Capital markets: flashes of insight: Part 3
Risk, as we learned in Part 1, is inherent to capital movement and value generation; unfortunately, as Part 2 revealed, risk adds complexity to the system, with outcomes we cannot predict.
Some of them may be good — for instance, distributing loan loss pain geographically, economically, and temporally, makes the system as a whole much more resilient. Other secondary consequences could be bad — and some probably will be. Paraphrasing Donald Rumsfeld, the unknown unknowns are the ones we know should worry us.
I know that where my hands are going is unknown
Banks should not be complacent about their financial models, either.
What’s the definition of a working program? One whose bugs have not yet all been found. It is ever thus with financial models — they work great until they don’t.
Prices of new instruments, by definition, have short histories, which makes it hard to predict how they will react in a crisis. At the height of the troubles with subprime mortgages earlier this year the price of indices based on tranches of subprime loans went into free fall. Regulators are now asking whether that was modelled for.
My old science fiction writing colleague Jim Morrow once insightfully said, “Science does have all the answers. The problem is we don’t have all the science.” As the Economist’s Eggheads and long tails piece noted:
The bond-market turmoil leading to the liquidation of Long-Term Capital Management (LTCM) in the summer of 1998 not only exposed the risk-management negligence of that institution, staffed by Nobel laureates and storied traders; many investment banks were caught out too. The lesson, learned at an exorbitant cost, was that models are only as good as what is fed into them. So risk management is as much about human judgment as about mathematical genius.
Computers can model only the algorithms that have been coded to model; phenomena that are unprecedented are, well, un-modeled.
It was unknown until I tried it
Many hope that when the
Risk pricing is a clear advance over standardized risk categorization. One can expect that it will take some time, however, to calibrate the new risk telescopes and get them properly focused.
Some aspects of the new regime require extensive discussion between banks and their supervisors on how to assess complex credit exposures. Capital also has to be set aside against operating losses, which for large investment banks exposed to complex transactions may be onerous.
Not everybody agrees that
Straw man, Economist — I doubt anybody thinks
Bit by bit, we improve the guidance
Sheila Bair, chairman of
I’d rather have more money than I ever needed or could possibly need under any conceivable circumstances. But in the world of real, that kind of certainty is too expensive.
Wilson Ervin, Credit Suisse’s chief risk officer, appropriately works in a building that is a living testament to risk. Credit Suisse’s
Recently I’ve spent some time in that magisterial building, with its portraits of stern Union generals such as William Tecumseh Sherman hanging from the high-ceilinged marble lobby walls. It’s a testament not just to risk but also to the value of tangible assets in surviving financial vicissitudes.
Surviving the vicissitudes is hell
Mr [Walter] Stuerzinger describes UBS’s approach to risk in stark terms:
· Zero tolerance for fiefs
· Beware of tail risks, risk concentrations, illiquid risks and legacies
· Avoid risks that cannot be properly assessed or limited
· Never be hostage to a single transaction or client
Those rules are sound, if stolid, since who is to say that a risk has been properly assessed? Only hindsight.
UBS sets its overall risk capacity on the basis that it wants to be able to pay dividends out of current earnings, not retained ones. But thanks to earnings growth and the divestment of its private-equity portfolio, its ability to take risks has grown much faster than its actual risk exposure. Indeed, it is sometimes criticised for not taking large enough punts. Earlier this year Ken Moelis, an investment banker prominent on Wall Street, left the firm, reportedly because he felt it was too conservative in using its own capital in private-equity deals.
Avinash Persaud, head of Intelligence Capital, a firm of financial advisers, and an expert on systemic risk, says a new culture has grown up in which risk has become a hot potato, to be passed on as rapidly as possible. Increasingly it is ending up in obscure and unregulated corners.
Don’t hold it too long
The financial system, he says, has “become better at trading risk and pricing it, but maybe worse at holding it”.
Perhaps: perhaps not. After all, a truism of business is that risk migrates to the party best able to assess and bear it — that’s the central premise of all forms of insurance. And dispersing risk presumably reduces the chances of a cataclysm, like the 1929 crash, that stops the whole system.
When The Economist published a report similar to this one exactly 20 years ago, much of the argument concentrated on the risks posed by securitisation and the proliferation of new instruments, such as (back then) junk bonds and swaps. At the time, Alexandre Lamfalussy, one of Mr Knight’s predecessors at the BIS, aired concerns that now sound eerily familiar. “It’s not the risk to individual banks I’m worried about but macro-prudential risk … it is much harder to tell who is bearing what risk and where it is ending up.” He continued: “Transparency is diminishing. Some risk-takers simply do not know the risk.”
Risk: now you see it …
… now you don’t.
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