Heresy in Financial Risk Management…

Following on from our previous post (“Fighting the Last War…”), we were prompted to write a further, related post after we came across the work of Jon Danielsson, an Icelandic economist, Reader in Finance at the LSE, and Director of its Systemic Risk Centre.

As we pointed out in “Fighting…”, the Fed (and other financial regulators) are still generally using the “GFC Playbook” to deal with financial crises, privatizing gains (for most), and socializing losses. Their aim, quite understandably and laudably, is to prevent systemic contagion and collapse, but the result is that moral hazard, hidden behind the protections of limited liability, always lurks in the undergrowth. The general absence of personal liability for the incompetent and avaricious tends to encourage risk- and rent-seeking behaviours, as the incentives of risk vs. reward are skewed.

Of course, it is easy to criticize those, such as financial regulators, who face a thankless task. However, as Danielsson has pointed out in his recent book “The Illusion of Control”, the characteristics of current financial regulation present some inherent problems in terms of effective risk management and mitigation.

As mentioned above, what the regulators truly care about is avoiding systemic contagion, which was obvious with the series of recent US bank failures, and with the forced acquisition of Credit Suisse by UBS. At the same, they do not wish to constrain the financial system to the extent that economic growth also becomes constrained because of a contraction in the availability of capital. To put it another way: effective risk management does not simply mean reducing risk; but rather it is supposed to be done in such a way that it avoids introducing further risk, or shifting its consequences elsewhere.

The paranoia which the GFC engendered created an ever more complicated framework which relies upon trying to quantify risk and then containing it through a prescriptive system of rules dependent upon those quantitative measurements, such as capital ratios, leverage, and liquidity. In themselves, these rules are a logical outcome. However, they are also backward looking. Danielsson makes that point that, in 2008, the ECB’s Composite Indicator of Systemic Stress (CISS) predicted a low probability of a crisis, only to predict a very high one after the GFC had waned.

One systemic irony is that, because banks are regulated individually, the focus is on ensuring that each component of the system is safe, in the expectation and hope that that will make the overall system safe. In essence, financial regulatory systems tend to encourage “herding” and conformity, which is all very well; but, in the absence of macroprudential regulation, the approach introduces an illusion of safety and resilience. If there are flaws or gaps in the prescriptive regulations, the whole system can be at risk. This is compounded by the fact that everyone is supposed to use the same methodologies in modelling risks (VaR, anyone?!). The GFC highlighted the dangers of that homogeneity.

A key point which Danielsson make is that financial regulation is endogenous: the mere fact of observing, measuring and then legislating for managing risk in a system actually affects those risks. If regulation is designed to encourage or discourage certain behaviours or risk selection, those regulated will act accordingly; and, at the same time, look for gaps that can be exploited.

The paradox is that, because system components are encouraged to act in similar ways, if there is a failure in the system, the consequences tend to be much more severe.

All this means that one should be very wary of accepting at face value the contention that, because everything appears to be stable and volatility is low, the system itself must be stable, and the risk of an adverse shock or failure is low. As the phrase from the iconic BBC TV series states: “It’s too quiet….”

A little heretical thinking can help prevent, or at least, minimize, the consequences of a flawed regulatory system, as it creates a healthy skepticism, which may enhance the possibility of avoiding becoming swept up in the general mayhem and uncertainties of a financial crisis.

The Awbury Team

Fighting the last war…

If it does, it was all your fault. Any credit underwriter can identify with that!

Yet the events do require a dispassionate look at whether bank regulators were, and are still fighting the proverbial last war, and need to adjust their perspective.

After all, the various reforms instituted after the Great Financial Crisis (GFC) – an episode which revealed how comprehensively banks had “gamed” the system- were intended to reduce the probability of a recurrence.

In 2023, that did not stop banks that were supposedly fully compliant at the point of failure, from having to be “put out of their misery” in a matter of days, if not hours, to prevent systemic contagion.

There are certainly differences between what lay behind what happened in the US, and in Switzerland. Nevertheless, each episode revealed that fractional reserve banking is inherently unstable, because the ability to continue to function depends upon retaining the confidence of both depositors and markets, as well as of regulators.

They also revealed that what one might call the “velocity of failure” and the possibility of a “gap to default” have increased substantially as the result of the speed of information flows and network effects. Bank depositors are supposed to be “information indifferent”. Clearly that is not the case.

So, if an architecture dependent upon regulators monitoring and adjusting minimum capital ratios, leverage caps and liquidity coverage ratios is insufficient in the “use cases” that actually matter, what then?

The underlying problem with all rules-based systems is that the entity intended to regulate them, while nominally having the power to act, is often resource-constrained; faced by managements which are not; and wary itself of sparking panic.

This creates the paradox that regulators (as the Federal Reserve has admitted in the case of the recent US bank collapses) could have acted, should have acted, but did not act until there was no realistic alternative but to seize the institutions involved.

In the case of Credit Suisse, FINMA (the actual regulator) seems to have felt constrained from acting until loss of confidence in the capacity and ability of the Bank’s management became self-fulfilling. The outcome (the hastily-enforced “merger” of Credit Suisse with UBS) has created a new paradox (and danger): what happens if the supposedly stable and Too Big To Fail (TBTF) merged entity becomes unstable, or loses the confidence of its depositors, customers and market counterparts?

It does not matter what the reality is of a bank’s solvency, asset quality and liquidity, but rather the external perception.

All of this argues not so much for more stringent regulatory capital and available liquidity requirements (although both might help), but rather for regulators having the courage (and ensuring that they have the unarguable authority) to act pre-emptively to stabilize or re-structure impaired banking entities.

Easy to say; hard to implement. Either way, it seems likely that there will be a period of regulatory introspection before it becomes clear what steps will be taken (yet again!) to mitigate the probability and scale of potentially catastrophic bank failures.

The Awbury Team