Is Systemic Risk Underestimated?

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The question of systemic risk, that is, the possibility of a generalized failure of the financial system, such as a stock market crash, is something that regulators think about a great deal and quite deliberately discuss a good bit less, since fear becomes a driving element in any market panic.

The reason for the heightened concern about systemic risk is the proliferation of new instruments and strategies, including credit default and total return swaps, collateralized debt obligations, and other exotica, very high levels of leverage, very low risk premia (that means that investors are cavalier about risk and aren’t asking to be paid very much to assume risk), and large, unsustainable (in the long term) global imbalances. Many of these new instruments have not been around long enough to have been tested in a recession or a market break. Thus, even though investors and brokers have models of how they will behave, they have never been tested in certain real-world scenarios.

The risk of these novel investments is compounded by internal inconsistencies in money and capital flows. At a minimum, the widespread low risk premia don’t mesh well with the global imbalances story. Presumably, the smart money recognizes that there will be a readjustment, hopefully gradual, but any realignment will create a lot of uncertainty and asset repricing. But no one wants to get out too early and miss the upside, so it appears that a lot of investors are assuming they will know when to abandon their current strategy and won’t be trampled in a rush for the exits.

Mind you, it’s important to note that things could unwind in a messy, painful way, without having a market break or crisis. Think of the end of the dot com era. A tremendous amount of wealth was wiped out, but it was merely a large market correction. But the bubble in debt markets, which are much larger and more levered than the equity markets, increases the risk of a nasty outcome.

There are two views of this situation, each with its own construct. One is the majority perspective, well represented by the Fed. It sees the complexity of the financial system in organic terms. The notion of diversification, of spreading risk, means greater safety and resilience. No one would disagree with that concept, but the question is whether high leverage, greatly increased trading volumes, and new instruments, particularly ones that require very high level math skills to understand, changes the nature of the risks enough to obviate the advantages of diversification and risk transfer.

Although regulators and economists would never admit to this analogy, the mainstream sees the changes in the financial system in evolutionary terms: it is progressing by developing more complicated and diverse instruments, more complicated institutional relationships, more interdependencies. In biology, you see a similar pattern when you go from simple organisms to more complicated ones.

Consider this speech, “Credit Markets Innovations and Their Implications,” from Timothy Geithner, president of the New York Fed:

The latest wave of credit market innovations has elicited some concerns about their implications for the stability of the financial system, concerns similar to those associated with earlier periods of rapid change in financial markets….

The recent changes in credit markets have been dramatic. We have seen rapid growth of structured credit products, credit default swaps and new types of collateralized debt and loan obligations. Although these instruments are very new, they are the natural extension of earlier innovations in credit markets. Over a long period we have seen innovations ranging from the syndication of bank loans and the direct provision of credit through the capital markets, to the spread of asset-backed securities and products that separate different parts of the payments stream and different dimensions of the risk in a credit obligation into different instruments.

These changes have contributed to a substantial reduction in the share of total credit held by banks. They have produced a greater separation or distance between the entity that first arranges a loan and those who end up holding the risk, and more intermediaries in that chain. And they have contributed to a dramatic increase in the number and diversity of creditors to any individual borrower, and a greater capacity to actively trade credit risk…

Some aspects of this latest wave of innovation are different in substance—therefore potentially in their implications—from their predecessors. And these differences require attention…

The first is about the role of market liquidity and liquidity risk in how credit markets work. Credit market innovations have transformed the financial system from one in which most credit risk is in the form of loans, held to maturity on the balance sheets of banks, to a system in which most credit risk now takes an incredibly diverse array of different forms, much of it held by nonbank financial institutions that mark to market and can take on substantial leverage…. Hedge funds, according to one recent survey, account for 58 percent of the volume in credit derivatives in the year to the first quarter of 2006.

Financial shocks take many forms. Some, such as in 1987 and 1998, involve a sharp increase in risk premia that precipitate a fall in asset prices and that in turn leads to what economists and engineers call “positive feedback” dynamics. As firms and investors move to hedge against future losses and to raise money to meet margin calls, the brake becomes the accelerator: markets come under additional pressure, pushing asset prices lower. Volatility increases. Liquidity in markets for more risky assets falls.

In systems where credit is more market-based and more credit risk is in leveraged financial institutions outside the banking system, a sharp rise in asset-price volatility and the concomitant reduction in market liquidity, can potentially have greater negative effects on credit markets. If losses in these institutions force them to withdraw from credit markets, credit availability will decline, unless or until other institutions in a stronger financial position are willing to step in. The greater connection between asset-price volatility, market liquidity and the credit mechanism is the necessary consequence of a system in which credit risk is dispersed outside the banking system, including among leveraged funds. This does not make the system less stable, though, only different. For if risk is spread more broadly, shocks should be absorbed with less trauma. Moreover, the system as a whole may be less vulnerable to distortions introduced by the moral hazard associated with the access that banks have to the safety net.

A second issue we need to consider stems from the complexity of the new credit instruments, the challenges they present in terms of valuation and risk measurement and their short history of experience in times of stress.

Even the most sophisticated participants in the markets for these instruments find the risk management challenges associated with these instruments daunting. This raises the prospect of unanticipated losses. Default rates are harder to predict where there has been a substantial change in the financial attributes of borrowers. The prices of instruments may not respond as expected to a given change in losses or in the value of the assets underlying these instruments. Hedging strategies may prove to be less effective than expected. Similarly rated instruments can behave very differently in stress events….

A third issue relates to the dynamics of failure and the infrastructure that supports these markets. The dramatic growth in the volume of over-the-counter derivatives and the growth in the number and size of leveraged funds inevitably complicate the resolution of the failure of a large financial institution that is active in these markets. The sheer number of financial contracts that would have to be unraveled in the context of a default, the challenge that a former colleague of mine likes to refer to as “unscrambling the eggs,” could exacerbate and prolong uncertainty, and complicate the process of resolution…

All these challenges merit attention. They describe some of the risks that have accompanied the substantial benefits of credit market innovation. And they help illustrate why these broad changes in financial markets may have contributed to a system where the probability of a major crisis seems likely to be lower, but the losses associated with such a crisis may be greater or harder to mitigate….

There are several crucial admissions in Geithner’s speech. First, no one understands the complexity and operation of the total system (at a minimum, one set of important players, hedge funds, hide their activities). Second, it is a given that some of the new instruments will behave in unexpected, probably adverse ways, in a stress event. Third, the Fed has much less influence than in the past because banks are no longer where the action is.

But not to worry. The system is Darwinian. Market discipline operates as a predatory force, wiping out the weak members of the herd.

To take a page from Emile Durkheim, this organic view of the financial system contrasts with the minority perspective, which sees it in mechanical terms. Richard Bookstaber, a hedge fund manager, risk management expert, and author of “A Demon of Our Own Design” (reviewed in the Economist) sees markets not in terms of their resilience but their vulnerability. He comes by his perspective from personal experience. He can claim to have helped cause not only the 1987 crash (as one of the designers of portfolio insurance that led to automated selling, turning a decline into a rout) but also the Long Term Capital Management meltdown that nearly created a financial crisis (an investigation he led into trading losses at Salomon led them to shut down their bond arbitrage desk, which lowered liquidity in the market, making it harder for LTCM to unwind its positions).

In a Wall Street Journal interview, Bookstaber describes the gears and plumbing of the financial system:

Financial markets are like jetliners and nuclear-power plants, he says: They are highly complex systems that require numerous interrelated steps to work together. But the “tight coupling” of these steps means when one of them goes wrong, the error rapidly ripples through the entire system, producing disasters like the ValuJet crash in 1996 or the Three Mile Island nuclear accident in 1979.

Bookstaber’s observation about “tight coupling” intuitively seems correct and fundamentally important. Financial markets players deal with each other through innumerable, rigid processes which require industry members to act in prescribed ways: counterparty agreements, exchange rules, regulatory requirements. In a crisis, the players lack the ability to suspend the rules.

After the 1987 stock market crash, the major stock and commodity exchanges created circuit breakers, which, like control rods in a nuclear reactor, stop the action, hopefully long enough for the situation to normalize. But the credit markets, the focus of innovation and of Geithner’s speech, operate through not through centralized exchanges but over the counter, among dealers. They have no circuit breakers. We can only hope they never need them.

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