed their prot margins Mortgageborrowers on teaser rates are vulnerable topayment shock So too are their lenders 7

THE Delta Works are a series of damssluices and dikes built in the second

half of the 20th century to protect the lowshyestshylying parts of the Netherlands from thesea They are considered one of the sevenwonders of the modern world The taskfacing global regulators is to construct thenancial equivalent of this protective netshywork said JeanshyClaude Trichet presidentof the European Central Bank in an intershyview last November

This will require success in three conshynected areas reducing the threat to stabilshyity posed by rms deemed too big to failbecause their demise could destabilisemarkets ensuring that banks have biggercushions against losses and improvingsystemshywide or macroprudential regulashy

tion The work is under way but some bitsare hobbled by a surfeit of architects othshyers by a lack of clear plans sup1 Too big to fail Dealing with systemicalshyly important giants is the thorniest proshyblem Having once been cornered into achoice between costly rescues and gutshywrenching failures governments are deshytermined to avoid a repeat When marketsswooned they were obliged to stand beshyhind the big and the highly connected (aswell as their creditors) but found themshyselves illshyequipped Tim Geithner Amerishycarsquos treasury secretary said his administrashytion had nothing but duct tape and stringto deal with American InternationalGroup (AIG) when it tottered

The problem has only worsened durshy

ing the crisis After a quartershycentury ofevershyincreasing nancial concentrationthe giants of nance grew even more domshyinant in 2008shy09 thanks to a series of shotshygun takeovers of sickly rivals (see chart 5next page)

Regulators can tackle the issue either byaddressing the too big part (shrinking orerecting rewalls within giants) or the tofail bit (forcing them to hold more capitaland making it easier to wind down bustrms) Until recently the focus was on thesecond of these approaches But since Presshyident Obamarsquos unveiling of two initiativeslast montha tax on the liabilities of bigbanks and the Volcker rule which proshyposed limits on their size and activitiesmomentum has been shifting towards

Fingers in the dike

What regulators should do now

some combination of the twoThe Volcker plannamed after Paul

Volcker the former Federal Reserve chairshyman who proposed itcalls for depositshytakers to be banned from proprietary tradshying in capital markets and from investing inhedge funds and private equity The Finanshycial Stability Board (FSB) a Baselshybasedbody that is spearheading the internationshyal reform drive gave it a cautious welcomestressing that such a move would need tobe combined with tougher capital stanshydards and other measures to be eective

The Volcker rule does not seek a fullseparation of commercial banking and inshyvestment banking Nor is America pushingto shrink its behemoths dramatically formost the plan would merely limit furthergrowth of nonshydeposit liabilities (there isalready a 10 cap on national market sharein deposits) Ocials remain queasy aboutdictating size limits Citigrouprsquos woes sugshygest a rm can become too big to managebut JPMorgan Chase and HSBC are strikingcountershyexamples

For all the hue and cry about theVolcker plan America sees it as suppleshymenting earlier proposals not supplantingthem The most important of these is animproved resolution mechanism for failshying giants Standard bankruptcy arrangeshyments do not work well for nancial rmsin the time it takes for a typical case togrind through court the companyrsquos valuewill have evaporated

Americarsquos resolution plan would allow

regulators to seize and wind down basketshycases The challenge will be to convincemarkets that these measures will not turninto lifeshysupport machines Worse there isno international agreement on how tohandle the failure of bordershystraddlingrms nor is one close That was a huge proshyblem with Lehman Brothers which hadnearly 3000 legal entities in dozens ofcountries And the struggle to retrieve $55billion that a bust Icelandic bank owescreditors in Britain and the Netherlandsstill continues

Questions also linger over the treatshyment of lenders Americarsquos plan wants itboth ways giving regulators discretion tooverride private creditors but also to suborshydinate the taxpayerrsquos claims This fuelsconcerns about handouts to politically fashy

voured groups as happened in the governshymentshyorchestrated bankruptcy of GeneralMotors Another worrying precedent wasthe generous treatment of troubled banksrsquoderivatives counterparties in 2008 Allcounterparty trading exposures to the exshytent that they are uncollateralised shouldbe at the bottom of the capital stack not atthe top Regrettably the opposite hapshypened This prompted a wave of creditshydeshyfaultshyswap buying because these contractswere underwritten by the state Todaytoo big to fail means too many countershyparty exposures to fail says Peter Fisherof BlackRock a money managersup1 Overhauling capital requirements Inthe hope of avoiding having to trigger theirresolution regimes in the rst place regulashytors will force banks to strengthen theircapital buers A number of countries areconsidering a punitive capital surchargefor the largest rms A report from the Bankof England last November suggested vashyrious ways of designing this It could varyby sector allowing regulators to inuencethe marginal cost of lending to some of themore exuberant parts of the economy Or itcould reect the lenderrsquos contribution tosystemic risk based on its size complexityand the extent of its connections to other shynancial rms

How such a penalty would t withbroader capital reforms is unclear In Deshycember the Basel Committee of supervishysors and central banks laid out proposedrevisions to its global bankshycapital regimeThese could come into force as early as2012shy13 The new standards dubbed Basel3 are less reliant than the last set of reformson banksrsquo own risk models Then the talkwas of capital eciency Now it is allabout robustness With markets alreadydemanding that banks hold more equity areversal of a long trend of falling ratios isunder way (see chart 6 next page)

Before the crisis banks could get awaywith common equitythe purest form ofcapitalof as little as 2 of riskshyweightedassets The new regulatory minimum willnot be clear until later this year but marshykets now dictate that banks hold four tove times that level Hybrid instrumentspart debt part equitywill be discouragedsince these proved bad at absorbing lossesRegulators are encouraging banks to issuea dierent type of convertible capitalcontingent bonds that automaticallyturn into common shares at times of stress

In another acknowledgment that relyshying too heavily on internal models was amistake the new rules will be suppleshymented by a leverage ratio Not weighted

99 01 03 05 07

5Big banks get bigger


Top five global banks and hedge fundsAssets as of industry total

0

5

10

15

20

25

30

1998 2000 02 04 06 08 09

Global banks

Hedge funds


2

1


2

1

to risk this measure looks appealingly simshyple these days One aim is to curb gamingof riskshybased requirements Europeanbanks which unlike American ones werenot subject to a leverage ratio could taketheir borrowing to dangerous heights beshycause many of their assets were highly ratshyed securities with low risk weightingsOne ocial likens the new approach toplacing a net under a trapeze artist

In an equally big philosophical shiftthe new measures will lean against procyshyclicality or the tendency of rules to exagshygerate both the good and the bad Bankswill be required to accumulate extra capishytal in fat years that can be drawn upon inlean ones Until now the rules have enshycouraged higher leverage in good timesand much lower in bad times adding todistress at just the wrong moment Securishyties regulators contributed to the problemfrowning on boomshytime reserveshybuildingas possible protshysmoothing in disguiseThe new proposals will encourage dyshynamic provisioning which allows banksto squirrel away reserves based on expectshyed losses not just those already incurred

Addressing procyclicality will also reshyquire tackling issues that straddle capitalrules and accounting standards Critics offairshyvalue (or markshytoshymarket) accountshying which requires assets to be held atmarket prices (or an approximation) comshyplain that having to mark down assets tothe value they would fetch in illiquid marshykets is likely to exacerbate downturns Thesolution is not to abandon fair valuewhich investors like because it is less opento manipulation than the alternatives Butthere is a case for decoupling capital andaccounting rules says Christian Leuz ofthe Booth School of Business This wouldgive bank regulators more discretion to acshycept alternative valuation methods yet stillallow investors to see the actual or estimatshyed market value

There are lots of potential devils in thedetails of the proposals A leverage ratio ispointless without strict monitoring of asshysets parked o balanceshysheets Contingentcapital meanwhile could have the opposhysite eect of that intended if the bankrsquostrading partners ee as its ratios near thetrigger point There are also worries overincreases in capital charges for securitisashytions exposure to swap counterpartiesand the like These make sense in theoryto treat mortgageshybacked securities as alshymost riskshyfree was nonsense But the newrules swing too far the other way threatenshying to choke o the recovery of assetshybacked markets

Americarsquos large banks having repaidtheir debts to taxpayers are sure to wagewar on higher capital standards An impactassessment stretching over several monthswill give them ample opportunity to lookfor holesand to lobby In Europe wherebanks were more highly leveraged andthus face a more wrenching adjustmenteven some supervisors are queasy sup1 Improving macroprudential regulationIn the meantime regulators can make proshygress in other areas such as overhaulingdayshytoshyday supervision In both Americaand Europe they have stepped up comparishysons of pay lending standards and the likeacross big rms They are also introducingpeer review Within the agency that overshysees Swiss banks for instance the lead sushypervisors of Credit Suisse and UBS arenow expected to scrutinise each otherrsquoswork Americarsquos Securities and ExchangeCommission whose failures included negshyligible supervision of investment banksand the Mado scandal has set up a newrisk division packed with heavyweightthinkers such as Henry Hu Gregg Bermanand Richard Bookstaber Part of their jobwill be to scan derivatives markets hedgefunds and the like for any emerging threatsto stability

This stems from a recognition that tradishytional oversight needs to go hand in handwith the macroprudential sort that takesaccount of the collective behaviour of shynancial rms contagion eects and so onFinance is full of clever instruments thatwork as long as the risk is idiosyncratic butcan wreak havoc if it becomes systemicsays Frederic Mishkin of Columbia Unishyversity Moreover the crisis showed howrisk can cross traditional regulatory linesPension funds and insurers previouslyseen as shockshyabsorbers were revealed aspotential sources of systemic risk

However there is no broad agreement

on how systemic regulation might workor who should do the regulating Mosteconomists see the job falling naturally tocentral banks because of their closeness tomarkets and because of the link betweencapital standards and monetary policythrough the price of credit But there arepolitical obstacles particularly in Americawhere a large and vocal contingent in Conshygress accuses the Fed itself of being a threatto stability pointing to loose monetarypolicy as a cause of the housing mania

International coshyordination is equallytricky The FSB has singled out 30 of thelargest banks and insurers for crossshyborderscrutiny by colleges of supervisorsThere is though a natural limit to coshyopershyation It remains to be seen how well nashytional risk regulators work with supranashytional bodies such as the EuropeanUnionrsquos systemicshyrisk council and the FSBPrivateshysector groups want to have theirsay too the Market Monitoring Group acollection of grandees linked to a bankingshyindustry group is already issuing warnshyings about fresh bubbles emerging

Another reason for scepticism is the difshyculty of identifying a systemic eventAIGrsquos liquidity crunch was thought tocount as one at the time hence the oer ofan $85 billion emergency loan from theFed But what exactly was the danger Thatmarkets would be brought to their kneesby the failure of its derivatives counterparshyties (who were controversially paid o atpar) Or by trouble at its heavily regulatedinsurance businesses More than a yearlater no one seems sure

Pricking bubblesanother mooted rolefor systemic regulatorsis also fraughtwith danger Many central bankers considshyer it unrealistic to make prevention of asshysetshyprice bubbles a specic objective ofsystemic oversight But thinking at the Fedhas been shifting Under Alan Greenspanits policy had been to stand back wait forthe pop and clean up the mess But BenBernanke the current chairman recentlybacked the idea of intervening to take theair out of bubbles This could be donemainly through stronger regulation hesuggested though he did not rule out monshyetary policy as a backshyup option

Mr Mishkin a former Fed governordraws a contrast between creditshyboombubbles and irrational exuberance instockmarkets such as the dotcom bubbleThe rst is more dangerous and the casefor preshyemptive action stronger he arguesbecause it comes with a cycle of leveragingagainst rising asset values

In retrospect all crashes look inevitable

6Threadbare cushion


Banksrsquo capital ratios

0

5

10

15

20

25

1880 1900 20 40 60 80 2005

United States

Britain


2

1

RISK antennae twitch after a crisis Bankshyers regulators and academics shaken

from their complacency jostle to identifythe next tempest Right now gusts areblowing from several directions Manycountriesrsquo scal positions are deterioratingfast after costly interventions to shore up shynancial systems and restore growth Thereis talk of demanding collateral even ondeals with formerly unimpeachable sovershyeign entities Recent terrorist incidentshave raised the spectre of external shocks

Yet at least a fragile sort of optimism hassurfaced born of ultrashycheap money andrelief at having avoided a depression Insome markets fresh bubbles may be formshying Stockmarkets have rebounded sharpshyly Americarsquos though still well o theirpeaks are up to 50 overvalued on a hisshytorical basis Banks are once again throwshying money at hedge funds and privateshyequshyity rms (though with tougher marginrequirements) Issuance of structuredshyloanfunds which a few months back lookeddead is booming Investment banksrsquo proshyts and bonus pools are back near preshycrishysis levels International regulators havebeen issuing warnings to chief executivesabout a return of irrational exuberanceBanks have been ordered to run stress testsinvolving a sudden jump in interest rates

in preparation for central banksrsquo withshydrawal of monetary adrenaline

Many will already be doing this as theytry to show that they have learnt their lesshysons Like the best chess players bankersinsist that they are now concentrating ashard on avoiding mistakes as on winningThose that sidestepped the worst mortshygageshyrelated landmines now top the indusshytryrsquos new order Blackrockrsquos Mr Fisher deshynes risk as deviation from objective onthe upside as well as the downside If yourmodels tell you that a security is safer thanits returns imply as with CDOs that mightjust suggest hidden risks

Fancy mathematics will continue toplay a role to be sure But nance is notphysics and markets have an emotionalside In their struggle with the quantsthose who would trust their gut instincthave gained ground

Learning to tie knotsGovernments are taking no chancesBloomberg counts some 50 bills and otherserious proposals for nancial reform inAmerica and Europe Leaders in AmericarsquosSenate hope to pass new rules by MarchBut there are limits to what can be expectshyed from regulators and supervisors Likebankers they have blind spots As the

mortgage asco showed they are vulnershyable to capture by those they police

Their job will be made easier if newrules tackle incentives for the private secshytor to take excessive risk It is human beshyhaviour more than nancial instrumentsthat needs changing says Mr Mauboussinof Legg Mason Like Odysseus passing thesirens bankers need to be tied to a mast tostop them from giving in to temptationPay structures should be better alignedwith the timescale of business strategiesthat run for a number of years and shouldnot reward leveraged beta unremarkshy

Blocking out the sirensrsquo song

Moneymen need saving from themselves

7Parti pris

Sources Company accounts Bloomberg Benn Steil

Global asset-backed-securities issuanceand Moodyrsquos profit per employee

0

025

050

075

100

125

0

50

100

150

200

250

2000 01 02 03 04 05 06 07 08

Total ABS issuance$trn

Profit per employee$rsquo000

Even with the most insidiousshylooking bubshybles though it is impossible to know at thetime how devastating the pop will beMany thought the economic fallout fromthe internet crash would be far greaterthan it turned out The economic cost ofprematurely ending a boom can be highEven so the worry is that a systemic regushylator would be biased towards intervenshytion because it would face less criticism forpuncturing a nonshybubble than for failing tospot a real one

Alex Pollock of the American Entershyprise Institute (AEI) a thinkshytank is conshycerned that the creation of an ocial sysshytemic regulator would bring false comfortjust as the Fedrsquos founding in 1913 did Acshycording to the then Comptroller of the Curshyrency it had rendered further crises mathshyematically impossible Mr Pollock wouldprefer to see the task go to an independentadvisory body manned by economic

heavyweights to provide institutionalmemory of past crises For similar reasonsAndrew Lo director of MITrsquos Laboratoryfor Financial Engineering suggests sepashyrating regulation from forensics as hapshypens in the airline industry Americarsquos Nashytional Transportation Safety Board is seenas independent because its job is to investishygate crashes not to set rules after the eventThat gives it more moral clout

Whatever form it takes systemic policshying would face a problem During boomsgovernments are loth to take the punchshybowl away at least until the next electionNor do they want to be criticised for theirown contribution to systemic risk Theymay have become even touchier now thatthey are as Pimcorsquos Mohamed ElshyErianputs it market players as well as referees

A way round this would be to introducerules requiring the regulator to step in ifsay credit and asset prices are growing at

aboveshyaverage rates That would shield itfrom claims that the next boom is someshyhow dierent and should be left to run itscourse But it comes at the cost of exibility

All of this suggests that although thereis a strong case for a more systemshywide apshyproach to oversight it could do more harmthan good if poorly crafted Meanwhiletaxpayers will continue to underwrite shynancial giants Americarsquos reforms in theircurrent shape allow the authorities to pullapart those that pose a grave threat butalso to bail out their creditors if they conshysider it necessary

The danger is that the very existence ofa systemic regulator creates an illusion ofincreasing stability even though it does theopposite by strengthening the implicitguarantee for the biggest banksa permashynent TARP as the AEIrsquos Peter Wallisonputs it Too big to fail sometimes seems toohard to solve 7


2

Previous special reports and a list offorthcoming ones can be found online


Future special reportsManaging information February 27thGermany March 13thAmericarsquos economy April 3rdManagement innovation in emergingmarkets April 17thTelevision May 1stInternational banking May 15th

Economistcomrights

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able returns juiced with borrowed moneyIn securitisation originators will have todisclose more information about loanpools and hold a slice of their products

Some of the worst abuses in securitisashytion stemmed from the use of credit ratshyings Rating agencies systematically undershyestimated default risk on vast amounts ofdebt resulting in puedshyup prices and asurfeit of issuance Paid by issuers theyhad every incentive to award inated ratshyings and keep the market humming avershyage pay at the agencies rose and fell in tanshydem with the volume of assetshybackedissuance (see chart 7 previous page)

An obvious way to deal with thiswould be to eliminate the agenciesrsquo ocialnationally recognised status openingthe business to unfettered competitionRaters would then have to persuade invesshytors of their competence rather than relyshying on a government imprimatur This inturn would force investors themselves tospend more time analysing loans Oddlyproposed reforms fall far short of this withno sign of anything tougher on the horishyzon CreditSights a research rm awardedratings rms its Houdini was an Amashyteur award for 2009

Nor alas is there much appetite totackle some of the public policies that conshytributed to the crisis The nonshyrecourse stashytus of mortgages in large parts of Americafor instance gives the borrower a highly atshytractive put option he can in eect sell thehouse to the lender at any time for the prinshycipal outstanding An even bigger problemis the favourable tax treatment of debt relashy

tive to equity Phasing this out would disshycourage the buildshyup of excessive leverageBut the idea has little political traction

There are to be sure risks to rushing reshyform Postshycrisis regulation has a long hisshytory of unintended consequences fromthe pay reforms of the early 1990s (whennew limits on the deductibility from corshyporate tax of executive salaries merelyshifted the excesses to bonuses) to keyparts of the SarbanesshyOxley act on corshyporate governance Another danger is thepricing of risk by regulation not marketsThe creditshycard act passed in America lastyear leaves providers with a choice beshytween underpricing for some productswhich is bad for them or restricting their

oerings which is bad for consumersMost would agree however that marshy

kets need both tighter rules and better enshyforcement The biggest question markhangs over the fate of those institutionswhose collapse would threaten the sysshytem Americarsquos proposal to cap banksrsquo sizeand ban proprietary trading has fortiedthose calling for radical measures to tacklethe too big to fail problem

The virtues of scepticismBy itself though the plan does little to backup Barack Obamarsquos promise to stop suchrms from holding the taxpayer hostageProprietary trading and investments are asmall part of most big banksrsquo activities andplayed only a minor role in the crisis Nordoes the plan cover brokers insurers or inshydustrial rmsrsquo nance arms all of whichhad to be bailed out To persuade marketsthat the giants no longer enjoy implicitstate guarantees whether they are banksor not policymakers will need to present acocktail of solutions that also includetougher capital and liquidity standardscentral clearing of derivatives and crediblemechanisms to dismantle rms whoselosses in a crisis would overwhelm even astrengthened safety buer

Together intelligent regulatory reformsand a better understanding of the limitashytions of quantitative risk management canhelp to reduce the damage inicted on thenancial system when bubbles burst Butthey will never eliminate bad lending orexcessive exuberance After every crisisbankers and investors tend to forget that itis their duty to be sceptical not optimisticIn nance the gods will always nd a wayto strike back 7

Administrator
New Stamp
Administrator
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1


2

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1Borrowed time



0

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AAA 0001 010

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1

















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0

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1998 2000 02 04 06 08 09

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0

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0

20

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1978 1988 1998 2008


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50

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AAA 0001 010

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BBB- 088 6667



















1

















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1























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0

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1973 80 85 90 95 2000 05 09


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1



















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99 01 03 05 07




0

5

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15

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25

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1998 2000 02 04 06 08 09

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2

1


2

1














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0

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0

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2

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1Borrowed time



0

20

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60

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1978 1988 1998 2008


2

1











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2000 01 02 03 04 05 06 07 08 0950

0

50

100

150

200

+

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Banks

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2

1





















AAA 0001 010

AA+ 001 168

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A 009 2921

A- 012 3665

BBB+ 034 4873

BBB 049 5610

BBB- 088 6667



















1

















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1























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0

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100

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1



















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99 01 03 05 07




0

5

10

15

20

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1998 2000 02 04 06 08 09

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2

1


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1














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0

5

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1880 1900 20 40 60 80 2005

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0

025

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100

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0

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2

1





















AAA 0001 010

AA+ 001 168

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1

















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1























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4Filling the pool



0

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1973 80 85 90 95 2000 05 09


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99 01 03 05 07




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1998 2000 02 04 06 08 09

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AAA 0001 010

AA+ 001 168

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99 01 03 05 07




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1998 2000 02 04 06 08 09

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1


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1














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1998 2000 02 04 06 08 09

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1998 2000 02 04 06 08 09

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2

1


2

1














6Threadbare cushion



0

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2

1












7Parti pris



0

025

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100

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2000 01 02 03 04 05 06 07 08












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1998 2000 02 04 06 08 09

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1














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1880 1900 20 40 60 80 2005

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2




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The gods strike back - vixek.com