Transcript The Subprime Crisis And The Yin and Yang of Financial

Second Annual Risk Management Conference
Risk Management Institute, National University of Singapore
Panel Discussion: Issues in Credit and Liquidity Risks in Volatile Markets in Asia
Subprime Crisis: The Yin and Yang of Market
Development And Movement
David Chow, Ph.D.
Adjunct Professor, SooChow Univ. and National Chengchi Univ.
(Formerly CRO at China Development Financial Holdings Co.)
June 30, 2008
The Seasoning of Finance As A Business Sector
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Since the 1990’s, finance was lifted by deregulation, globalization
and technological innovation, these forces have made capital
more readily available to the economy and made finance lucrative.
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In the U.S., financial-sector profits accounted for 13% of pretax profits
in 1980, it was 27% in 2007
In 1980, GE garnered 92% of its profit from manufacturing, finance
workers made about 10% more than comparable workers in other
fields,
By 2007, GE’s financial businesses generated over 55% of its total
profit, finance worker’s compensation premium is 50% (according to
Prof. Thomas Philippon of NYU)
The brightest minds diverted to finance from other economic sectors
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After the crisis, governments are moving to make tighter controls
over the finance industry and to require financial firms to hold
bigger capital cushions against the credit they extend.
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Initial adjustments to the new framework means re-focusing of
businesses and massive lay-offs
Lower leverage, inevitably, means smaller play ground, lower profits,
and less employment opportunities as a whole in the medium run
The Securitization Market Pendulum
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Securitization is a financial innovation that has made the capital
more accessible, the associated markets more competitive and
more flexible
On the other hand, some financial products have become overly
complex and less transparent, which will affect market efficiency in
the long run.
Years of benign economic financial conditions and abundant
liquidity have made market participants and regulators became
complacent about all types of potential risk
But securitzation is not a free lunch:
1. It requires an in-depth understanding of credit risk not only for financial
institutions but also for the common market participants
2. Firms that rely on models to assess valuation and risks should properly
understand their limitations and to have sufficient commitment to form
contingency plans in time to back it up
3. Regultors also often failed to highlight contingent credit risk
requirements when liquidity becomes an issue
Incentives That Created A Food Frenzy
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Areas where banks were most willing to increase lending during the boom
years have since seen the biggest rise in defaults
– Places where it became easier to obtain a mortgage also saw declining
income and employment growth compared with nearby districts
– Districts with the highest level of mortgage rejections in 1996
subsequently have enjoyed the largest increase in the rate of approvals
between 2001 and 2005
This suggests that the issuing banks, knowing that they aren’t totally
responsible for the outcome once the loans are out of their possession,
tend to treat the suspected mortgages with roughly the same care as a
second-hand car salesman
Firms that actively packaging and selling credit exposures retained
increasingly large pipelines of these exposures, without adequately
considering or managing their pipeline risks
Originators that do not have contractual obligations still provided voluntary
support to off-balance sheet financing vehicles, such as SIVs and ABCP’s
Innovations That Says Buyers Beware
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Credit default swaps (CDS) allow two parties to exchange credit risks of an
issuer or an underlying company. As a derivative contract, this types of
transactions can be done without owning the underlying entities and can
generate huge gains or losses through leveraging
Through CDS, banks found partners in hedge funds, where lightly regulated
pools of capital are looking for high returns (as well as insurance companies
and pension funds that were also seeking high yields as interest rates hit
historically lows)
Shedding exposure to credit risk also means for banks not having to reserve
as much capital for potential losses, that allows banks to free up capital for
other businesses or to make even more loans
Transactions such as the ones illustrated above tie up the regulated part of
the institutions together with the unregulated entities.
On the OTC market, When everyone is cross-insured, who is the last resort
when the system is insolvent?
For now, regulators are proposing additional capital requirements on liquidity
and modeling risks
Risk Management That Has Developed Tunnel
Vision During Stress
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One of the most serious shortcomings of traditional risk management is its
silo-based risk framework, where communication among risk, finance, and
operations are insufficient
– The Basel-based risk management excludes “strtegic risk” and divide risks into
“market risk”, “credit risk”, and “operational risk”
– Under a strong profit-focused environment, banks usually view risk management
as a cost center, its operation is independent yet lacks interaction and support
from other departments
– Thus, while many financial institutions are good at quantitative analysis and
financial modeling, the risk governance often becomes fragmented and
disconnected from risk measurement
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ERM is often defined as an organization-wide approach to the assessment,
identification communication and management of risk.
– The division of “banking book” vs “trading book” has created loopholes, where
credit risks in trading books have been ignored
– Since mitigation strategies don't always work as well as planned, it is important to
measure exposure on both an integrated (ERM) and residual basis
– For banks, that entails the coordination of risk management between disparate
but vital areas of finance, including operations, credit, interest rate and markets.
Is Value-at-Risk at Risk?
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VaR captures how bad things can get 99% of the time, but the real trouble is
caused by the outlying 1%, the “long tail” of risk
– The data used to estimate VaR are drawn generally from both periods of
expansion and periods of fear, but it happens that the latter usually occur in a far
shorter period than the former, which is driven by a slow but cumulative build-up
of euphoria
– Hence VaR itself is programmed to instil a false comfort bacause of the limited
historical data it uses
– Common sense suggests that the risk of a blow-up will increase, not diminish,
the farther away one gets from the last one
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Yet VaR acts as an amplifier when trouble does hit.
– Episodes of volatility would send VaR spiking upwards, which triggers moves to
sell, creating further volatility
– In general, VaR’s passive and pro-cyclical feature has been known but accepted
– There is likely more emphasis on using non-statistical ways of thinking about risk,
we should be more rigorous about imagining what could go wrong and thinking
through the causal effects
Basel: I, II and III: Frameworks for Pandora’s Box?
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The 1988 Basel Accord first created the opportunity for regulatory arbitrage
– A capital discipline designed to improve risk management had the
unintended consequence of help creating a new market sector
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The 2007 Basel II allows qualified banks with sophisticated risk management
systems to use risk assessment based on their own models in determining
the minimum amount of capital they are required to hold
– It has created perverse incentives for banks to underestimate credit risk
in order to minimise required regulatory capital
– In many banks the internal risk models, especially when pricing lowprobability credit risks, performed poorly and greatly under-estimated risk
exposure
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As reflect in the new Financial Stability Forum, Basal II will receive a major
facelift in order to bring the unforseenable risks into order
– The old rules are lacking in dealing with systems whose complexity and
lack of transparency caused the market seize-up
– Can we count on another set of rules such as Basel III as a cure-all for
today’s problems?
Can Financial Bubbles Be Micro-Managed?
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The Fed’s traditional approach to fight bubble formation is under attack. Can
monetary policy known as “leaning against the wind” be used to fight
bubbles?
– But it is difficult to judge whether you are seeing a bubble or not. Usually one
does not know until afterwards
– Bubble dynamics are too powerful to be arrested by anything other than very
large increases in interest rates that its effects could be devastate to the economy
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Mr Bernanke is tempting to use regulation selectively and aggressively to
target specific excesses
– Using regulation as separate tool to ensure that asset prices are not widely out of
line with fundamentals.
– But heavy-handed requlation can have severe consequences, the lesson learned
from Sarbanes-Oxley was not to rush
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The U.S. Treasury is also proposing a new “macro-prudential” powers – the
ability to regulate large banks according to specific regulations
– The proposed macro-prudential authority would allow the Fed to order any
financial institution to alter behavior it believed jeopardized overall financial and
economic stability
Boom-and-Bust Market Swings That Reflected
Excesses And Misalignments
• What we are witnessing is not just a collapse of faith in a few
institution or even an asset class. It is a loss of trust in the whole style
of modern finance that reflected in the following areas:
– The complexed slicing and dicing of risk into ever-more opaque forms
that left buyers in the dark when shocks occur
– As a result of financial innovation, banking itself has also become
complex and opaque
– Unexpected chain reactions can happen from shocks that occur in an
obscure corner of finance
• People now are too focused on subprime and missing the broader
storm coming:
– Separate from subprime, we could see diminished ability for consumers
to spend in an inflationary scenario, banks might slow their funding, and
the economy could falter
– The tsunami that started with subprime may not be ended in financial and
housing sectors alone -- what about inflation and oil crisis?