Download 01 What just happened?! Some perspectives and their implications

What just happened?! Some perspectives
and their implications
April 2009
01
Craig Turnbull
[email protected]
Perspective 1 (ex-post rationalist)
In recent years, risk, capital and leverage have been globalized and securitized
in unprecedented ways. This has occurred at all levels of the economy. For
example, at government level, foreign ownership of US government debt is at
an all-time high, as is the overall level of the debt as a percentage of GDP. At
the corporate financial services level, the securitization and distribution of
traditional banking loans has globalized banks’ credit exposures; at a personal
level, personal debt levels in developed economies have reached record
levels.
The securitization and globalization of bank’s’ mortgage books is, in theory, a
positive development – it should create more diversification for banks, and
improve the efficiency of capital allocations. But its rate of growth was caused
by (and then created) a number of principal-agent problems and other forms
of market failure. Many loan originators had little incentive to perform effective
underwriting, as they were acting primarily as distributors rather than risk
underwriters. It became very difficult to know who was ultimately exposed to
what. Financial innovators packaged these securitizations to keep them offbalance sheet, thereby helping banks to understate the true leverage of their
economic position. Rating agencies were incentivised to rate these securities
highly. Banks were incentivised not to look beyond the ratings if they could
get away with it. Regulators let them get away with it – and at some point this
created a fundamental dislocation of risk and capital in the global banking
sector.
The net result of all of this was that leverage (government, corporate and
personal) reached unprecedented levels, and some of this was inherently
understated and lower quality than assumed at origination. This fuelled an
asset price (real estate) bubble that was unsustainable and the level of
leverage made the economy inherently very vulnerable to it bursting. It burst.
The financial crisis wasn’t caused by illiquidity; it wasn’t caused by procyclicality; it wasn’t caused by mathematicians and their models. It was caused
because the managers of financial institutions had incentives to write puts and
not value them properly on their balance sheet or to hold capital for the risks
they created. It was caused because regulators and accounting standardsetters were two steps behind financial innovators who were incentivised to
stay two steps ahead. Fundamentally, regulatory capital-setting got broken in
an avoidable way.
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Perspective 2 (sceptical empiricist)
Ex-post rationalization is a wonderful thing, but risk is an inherent part of the
financial / economic system. It is inevitable that asset prices will occasionally
experience significant short-term downward shocks. This is not predictable or
avoidable, except when looking backwards. But managers, regulators, rating
agencies and perhaps even financial market prices systematically
underestimate the frequency and severity of these events. Who cares about
rationalizing the cause, it will be a different cause next time. The point is that
next time is sooner than we think, and there is little we can do about that. So
let’s address that issue by addressing the systematic flaws in our risk
measurement techniques.
In particular, the prevailing approach of using normal distributions that are
calibrated to very short-term data horizons is a structurally flawed approach to
capturing the extreme low-frequency events that drive the results of interest.
Our models and calibration methods need to go beyond this. That isn’t hard –
we have hundreds of years of economic data to learn from; we have a range of
fat-tailed financial models that can capture the inherent uncertainty in financial
tail risk measurement. Managers need to understand this – not the formulas,
just the quite simple principle that market risk is a complex and ill-tempered
phenomena, and extreme events can be much, much worse than is implied by
a normal distribution with a volatility based on last month’s market behaviour.
Regulators and governments need to demand that risk analysis takes a
broader, more judgment-based approach that goes further than short-term
algorithmic data analysis and self-servingly sanguine extrapolation.
Perspective 3 (Anti-geek)
Markets are crazy. Let’s try not to worry about it. Worrying about it makes it
worse – it creates pro-cyclical price depressions. Short-term market volatility is
irrational and vastly overstates changes in investors’ expectations. Reacting to
it creates a self-fulfilling prophecy. Mortgages and pensions are long-term, so
we can safely ignore the short-term. These geeks and their fancy models have
blinded managers and regulators and stopped them from thinking about the
business fundamentals. Turn the fancy models off and let’s get back to simpler
sums that the people that know the business can understand.
And my perspective?
Most of us will be able to find some grains of truth in each of these
perspectives. In these fascinating times, truth is in the eye of the beholder. But
the point is that there are valuable regulatory and internal risk management
improvements that can be found from each of these perspectives. As a selfconfessed wanna-be-a-geek-but-wasn’t-smart-enough-so-they-put-me-inmarketing person, it is perhaps not surprising that the first two perspectives
resonate most strongly (and feel mutually re-enforcing).
Smarter use of more sophisticated models is essential to better appreciating
the quantum of the extreme tail that market risk exposures create. Using a
normal distribution with a volatility based on the last 30 days to estimate
99.97th percentiles of market risk exposures is a fundamentally bad idea, and
that was as obvious before Q4 2008 as it was after it. Fat-tailed distributions
and calibration approaches that are aimed at robust estimation of the tail are
essential improvements to the VaR methodology. This will mean greater
reliance on qualitative judgment and less on Exponential GARCH models
(which are great for volatility forecasting, but not so great for 99.5th percentile
forecasting). So, we need to make better use of the available science. And we
need to recognize that risk managers must employ some (independent)
judgment in the application of this science or ruthless innovation will again
expose its weakest link (remember principles not prescription?).
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But that alone isn’t enough. Regulatory and accounting systems need to
incentivise holistic, bottom-up risk analysis – market risk, no matter its source
or its wrapper, must have nowhere to hide on a financial institution’s balance
sheet or regulatory capital assessment. Managers need to see this risk analysis
as a source of insights into business decision-making, not merely a tool for
regulatory appeasement. Aligning performance measurement and hence
business models with the true economics of the business is a must-do. The
banking sector has experienced the greatest public scrutiny as this financial
crisis as unfolded, but on this latter point, the global insurance sector has at
least as much to do.
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