Current articles and case studies
A Forseeable Crisis? Lessons from Subprime: The Sheep on the HillAuthor: Dr Jacques Pézier is a Visiting Professor at the ICMA Centre - the business school for financial markets - University of Reading First Published: December 2007
If nothing else, the subprime storm that is still rolling as we write illustrates the importance of market sentiment. Market sentiment does not necessarily mean irrational, emotional behaviour – although it sometimes does. What is irrational in economics and finance is to ignore the personal views and risk attitudes of the economic agents that drive the markets. The subprime storm built up over years. Taking advantage of low interest rates, engineered to lessen the aftermaths of the previous TMC (Technology, Media & Communications) crisis, lending institutions started to extend their facilities to people with inadequate ability to repay in less favourable circumstances. These loans were repackaged in attractively named investment vehicles and sold to investors keen to secure a substantial interest margin in excess of pallid base rates. Borrowers started to spend beyond their means until inflation crept in and central banks felt obliged to raise base rates. Defaults and foreclosures ensued and investors in ‘high yield’, ‘enhanced leverage’ and such funds are now paying with their capital. Money is not lost, only redistributed; yet economic dislocations may be substantial. A major consequence is that financial institutions suddenly become wary of the quality of some assets they hold, and, by extension, even more wary of the lesser-known quality of assets held by their competitors. In these circumstances, extension of credit between financial institutions is restricted and becomes more expensive. We now have a liquidity crisis. Central banks ‘pump’ money in the system, but uncertainty and fear are narrowing the pipes and interbank lending rates have surged above the base rates. The TED spread – the difference between the three-month Eurodollar interbank rate and the US Treasury bill rate, a barometer of credit risk spread – has never been so high in more than twenty years. Institutions that rely heavily on interbank loans are threatened. Panic could erupt. Who or What is Responsible for the Liquidity Crisis?How is it that eminent banking regulators, supervisors and central bankers have not seen this crisis looming and are finding it so difficult to control? How is it that sophisticated minimum regulatory capital requirements designed to cover potential losses at the 99.9% confidence level over a year have not signaled the dangers? Armies of well-trained risk managers, equipped at great expense with powerful computers fed by huge historical databases, dutifully and continually carry out these calculations. How is it that quantitative analysts, or ‘quants’, with PhDs in mathematics from the best universities have not priced the risks correctly? The blame game is in full swing. Some individuals from chief executives of banks to central bank governors and Treasury ministers have been accused personally of recklessness, negligence, or simply bad judgment. Some have resigned. That is the honourable thing to do in business and politics; but does it solve any problems? Have they learnt anything more than the importance of covering their own backsides? Have we purged the system? Or could it be that what is more fundamentally at fault are the very quantitative methods that contribute to the success of modern finance? Could modern finance contain the seeds of its own destruction? It is facile to either dismiss this opinion instantly because modern finance is based on rational theories, or to embrace it wholeheartedly because people do not always appear to act rationally. These absolutes dispense from further thinking. Reality may be more complex. The pillars of modern finance – portfolio theory, market equilibrium models, the pricing of derivative products – were erected more than a generation ago. The edifice grew under the twin influences of financial deregulation and globalization. It has been equipped with powerful computers and the best information and communication systems. Since the mid-eighties, traditional bankers have had to make room for a new breed of financiers with diplomas in mathematics, physics and engineering rather than Latin or medieval history. Surprisingly, many are French, perhaps a conspiracy? The Objective but irrational View of Risk ManagementCentral to the activities of financiers are the concepts of risks and returns. Risks are continually assessed, priced and transferred. Modern economies benefit enormously from this ‘risk market’. Banking regulators and supervisors focus mainly on risks. They set minimum capital requirements for individual financial firms commensurate with the risks these firms take. But regulators must be seen to act fairly and objectively. Therefore the assessment of risks has to be codified, supported by historical data, limited to areas were quantification can be objectively validated (market, credit and operational risks), and aggregated into standardized ‘worst case’ measures according to simplistic rules. No French conspiracy here, rather good old-fashioned British empiricism with a tad of conservatism. Chris Matten’s useful little book on Capital Management in Banking has a telling diagram. It shows credit ratings and capital relative to regulatory capital requirements for a sample of 78 banks. There is no visible pattern, no correlation between the two. Ask a banking analyst whether excess capital over minimum regulatory requirement is important for credit rating, he will say yes, undoubtedly, but so are many other factors, among which the ability to generate regular profits over the long term. The objective view of supervisors is shortsighted. It leaves unexplored large areas of business risks, reputational risks and systemic risks. Systemic risk is the danger that a large number of financial firms might be exposed simultaneously to the same risk factors and that failures could be contagious; a liquidity crisis is a type of systemic risk. These risks are not overlooked because they are less important, but simply because they are more difficult to quantify objectively and manage. For example, regulators are aware that the pro-cyclical effects of capital requirements could increase systemic risks, but they do not know how to counter this effect, except by relaxing the rules in exceptional circumstances; they also have to rethink the pros and cons of public transparency versus covert intervention. Quants, traders and financial engineers can hardly be blamed unless they engage in illegal activities. It is in the nature of competitive capitalistic economies that their incentives are to make profits for themselves by making profits for their firms. When they act as intermediaries, they must design products that look attractive to both borrowers and investors. The onus for understanding the products rests with the clients; the reputation of the firm is at risk if craftiness leads to blatant deception. When they trade, they use, as they should, all the intelligence, analytical tools and computational resources they can marshal to design and implement profitable trading strategies. Mistakes do happen by accident, but the stability of the financial markets is not a concern for traders. And, by and large, financial market crises have not become more frequent or deeper with the introduction of derivatives and more efficient trading mechanisms. The Rational and Subjective View of Risk ManaagementSo who is to blame and how could one improve risk management in financial firms as well as ensure better market stability? First one should recognize that, in an uncertain world (and the financial markets are by construction quite random), good results do not equate with good decisions; they are mostly due to chance. Therefore, rewarding or penalizing people mostly on the basis of their results rather than on the quality of their decisions is a management failure. It does not improve the likelihood of better results in future. On the contrary it creates perverse effects such as herd instincts or excessive risk taking, when the situation is already poor. But how does one recognize good decisions? That is the challenge. It comes down to three things:
Creativity is fostered by unfettered communications among people with a variety of backgrounds. Preferences, in a financial context, are essentially about trade-offs between risks and returns. Yet trade-offs are often poorly articulated; many financial firms still prefer to set limits to risks rather than to price them. Finally, knowledge consists of views about uncertain quantities (e.g., future prices) as well as models for relating such quantities to the outcomes of a decision. Now, there is little wrong with financial models; they are the best approximations we have for specific problems; if they need be improved, they will. But there is something wrong about taking into account only objective empirical data and neglecting the more subjective but no less important information. Risks are about the future, not the past. Behaviourists would have us throw away formal models, but we would be left with nothing to organize our thoughts. Rationalists prefer to use logical models with subjective information as may be relevant. At least, this is what we try to teach our students so that they do not end up as the fabled British accountant: A young British accountant visits his uncle, a sheep farmer in New Zealand. “So, I hear you are an accountant now, my boy; very useful” says the uncle “Perhaps you could tell me how many sheep I have?” “12,123” comes the reply after a minute. “How did you get that?” exclaims the uncle. “Simple”, says the accountant, “I just counted 123 sheep in the pen near the farm, and I guess you have about 12,000 on the hills.”
For more information on: ICMA Centre - University of Reading
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