20050215 FT Resistance to systemic risk may be eroded

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Resistance to systemic risk may be erodedResistance to systemic risk may be eroded
>By John Plender
>Published: February 15 2005 20:25 | Last updated: February 15 2005 20:25

At the start of 2005 an overwhelming consensus existed among hedge funds and international banks that the dollar could only go down against the euro. The bears were then ferociously squeezed in the first six weeks of the year as the dollar hit its highest level against the eurozone currency in three months.

Yet no hedge fund or investment bank has been brought, as Long-Term Capital Management was in 1998after similar adverse market movements, to the brink of insolvency. Nor has any big financial institution so far been wrong-footed by the US Federal Reserve's well-signalled interest rate increases since last June.

This raises important questions about the plumbing of global high finance. Has a newly resilient international banking system acquired near-immunity to crises? Or could a financial bolt from the blue still expose global finance to a devastating systemic shock?

Since manias and panics are endemic in financial markets, the eternal financial verities surely still apply. That said, the conventional wisdom among establishment bankers is that the vulnerabilities are all some way into the future. In its most recent Global Financial Stability Report, the International Monetary Fund said: "Short of a major and devastating geopolitical incident or a terrorist attack undermining, in a significant and lasting way, consumer confidence, and hence financial asset valuation, it is hard to see where systemic threats could come from in the short term." Last December the Bank of England's Financial Stability Review referred to a contrast between "low near-term risks and heightened longer-term volatilities".

The case for playing down the near-term worries is, first, that the global economy is stable and growing. Much has been done to enhance the robustness of the financial system in the US and elsewhere since the LTCM debacle. Banks have diversified their credit exposure as never before via derivatives such as structured credits, which can be used to transfer risk to insurance companies, pension funds, hedge funds and others outside the banking system. Payment and settlement systems have been strengthened. Above all, banks have been reporting high profits for an extended period and delinquent loans are at a low level. They thus have an impressive looking cushion of capital as a defence against loss-inflicting shocks.

Yet banking is a cyclical business, in which the seeds of future trouble are sown precisely at times such as this. So could this capital cushion disappear in short order, just as the taken-for-granted pension fund surpluses of the 1990s evaporated, to be replaced with the oversized deficits of today?

A useful starting point is to consider the causes of financial crises. According to Timothy Geithner, president and chief executive officer of the Federal Reserve Bank of New York, in a recent speech: "Most financial crises involve a shock whose origins lie in the realm of macroeconomic policy error, often magnified by the toxic combination of poorly designed financial deregulation and an overly generous financial safety net. Probably the most important contribution policymakers can make to financial stability is to avoid large monetary policy mistakes or sustained fiscal and external imbalances that increase the risk of large macroeconomic shocks."

Measure the US, which holds the key to global financial stability, against that template and warning lights immediately flash. The US economy does indeed suffer from big imbalances, in part because monetary policy under Alan Greenspan, the Fed chairman, has delivered freakishly low interest rates to stave off economic stagnation after the bursting of the extraordinary equity market bubble in 2000.

The huge US fiscal and current account deficits have not been difficult to finance, because there is a surplus of global savings over investment. Yet there must be a risk that the US's financing needs will at some point outstrip the willingness of the handful of key countries to continue investing their official reserves in dollars. The rise in interest rates that might then be required to tempt private capital to finance the deficit could lead to a market crunch, which is why Paul Volcker, the former Fed chairman, asks whether Asian central bank financing of the current account deficit will prove to be "a fatal embrace".

Meanwhile, interest rates that are still very low by historic standards are doing strange things to a financial system that is highly deregulated. Note, in passing, the astonishing fact that most of the assets of US financial institutions are not subject to the risk-based capital regime and supervisory constraints that apply to US banks. This is because a high proportion of US financial activity now takes place outside the banking system, in institutions ranging from non-banks such as GE Capital to giant hedge funds.

An overly generous financial safety net has potentially been extended by default as a result of the growing concentration of financial assets and liabilities. The top five bank holding companies in the US own 45 per cent of all banking assets - nearly twice their share 20 years ago. The markets assume the Fed would come to the rescue, acting as lender of last resort, if any of the five hit trouble. Also seen as too big to fail are Fannie Mae and Freddie Mac, the home loan institutions. Their balance sheets have been bloated by the Fed's low post-bubble interest rates, which have fuelled housing booms across the nation. Such concentration means that the impact of any failure would be far greater than in the past.

The Fed's low interest rates have also fuelled an increase in risk appetite and leverage across the world - leverage in the form of borrowing or in the structure of derivative instruments such as swaps and options where a small downpayment brings a big exposure to movements in the capital markets, which is known as economic leverage. In order to boost returns, investors and banks look to more risky and illiquid assets in a search for yield regardless of risk. >

Nearly all big financial institutions have been engaging in so-called carry trades, whereby investors borrow cheaply to invest in assets that yield a margin over borrowing costs. The snag is that, since the Fed started to raise rates last June, the margin has become thinner. To achieve the same profit, people are taking on more leverage and making bigger bets. This makes for more volatile markets of the kind seen since the start of the year. Yet financial institutions continue to set targets for high and increasing revenues and profits that assume the good times spawned by a freakish monetary policy will continue to roll.

Leverage is not confined to financial institutions. Outstanding US household sector debt of just under $10,000bn in the third quarter of 2004 was at an all-time peak both in absolute terms and relative to gross domestic product. This is no great threat in the short run because of the remarkable structure of the mortgage market, which allowed borrowers to lock in low rates at the bottom of the cycle. More than 80 per cent of the mortgage debt stock is reckoned to be at fixed rates and around 60 per cent of mortgage debt was financed or refinanced in the 18 months before the Fed started raising interest rates in June last year. The problem comes when there is a recession and rising unemployment hampers debt servicing.

With that background, the biggest conundrum on potential systemic threats is whether financial innovation could have the same destabilising impact in the present cycle as deregulation had in earlier ones. The first ground for concern is the phenomenal growth since 1998 in the number of hedge funds and the amount of capital they manage, which has doubled to $1,000bn over the period. Hedge fund activity is very diverse, ranging from fixed income arbitrage to bets on credit derivatives or even, latterly, catastrophe reinsurance. The business is opaque and little regulated. A big lesson of LTCM was that the banking system can be jeopardised by the ill-judged risk-taking of a single hedge fund. >

Since then, central bankers have argued that risk management in both banks and hedge funds has improved. Some market practitioners claim the hedge fund sector is less leveraged than in 1998. Yet figures of bank lending to the Cayman Islands, where many hedge funds are domiciled, hint at a big increase in leverage since 1998, while economic leverage is anyone's guess. With margins in traditional business squeezed, big banks are falling over themselves to provide prime brokerage services to hedge funds, which include extending credit, securities dealing, clearing and settlement and so forth. Competition has led to an erosion of credit standards. In a forthcoming survey of potential banking banana skins from The Centre For The Study Of Financial Innovation, a London and New York-based think-tank, one respondent even refers to prime brokerage as "the crack cocaine of the financial system".

A second ground for concern is the dramatic growth of derivatives markets and, especially, over-the-counter derivatives in which financial institutions deal with each other directly rather than through public markets. According to the Office of the Comptroller of the Currency, the outstanding notional value of outstanding derivatives held by US banks at the end of the third quarter of 2004 was $84,000bn. Credit derivatives are the fastest growing component of this figure, having risen from $144bn in the fourth quarter of 1998 to $1,909bn last year. When the OCC numbers are combined with those from the Bank for International Settlements, the global total of credit derivatives comes to $4,500bn.

The degree of concentration in these markets is hair-raising. The largest five US banks hold 95 per cent of the total stock of derivatives, while the top 25 hold 99 per cent. JP Morgan Chase alone holds more than half the total stock.

The positive feature of credit derivatives is that they can give banks an opportunity to transfer risk to those institutions that are best equipped to bear it. But the market can be illiquid, while trading strategies depend on highly complex pricing models. And credit derivatives have never been tested in times of acute market stress. With so much of the market concentrated in a handful of complex giants, there is a risk that any attempt to reduce their exposure in the face of a shock could magnify rather than diminish the shock. >

The banks' first line of defence, in the event of trouble, is their capital cushion. Yet it is hard to know what constitutes an adequate cushion when so much financial activity that could pose a systemic threat is outside the banking system, and when the degree of leverage in finance is so hard to gauge.

The risk-based capital ratio of the 10 largest US bank holding companies is not very different from what it was in 1998. Given the explosive growth of hedge funds and credit derivatives since then, it follows that the supervisory authorities must believe big improvements in risk management more than compensate for the dangers implicit in the changes in the financial structure - a worryingly large assumption.

At some point, today's voracious risk appetite will reverse. The nature of the shock that brings this about is inherently unforecastable, though a dollar plunge accompanied by an unexpected rise in interest rates could be part of the mix, given the nagging global imbalances and problematic exchange rate regime. With Alan Greenspan finally taking his leave from the Fedlater this year, it will probably fall to a less experienced pair of hands to pick up the pieces. In addition, the job will have to be done in a global marketplace where the legal and supervisory frameworks remain resolutely national and far too little is known about the risks that are being run.>

Peril can also lurk in the ordinary

Since exchange rates were freed in the 1970s, economic cycles have been marked by greater volatility in asset prices and by financial fragility. Deregulation, which has taken banking from a public utility ethos to a growth-oriented business model, is largely responsible.

As Charles Goodhart, Boris Hofmann and Miguel Segoviano have shown*, the authorities’ attempt since the 1980s to regulate banks through capital adequacy requirements is pro-cyclical, amplifying rather than damping fluctuations in the business cycle. The better the value and riskiness of banks is measured, the greater the pro-cyclicality of the capital regime, the academics find.

In the present cycle, innovation has done at least as much as regulation to change the financial infrastructure - most strikingly through the rapid growth of hedge funds and credit derivative markets. Alan Greenspan, chairman of the US Federal Reserve, has been a cheerleader for these developments. He argues that hedge funds’ arbitrage activity makes markets more efficient and keeps the financial system fluid and flexible.

Credit derivatives, meanwhile, permit risks to be unbundled and transferred to those players in the financial markets best able to absorb them. Mr Greenspan talks of a “new paradigm” of active credit management - arguing that, because exposures to telecommunications companies were laid off in the 1990s through credit default swaps, collateralised debt obligations and other financial instruments, huge bankruptcies such as that of WorldCom of the US failed to dent the banking system. So, too, with Argentina’s sovereign default.

That said, the near-collapse of the Long-Term Capital Management hedge fund suggested that risk was being transferred to where it was least visible and least supervised, rather than where it sensibly belonged. Moreover, when financial instruments are new, risk is easily mispriced. If it is mispriced on any big scale, there can be systemic consequences.

Timothy Geithner of the New York Fed has summed up the dangers: “The frontier of financial innovation inevitably advances somewhat ahead of improvements in the risk management and clearing infrastructure. The models used to assess risk in the more novel areas of finance are, by definition, less grounded in experience and less valuable in anticipating how prices and correlations change in conditions of stress.” That helps explain why bankers are often hit by what their risk models saw as “once in 1,000 year” events. Historically based models are not good at preparing banks for extreme market movements.

Yet conventional credit risk could yet be the cause of systemic trouble in the current cycle. Messrs Goodhart, Hofmann and Segoviano point out that liberalisation has increased the sensitivity of bank lending to property price fluctuations. Both commercial and residential property prices have been soaring in English-speaking countries and buoyant residential property prices in the eurozone are of growing concern for the European Central Bank. Among the more extreme cases is the UK, where more than half of new corporate lending in the year to September 2004 was to commercial property, which now accounts for more than a third of the outstanding stock of lending to UK non-financial companies.