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Liquidity Crunch

History Repeats Itself

The meltdown of the US sub-prime mortgage market and the growing global credit crunch led to a great economic slump, as it dominated all the financial markets in the second half of 2007. The sudden evaporation of liquidity and dramatic repricing of risk caused a widespread financial instability, which ultimately threatened the viability of smaller financial institutions even in well-regulated markets such as Germany and the United Kingdom. The US Federal Reserve faced a direct loss of almost 150 billion USD in sub-prime category while numbers are supposed to be greater in non sub-prime category.

As in past systemic financial crisis, complacency in credit standards was driven by bad incentives and moral hazard, which lowered the risk premiums to unsustainable levels. The periodic under pricing of risk in financial markets can be structural and till some extent, it is unavoidable. But few systemic financial crises are entirely dissimilar to its earlier episodes; hence, a room for improvement in the management of crisis is suggested. It can be done by incorporating features of better early warning systems in crisis-management program and more coordinated and forceful action by market supervisors and central banks.  

It is true that financial crisis are unavoidable but their frequency and severity can be significantly reduced. Some recent experiences, such as the relatively benign Y2K rollover, the very short-lived market disruption following the events of 9/11 and the relatively muted effects of more recent spikes in the dollar price of oil – have led experts to come with a conclusion that markets are now more resilient to exogenous shocks. Nevertheless, there are disputes over the resilience of the global financial system, as many argue that it would become fully evident only under the conditions of severe stress over the next year.

A System Transformed

Over the last 20 years, financial markets have undergone a revolution, which is driven by deregulation, a rapid pace of financial innovation, global financial integration and the increasing role of the financial sector in the economy. The salient features of the transformation can be summarized in following six points-

Deregulation: The process of deregulation has deeply affected the financial markets of advanced economies by removing entry barriers, reducing artificial borders between different financial institutions, increasing cross-border competition, encouraging the emergence of large, complex financial institutions; and spurring financial innovation.

Financial innovation: There has been an explosion in derivative and structured products.
Such innovations allowed a more efficient allocation of financial-resources. Many argue that this helped in strengthening of the global financial system by better apportioning of risk. However, innovation raises challenges in terms of evaluating risk, correctly identifying ultimate bearers of risk and assessing whether it can be manageable or not. Rating asset classes without checking market history has put rating agencies in a crucial position in global markets. Regulators may not have the capacity to monitor the range of risks within the financial system.

Rise of alternative capital pools: The rise of hedge funds, private equity and sovereign wealth funds has altered the balance of the global financial system. Hedge funds are sometimes highly leveraged (with consequently higher risk profiles) with shorter investment time horizons than standard investors, operating under conditions of reduced disclosure and oversight.

Private equity firms, while often investing for the longer term, are similarly unburdened by regulatory oversight. Sovereign wealth funds have become particularly important, as rising oil prices and global economic disproportions have massively increased the foreign reserves of certain countries. This presents a new set of challenges including relative lack of transparency over investment strategies, concern over possible political intervention and potential large-scale market moves.

Role of non-bank institutions and intermediaries: The increased role of market intermediaries widened the offering of structured financial products to investors. Nonetheless, all intermediaries are not subjected to consolidate risk based capital frameworks or the full complement of supervisory constraints. The originate –to-distribute (OTD) model has lowered the underwriting standards while growing importance of credit rating agencies enhanced the similar challenges with respect to incentives , as these are  supposed to play a key role in pricing risk but do not hold it.

Shift to multi-polar currency regime: Nevertheless, the US dollar is the global reserve currency and  likely to remain the same in near future but creation of Euro and growing importance of emerging country currencies can weaken the dominance of Dollar. This can bring consequences for the global management of central banks’ reserve holdings and the resolution of currency alignments.

What are the implications of these changes for the nature of systemic financial risk?

While considering the implications of these changes for systemic financial risk, three major observations stand out:

  • Risk ownership has been decentralized
  • Risk transmission has become more important
  • Risk management is critical

These developments seemed to increase the capacity of financial system to assume and distribute risk; it was appearing more stable now. More risk is apportioned to market participants who have indicated willingness to absorb risk. However, in accordance with recent developments highlight, this appears to be factual only under the “normal” market conditions. The complexity and forthcoming infinite feedback loops of the modern financial system turns the small risks into very large systemic shocks. Some analysts suggest that the financial system should be more pro-cyclical if the growing dispersion of risk is not coupled with a better understanding of the driving factors of risk segmentation and diversification.

Hence, it can give birth to a paradox, as the financial system has been made more efficient and stable in normal times; it is now also more prone to excessive instability in bad times. At the same time, the increased importance of the financial sector in the global economy means that the impact of financial instability on the real economy is also increased.

Pathways to catastrophic failure

All the trends mentioned above can be observed in the recent turmoil in financial markets. The subsequent liquidity freeze and broad-based asset records indicate that many existing risk models are inadequate, failing to reflect the dynamic complexity and unpredictable nature of financial crises. Statements to the effect that 10-standard deviation events were occurring several days in a row demonstrate the aspects of underlying distributions, which are still to be learned. It also tells about to "tail" events that refer to the extremes of a probability distribution.

An Urgent Requirement of New Ideology

Conventional wisdom emphasizes that in equal measure there are two components of risk, which are respectively likelihood and severity. This naturally drives risk ratings, prioritization and corrective actions focused on both prevention (i.e. reducing likelihood of the event) and mitigation (i.e. reducing severity of the event). Although changes in the financial markets, while providing many benefits, have also created new and unforeseen risks which may lead to exogenous shocks (such as geopolitical risk) or internal factors (such as speculative bubbles). Many of these risks are unpredictable, making prevention and mitigation impossible. It may not make sense to attempt to eliminate risks, which are hazardous but ultimately represent a source of opportunity; in spite of this, interpretation of the global financial system as flexible and resilient by improving early indicators, enforcing more stress testing, enhancing understanding of tail risk and implementing better contingency plan would be more effective.

Most importantly, strategies to deal with systemic financial risk must reflect the fundamental shift in the global financial system. There is considerable scope for increased public and private sector collaboration on stress testing, liquidity management, risk assessment and prevention. As an instance, formation of the Counterparty Risk Management Policy Group in the wake of the collapse of Long-term Capital Management has helped in reduction of risks stemming from hedge fund leverage.

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