The 2008–2009 Icelandic financial crisis illustrates how an interconnected global financial system can threaten the very existence of a small economy with an outsized financial sector. The crisis was triggered off by the collapse of all three of the country's major banks following their difficulties in refinancing their short-term debt. In late September 2008, the government stepped in and partly nationalised Glitnir, the third-largest bank. Having tried to bail out one bank, the government soon had to take care of the two others, Landsbanki and Kaupthing. Relative to the size of its economy, Iceland’s banking collapse was the largest suffered by any country in economic history.
The financial crisis had serious consequences for the Icelandic economy. The national currency fell sharply in value. Foreign currency transactions were suspended for weeks. The market capitalisation of the Icelandic stock exchange dropped by more than 90%. The nation's gross domestic product decreased by 5.5% in real terms in the first six months of 2009. The standard of living in the country came down dramatically.Looking back, the collapse of Iceland’s banks, was not a sudden development. After a set back in 2006, when the main banks struggled to finance themselves, the banks had been trying to shift to safer policies. The banks had attempted to attract foreign deposits to back their assets abroad. On the other hand, the central bank had been raising interest rates to try to cool the economy. In the end, however, thanks to the frozen credit markets, the banks were unable to roll over their debts.
Various factors contributed to Iceland’s fall. One of them was the monetary policy pursued by the country’s central bank. High interest rates encouraged domestic firms and households to borrow in foreign currency, and also attracted currency speculators. This brought large inflows of foreign currency, leading to sharp exchange rate increases, giving the Icelanders an illusion of wealth. The speculators and borrowers profited from the interest rate difference between Iceland and abroad as well as the exchange rate appreciation. All this fuelled both economic growth and inflation, prompting the central bank to raise interest rates further. The end result was a bubble caused by the interaction between domestic interest rates and foreign currency inflows.
Before the crisis, the Icelandic banks had foreign assets worth around 10 times the Icelandic GDP. This was a clear sign that the financial sector had assumed monumental proportions. Yet in normal circumstances, this was not a cause for worry. Indeed, the Icelandic banks were better capitalized and with a lower exposure to high risk assets than many of their European counterparts. But in this crisis, the strength of a bank's balance sheet was of little consequence. What mattered was the explicit or implicit guarantee provided by the state to the banks to back up their assets and provide liquidity. The size of the state relative to the size of the banks became the crucial factor. Going by this criterion, the government was in no position to guarantee the banks.
The Icelandic authorities failed to show leadership. They did not communicate appropriately with their international counterparts, leading to an atmosphere of mistrust. At the same time, Iceland failed to receive support from Britain when the Scandinavian nation badly needed the support. The UK authorities seemed to have overreacted, using antiterrorist laws to take over Icelandic assets, and causing the bankruptcy of the remaining Icelandic bank.
To conclude, the original cause of the Icelandic crisis was a combination of inappropriate monetary policy and an outsized banking system. Throughout 2008, the Icelandic currency had been falling due to the currency speculators running for shelter. But the extreme global financial uncertainty, the mishandling of the crisis by the Icelandic authorities and the overreaction of the UK authorities served as the tipping points. In conclusion, we must appreciate that Iceland was done in as much by its policy failures as by the interconnectedness of the global financial system.
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Showing posts with label The Global Financial System. Show all posts
Showing posts with label The Global Financial System. Show all posts
Saturday, 2 January 2010
Decoupling and recoupling
Britain was the colonial superpower of the world till the start of the 20th century. Following World War II, the US took over the global economic leadership. Japan and Germany became economically powerful as they became export powerhouses. Till about 30 years back, the G-7 countries (USA, Canada, Britain, France, Germany, Italy, Japan) dominated the global economic agenda. The developed countries did not really take the developing ones like India and China very seriously. These Asian giants were considered too poor and too insignificant and struggling to get their economies going. But since the late 1990s, China and India, thanks to economic liberalisation, have emerged as two of the most dynamic economies of the world. Many economists have argued that these emerging markets have grown to a point where they would more than compensate for any slowdown in western economies. This phenomenon has come to be called decoupling.
In the early months of the sub prime crisis, the champions of decoupling seemed to be winning the argument. China and India continued to grow smartly even as the economies of the Western nations went from bad to worse. In the initial stages, the capital flows to the emerging economies actually increased. In the case of India, for example, the net FII flows during the five-month period from September 2007 to January 2008 was US$ 22.5 billion as against an inflow of US$ 11.8 billion during April-July 2007, the four months prior to the onset of the crisis.
But as the crisis deepened in 2008, it became clear that emerging economies could not be completely insulated from the current financial crisis. There was a reversal of portfolio flows due to unwinding of stock positions by FIIs to replenish cash balances abroad. Withdrawal of FII investment led to a stock market crash in many emerging economies and many currencies plunged against the US dollar. In the case of India, the extent of reversal of capital flows was $ 15.8 billion during the five month period February-June, 2008.
The situation worsened, following the collapse of Lehman Brothers in mid-September 2008. The Lehman bankruptcy combined with the fall of Fannie Mae, Freddie Mac and AIG created a crisis of confidence that led to the seizure of the interbank market. This had a trickle-down effect on trade financing in the emerging economies. Together with slackening global demand and declining commodity prices, it led to a fall in exports. Many South-East Asian countries that depended upon exports were severely affected. China’s GDP growth slowed down appreciably.
As the events unfolded, it became clear that India was far too integrated into the global economy. Export growth which had been robust till August 2008, became low in September and negative from October 2008 to March 2009. The sharp decline in growth to 5.8 per cent in the second half of 2008-09 from 7.8 per cent in the first half of 2008-09, seemed to support the recoupling perspective.
Meanwhile, the Indian financial markets were affected indirectly through the linkages with the global economy. The drying up of liquidity, caused by repatriation of portfolio investments by FIIs, affected credit markets in the second half of 2008-09. This was compounded by the “risk aversion” of banks to extend credit in the face of a general downturn. There was a contraction in reserve money by more than 15 per cent between August 2008 and November 2008. A series of unconventional measures by the Reserve Bank helped to push up the rate of growth of bank credit from 25.4 per cent in August 2008 to 26.9 per cent in November 2008. However, this only partly offset the impact on Indian companies due to the freezing of financial markets in the US and EU. The Indian IT industry went into a tailspin and employees became resigned to salary cuts and job losses, a dramatic change from the “red hot” labour markets of 2006 and 2007.
Other emerging markets also started facing a slow down. Dubai, the hub of the middle east, saw a major crash in the real estate markets and severe job cuts. This jewel of the middle east had to be “bailed out,” by the government of Abu Dhabi. Singapore, one of the major hubs of East Asia went through a severe recession.
As mentioned earlier, emerging economies also suffered in terms of foreign investment inflows due to a retreat to safety away from the emerging economies. In 2008, investors pulled out $67.2 billion for emerging market equity and bond funds, the worst since 1995. This represented more than 50% of the inflows of $130.5 billion into emerging markets between March 2003 and end of 2007.
Now as we approach the fall of 2009, many Asian economies seem to be rebounding smartly, through their growth alone may not be able to pull the global economy back on track. The rebound of the Asian economies has been aided by a turnaround in manufacturing, return of normalcy to trade finance and a huge fiscal stimulus. Many Asian economies entered the downturn with healthy government finances. Hence they have been able to inject a fiscal stimulus easily. Despite this impressive growth, The Economist[August 15, 2009.]sounded a word of caution: “But it would be a big mistake if Asia’s recovery led its politicians to conclude that there was no need to change their exchange rate policies or adopt structured reforms to boost consumption.” China for example, despite its impressive growth does not yet have a deep, well functioning financial system. The difficulties faced by Chinese leaders in stimulating domestic demand, have been partly due to the inadequacies of the country’s financial sector.
In the early months of the sub prime crisis, the champions of decoupling seemed to be winning the argument. China and India continued to grow smartly even as the economies of the Western nations went from bad to worse. In the initial stages, the capital flows to the emerging economies actually increased. In the case of India, for example, the net FII flows during the five-month period from September 2007 to January 2008 was US$ 22.5 billion as against an inflow of US$ 11.8 billion during April-July 2007, the four months prior to the onset of the crisis.
But as the crisis deepened in 2008, it became clear that emerging economies could not be completely insulated from the current financial crisis. There was a reversal of portfolio flows due to unwinding of stock positions by FIIs to replenish cash balances abroad. Withdrawal of FII investment led to a stock market crash in many emerging economies and many currencies plunged against the US dollar. In the case of India, the extent of reversal of capital flows was $ 15.8 billion during the five month period February-June, 2008.
The situation worsened, following the collapse of Lehman Brothers in mid-September 2008. The Lehman bankruptcy combined with the fall of Fannie Mae, Freddie Mac and AIG created a crisis of confidence that led to the seizure of the interbank market. This had a trickle-down effect on trade financing in the emerging economies. Together with slackening global demand and declining commodity prices, it led to a fall in exports. Many South-East Asian countries that depended upon exports were severely affected. China’s GDP growth slowed down appreciably.
As the events unfolded, it became clear that India was far too integrated into the global economy. Export growth which had been robust till August 2008, became low in September and negative from October 2008 to March 2009. The sharp decline in growth to 5.8 per cent in the second half of 2008-09 from 7.8 per cent in the first half of 2008-09, seemed to support the recoupling perspective.
Meanwhile, the Indian financial markets were affected indirectly through the linkages with the global economy. The drying up of liquidity, caused by repatriation of portfolio investments by FIIs, affected credit markets in the second half of 2008-09. This was compounded by the “risk aversion” of banks to extend credit in the face of a general downturn. There was a contraction in reserve money by more than 15 per cent between August 2008 and November 2008. A series of unconventional measures by the Reserve Bank helped to push up the rate of growth of bank credit from 25.4 per cent in August 2008 to 26.9 per cent in November 2008. However, this only partly offset the impact on Indian companies due to the freezing of financial markets in the US and EU. The Indian IT industry went into a tailspin and employees became resigned to salary cuts and job losses, a dramatic change from the “red hot” labour markets of 2006 and 2007.
Other emerging markets also started facing a slow down. Dubai, the hub of the middle east, saw a major crash in the real estate markets and severe job cuts. This jewel of the middle east had to be “bailed out,” by the government of Abu Dhabi. Singapore, one of the major hubs of East Asia went through a severe recession.
As mentioned earlier, emerging economies also suffered in terms of foreign investment inflows due to a retreat to safety away from the emerging economies. In 2008, investors pulled out $67.2 billion for emerging market equity and bond funds, the worst since 1995. This represented more than 50% of the inflows of $130.5 billion into emerging markets between March 2003 and end of 2007.
Now as we approach the fall of 2009, many Asian economies seem to be rebounding smartly, through their growth alone may not be able to pull the global economy back on track. The rebound of the Asian economies has been aided by a turnaround in manufacturing, return of normalcy to trade finance and a huge fiscal stimulus. Many Asian economies entered the downturn with healthy government finances. Hence they have been able to inject a fiscal stimulus easily. Despite this impressive growth, The Economist[August 15, 2009.]sounded a word of caution: “But it would be a big mistake if Asia’s recovery led its politicians to conclude that there was no need to change their exchange rate policies or adopt structured reforms to boost consumption.” China for example, despite its impressive growth does not yet have a deep, well functioning financial system. The difficulties faced by Chinese leaders in stimulating domestic demand, have been partly due to the inadequacies of the country’s financial sector.
The global economic imbalances and the sub prime crisis
At the heart of the sub prime crisis lies the huge global economic imbalances that have developed in recent years. In the past decade, emerging markets have grown impressively by exporting to the western countries especially the US in a big way. As Raghuram Rajan[Federal Reserve Bank Of St. Louis Review September/October, Part 1 2009. pp. 397-402.]mentions, this was a response to a wave of crises that swept through the emerging markets in the late 1990s. East Asia, Russia, Argentina, Brazil, and Turkey all went through turmoil during the 1997-98 currency crisis. As a result, these countries became far more circumspect about borrowing from abroad to finance domestic demand. They cut back on investment and reduced consumption. Formerly net absorbers of financial capital from the rest of the world, many of these countries started to record trade surpluses and became net exporters of financial capital.
Many of these emerging markets were also characterised by high savings rates. In mid-2008, emerging-economy central banks held over $5 trillion in reserves, a five fold increase from 2000. The large savings surplus in these economies caused a flood of capital to America. These surplus funds had to go somewhere. Bulk of these funds were parked in safe government securities in the US. This flood of capital helped in pushing long-term interest rates down.
In a speech in Beijing on December 9, 2008, Lorenzo Bini Smaghi of the European Central Bank explained how a marked asymmetry in the global financial system aggravated the economic imbalances. In the developed countries, rapid financial innovation and sophisticated financial products encouraged easy financing and consequently indebtedness. On the other hand, relatively rudimentary financial systems in the emerging markets encouraged the recycling of current account surpluses and savings into developed countries, especially the US to fund their growing deficits. At the same time, economies like India and China “managed” their currency even as many western countries had floated their currencies. To manage their currencies, the emerging markets were compelled to buy dollars and dollar denominated assets. If they did not do so, their currencies would have appreciated, making exports more difficult. These countries also made significant purchases of paper issued by government sponsored enterprises like Fannie Mae and Freddie Mac.
At the same time, the rise of China and India not only made many products cheaper but also added vast pools of cheap and skilled labour to the global economy. So inflationary pressures remained low, enabling the Fed to manage the economy with low interest rates. The Fed’s simple argument was: Why raise interest rates and thereby threaten the growth prospects of an impressively performing economy when inflation is under control?
Low interest rates, while good for economic growth, also created a bubble in the real estate market. They spurred off an unprecedented demand for homes and home loans. Raghuram Rajan has explained how the surplus capital might have landed in the real estate sector. Corporations in the US and industrialized countries initially absorbed the savings of emerging markets by expanding investment, in areas such as information technology. But this proved unsustainable. The investment was cut back sharply after the collapse of the information technology bubble. And as monetary policy continued to be accommodative, these funds moved into interest sensitive sectors such as automobiles and housing. This triggered off a housing boom.
But the housing boom had to collapse at same point of time. And only when it collapsed, did policy makers begin to appreciate the true significance of the global economic imbalances. Indeed, the sub prime crisis can be viewed as the consequence of the disorderly, unwinding of the economic imbalances that had accumulated in the global financial system over time. The disorderly adjustments have thrown the system out of balance. There has been a sudden escalation in risk aversion even as there have been corrections in prices of real estate, oil, various financial assets. There have also been sharp reversals in the direction of capital flows and exchange rates movements. The net consequence is that the global GDP growth has come down sharply.
Tackling the global imbalances will require a complete change in the mindset of the countries involved. And by no stretch of imagination, will it be an easy task. In mid August, 2009, a leading US Economic policy spokesman, Larry Summers called for a shift in the US economy from a consumption based one to an export oriented one. At the same time, American politicians have been putting pressure on China to revalue its currency, thereby reducing exports and increasing domestic consumption. Many commentators have argued that China’s high savings – high investment economy (at the cost of consumption) is destabilizing for the world economy. Some progress has already been made since the onset of the financial crisis. The US trade deficit has already come down from 6% of GDP at the peak to about 3% currently. At the same time China’s current account surplus has shrunk from 11% of GDP to about 9.8%. But there is no guarantee that this trend will continue unless the US can tackle its huge budget deficit. At the G-20 meeting at Pittsburgh in September 2009, a lot of time was devoted to the issue of achieving balanced, higher global GDP growth.
Many of these emerging markets were also characterised by high savings rates. In mid-2008, emerging-economy central banks held over $5 trillion in reserves, a five fold increase from 2000. The large savings surplus in these economies caused a flood of capital to America. These surplus funds had to go somewhere. Bulk of these funds were parked in safe government securities in the US. This flood of capital helped in pushing long-term interest rates down.
In a speech in Beijing on December 9, 2008, Lorenzo Bini Smaghi of the European Central Bank explained how a marked asymmetry in the global financial system aggravated the economic imbalances. In the developed countries, rapid financial innovation and sophisticated financial products encouraged easy financing and consequently indebtedness. On the other hand, relatively rudimentary financial systems in the emerging markets encouraged the recycling of current account surpluses and savings into developed countries, especially the US to fund their growing deficits. At the same time, economies like India and China “managed” their currency even as many western countries had floated their currencies. To manage their currencies, the emerging markets were compelled to buy dollars and dollar denominated assets. If they did not do so, their currencies would have appreciated, making exports more difficult. These countries also made significant purchases of paper issued by government sponsored enterprises like Fannie Mae and Freddie Mac.
At the same time, the rise of China and India not only made many products cheaper but also added vast pools of cheap and skilled labour to the global economy. So inflationary pressures remained low, enabling the Fed to manage the economy with low interest rates. The Fed’s simple argument was: Why raise interest rates and thereby threaten the growth prospects of an impressively performing economy when inflation is under control?
Low interest rates, while good for economic growth, also created a bubble in the real estate market. They spurred off an unprecedented demand for homes and home loans. Raghuram Rajan has explained how the surplus capital might have landed in the real estate sector. Corporations in the US and industrialized countries initially absorbed the savings of emerging markets by expanding investment, in areas such as information technology. But this proved unsustainable. The investment was cut back sharply after the collapse of the information technology bubble. And as monetary policy continued to be accommodative, these funds moved into interest sensitive sectors such as automobiles and housing. This triggered off a housing boom.
But the housing boom had to collapse at same point of time. And only when it collapsed, did policy makers begin to appreciate the true significance of the global economic imbalances. Indeed, the sub prime crisis can be viewed as the consequence of the disorderly, unwinding of the economic imbalances that had accumulated in the global financial system over time. The disorderly adjustments have thrown the system out of balance. There has been a sudden escalation in risk aversion even as there have been corrections in prices of real estate, oil, various financial assets. There have also been sharp reversals in the direction of capital flows and exchange rates movements. The net consequence is that the global GDP growth has come down sharply.
Tackling the global imbalances will require a complete change in the mindset of the countries involved. And by no stretch of imagination, will it be an easy task. In mid August, 2009, a leading US Economic policy spokesman, Larry Summers called for a shift in the US economy from a consumption based one to an export oriented one. At the same time, American politicians have been putting pressure on China to revalue its currency, thereby reducing exports and increasing domestic consumption. Many commentators have argued that China’s high savings – high investment economy (at the cost of consumption) is destabilizing for the world economy. Some progress has already been made since the onset of the financial crisis. The US trade deficit has already come down from 6% of GDP at the peak to about 3% currently. At the same time China’s current account surplus has shrunk from 11% of GDP to about 9.8%. But there is no guarantee that this trend will continue unless the US can tackle its huge budget deficit. At the G-20 meeting at Pittsburgh in September 2009, a lot of time was devoted to the issue of achieving balanced, higher global GDP growth.
Deregulation and innovation and the sub prime crisis
Rapid deregulation and financial innovation combined to set the stage for the sub prime crisis. This blog provides a brief hsitorical perspective.
After the economic turmoil of the 1970s, the market economy found passionate champions in Ronald Reagan and Margaret Thatcher. Believing that freer markets would bring economic gains, they took the plunge and abolished various controls. Both Reagan and Thatcher had a lot of fan following. And they commanded respect in many countries. Liberalisation of the financial system soon became a major theme in many developed countries.
In London, the Big Bang of 1986 abolished the distinction between brokers and jobbers and allowed foreign firms, with more capital, into the market. These firms could handle larger transactions, more cheaply. The Big Bang undoubtedly played a big role in the emergence of London as a preeminent global financial centre. Meanwhile, the No.1 financial centre in the world, New York had already introduced a similar reform in 1975, following pressure from institutional investors.
These reforms had major implications for the business models of market participants. The fall in commissions contributed to the long-term decline of broking as a source of revenue. The effect was disguised for a while by a higher volume of transactions. But the broker-dealers (the then popular name for investment bankers) increasingly had to commit their own capital to deals. In turn, this made trading on their own account, or proprietary trading, a potentially attractive source of revenue. No bank made more impressive strides in this area, than Goldman Sachs.
Meanwhile, commercial banks faced intense competition in corporate lending. At the same time, retail banking required expensive branch networks. Naturally, commercial banks wanted to diversify into more lucrative “fee based” businesses. With their strong balance-sheets, they started to compete with investment banks for the underwriting of securities. Investment banks responded by getting bigger. As banks became more diversified, they also became more complex.
As the same time, there were major advances in risk management thanks to innovative financial instruments and sophisticated quantitative techniques. Option contracts have been known since ancient times but the 1970s saw an explosion in their use. The development of the Black Scholes Merton Option Pricing Model, for which Myron Scholes and Robert Merton later won the Nobel Prize, no doubt played an important role. While Black Scholes enabled options trading to take off, other derivatives also became rapidly popular. Currency swaps and interest-rate swaps enabled hedging and speculation in currency and interest rate risk respectively. More recently, credit derivatives have made possible the slicing and dicing of credit risk in ways which would have been unimaginable about 40 years back.
The concept of securitisation rapidly became popular. Securitisation was projected as a mechanism for spreading risk and creating new growth opportunities for banks by freeing up capital. Commercial banks did not have to depend on the slow and costly business of attracting retail deposits to fund their transactions. Of course, securitisation was also misused by some market participants. That is how the sub prime crisis was fuelled.
As deregulation gathered momentum, the global financial system faced crises from time to time. These included the failures of Drexel Burnham Lambert, which dominated the junk-bond market and the collapse of Barings. But these crises were regarded as individual instances of mismanagement or fraud, rather than evidence of any systemic problem. The American savings-and-loan crisis, (mentioned earlier) which was a systemic failure was resolved with the help of a bail-out plan and easy monetary policy, and dismissed as an aberration. Even the Long Term Capital Management crisis of 1998 did not create any serious problems. A Fed sponsored bailout ensured that the markets continued to function normally.
But the recent financial meltdown has resulted in a lot of soul searching about the merits of aggressive deregulation. The melt down has been unprecedented in terms of magnitude and impact. The long drawn out crisis is a reflection of how complex and inter connected the world of finance has become. An array of financial instruments has emerged that make it possible to bundle, unbundle and rebundle risk in various ways. Deregulation, technology and globalization have transformed the world of finance beyond recognition. At the end of 2007, the notional value of all derivative contracts globally was estimated at $600 trillion or 11 times the world GDP. Ten years back, it had been $75 trillion or 2.5 times the world GDP.
Clearly, finance has grown much more rapidly than the underlying, “real” economy. That probably explains why regulation has become so difficult.
After the economic turmoil of the 1970s, the market economy found passionate champions in Ronald Reagan and Margaret Thatcher. Believing that freer markets would bring economic gains, they took the plunge and abolished various controls. Both Reagan and Thatcher had a lot of fan following. And they commanded respect in many countries. Liberalisation of the financial system soon became a major theme in many developed countries.
In London, the Big Bang of 1986 abolished the distinction between brokers and jobbers and allowed foreign firms, with more capital, into the market. These firms could handle larger transactions, more cheaply. The Big Bang undoubtedly played a big role in the emergence of London as a preeminent global financial centre. Meanwhile, the No.1 financial centre in the world, New York had already introduced a similar reform in 1975, following pressure from institutional investors.
These reforms had major implications for the business models of market participants. The fall in commissions contributed to the long-term decline of broking as a source of revenue. The effect was disguised for a while by a higher volume of transactions. But the broker-dealers (the then popular name for investment bankers) increasingly had to commit their own capital to deals. In turn, this made trading on their own account, or proprietary trading, a potentially attractive source of revenue. No bank made more impressive strides in this area, than Goldman Sachs.
Meanwhile, commercial banks faced intense competition in corporate lending. At the same time, retail banking required expensive branch networks. Naturally, commercial banks wanted to diversify into more lucrative “fee based” businesses. With their strong balance-sheets, they started to compete with investment banks for the underwriting of securities. Investment banks responded by getting bigger. As banks became more diversified, they also became more complex.
As the same time, there were major advances in risk management thanks to innovative financial instruments and sophisticated quantitative techniques. Option contracts have been known since ancient times but the 1970s saw an explosion in their use. The development of the Black Scholes Merton Option Pricing Model, for which Myron Scholes and Robert Merton later won the Nobel Prize, no doubt played an important role. While Black Scholes enabled options trading to take off, other derivatives also became rapidly popular. Currency swaps and interest-rate swaps enabled hedging and speculation in currency and interest rate risk respectively. More recently, credit derivatives have made possible the slicing and dicing of credit risk in ways which would have been unimaginable about 40 years back.
The concept of securitisation rapidly became popular. Securitisation was projected as a mechanism for spreading risk and creating new growth opportunities for banks by freeing up capital. Commercial banks did not have to depend on the slow and costly business of attracting retail deposits to fund their transactions. Of course, securitisation was also misused by some market participants. That is how the sub prime crisis was fuelled.
As deregulation gathered momentum, the global financial system faced crises from time to time. These included the failures of Drexel Burnham Lambert, which dominated the junk-bond market and the collapse of Barings. But these crises were regarded as individual instances of mismanagement or fraud, rather than evidence of any systemic problem. The American savings-and-loan crisis, (mentioned earlier) which was a systemic failure was resolved with the help of a bail-out plan and easy monetary policy, and dismissed as an aberration. Even the Long Term Capital Management crisis of 1998 did not create any serious problems. A Fed sponsored bailout ensured that the markets continued to function normally.
But the recent financial meltdown has resulted in a lot of soul searching about the merits of aggressive deregulation. The melt down has been unprecedented in terms of magnitude and impact. The long drawn out crisis is a reflection of how complex and inter connected the world of finance has become. An array of financial instruments has emerged that make it possible to bundle, unbundle and rebundle risk in various ways. Deregulation, technology and globalization have transformed the world of finance beyond recognition. At the end of 2007, the notional value of all derivative contracts globally was estimated at $600 trillion or 11 times the world GDP. Ten years back, it had been $75 trillion or 2.5 times the world GDP.
Clearly, finance has grown much more rapidly than the underlying, “real” economy. That probably explains why regulation has become so difficult.
Wednesday, 30 December 2009
The future of derivatives
Derivatives have often been held responsible for various market breakdowns in the past. The sub prime crisis is no exception. At the heart of the current financial crisis have been OTC derivatives, especially Credit Default Swaps (CDS). The CDS market had grown to $62 trillion in notional value by early 2008. To put this figure in perspective, the size of the global economy in 2008 was approximately $55 trillion! It is because of the huge volumes of CDS transactions that insurance giant AIG had entered into, that the US Treasury had no option but to intervene and bail out the insurance giant. If AIG had collapsed resulting in the dishonor of many CDS contracts, these would have been mayhem all around. Similarly Bear Stearns was so deeply entangled in the CDS market that regulators feared its collapse would lead to chaos. That is why it was bailed out in early 2008.
It is because of such concerns that regulators and the industry body, International Swaps and Derivatives Association (ISDA) have had to intervene. And there are some indications that the CDS market has started to cool down. After growing 100 fold from the middle of 2001 to the end of 2007, to a value of $62 trillion, in the first half of 2008, the value of outstanding CDS positions has declined significantly. The decline has been facilitated by netting out trades that offset each other. The next step being discussed is central clearing of OTC trades.
Despite the problems arising out of the indiscriminate use of CDS, one can hardly imagine a world without derivatives. Just because a few players used derivatives indiscriminately is hardly a reason for banning the use of derivatives. Instead what we need are better mechanisms for reducing counterparty and settlement risk. To address the current concerns in the CDS market, some 17 large dealers have come together to launch a clearing house for credit derivatives. A central counterparty backed by a default fund would greatly reduce the probability of the system becoming unstable due to any one player’s failure. Exchange based arrangements may also over time deal with other challenges such as a more precise definition of credit events. More recently, the US Treasury has come out with new guidelines that would call for better disclosure of derivative trades and capital backing and a shift from OTC trades to exchange trades wherever possible.
It is because of such concerns that regulators and the industry body, International Swaps and Derivatives Association (ISDA) have had to intervene. And there are some indications that the CDS market has started to cool down. After growing 100 fold from the middle of 2001 to the end of 2007, to a value of $62 trillion, in the first half of 2008, the value of outstanding CDS positions has declined significantly. The decline has been facilitated by netting out trades that offset each other. The next step being discussed is central clearing of OTC trades.
Despite the problems arising out of the indiscriminate use of CDS, one can hardly imagine a world without derivatives. Just because a few players used derivatives indiscriminately is hardly a reason for banning the use of derivatives. Instead what we need are better mechanisms for reducing counterparty and settlement risk. To address the current concerns in the CDS market, some 17 large dealers have come together to launch a clearing house for credit derivatives. A central counterparty backed by a default fund would greatly reduce the probability of the system becoming unstable due to any one player’s failure. Exchange based arrangements may also over time deal with other challenges such as a more precise definition of credit events. More recently, the US Treasury has come out with new guidelines that would call for better disclosure of derivative trades and capital backing and a shift from OTC trades to exchange trades wherever possible.
Lessons from past financial crises
Here are some useful lessons as captured by Derivatives Guru, John Hull.
Companies and banks must define clearly the limits to the financial risks that can be assumed.
Violations of risk limits must be sternly dealt with.
Even successful traders must be monitored carefully. Luck rather than superior trading skills often explain the success of traders. “Star” traders should not enjoy immunity from audit checks by risk managers.
Diversification benefits should not be over estimated. Concentration risk must be managed carefully.
Scenario analyses and stress testing must back risk measures such as value-at-risk. It is important to think outside the box and consider extreme situations. As Nicholas Nassem Taleb would say, just because we have never seen a black swan, it does not imply that one does not exist.
Models should not be blindly trusted. If large profits result from relatively simple trading strategies, risk managers should become suspicious. Maybe, the profits are being measured in the wrong way.
Getting too much trading business of one type, warrants as much critical examination as getting too little of these businesses.
Traders should not be allowed to book inception profits , i.e., profits at the start of a trade, by marking-to-model. By recognizing inception profits slowly, a longer term, more mature orientation can be inculcated among traders.
Banks must sell clients products that are appropriate for them. Before the sub prime crisis, many wealth management clients seem to have been been sold complex products whose risks they did not fully appreciate.
The possibility of liquidity black holes must not be underestimated. Liquidity problems can crop up more frequently than what models would seem to suggest. Less actively traded instruments will not always sell at close to the theoretical price, as predicted by models. When many market participants are following the same strategy, there might be big market moves leading to a liquidity crisis. So liquidity and market risks should be examined together.
Top management should not approve a trading strategy that they do not fully understand. Otherwise, traders are quite likely to take advantage of the situation.
Caution should be exercised before turning the treasury department of a company into a profit centre. The treasury can become a profit centre only by taking more risk. This implies that hedging will inevitably move towards speculation.
Companies and banks must define clearly the limits to the financial risks that can be assumed.
Violations of risk limits must be sternly dealt with.
Even successful traders must be monitored carefully. Luck rather than superior trading skills often explain the success of traders. “Star” traders should not enjoy immunity from audit checks by risk managers.
Diversification benefits should not be over estimated. Concentration risk must be managed carefully.
Scenario analyses and stress testing must back risk measures such as value-at-risk. It is important to think outside the box and consider extreme situations. As Nicholas Nassem Taleb would say, just because we have never seen a black swan, it does not imply that one does not exist.
Models should not be blindly trusted. If large profits result from relatively simple trading strategies, risk managers should become suspicious. Maybe, the profits are being measured in the wrong way.
Getting too much trading business of one type, warrants as much critical examination as getting too little of these businesses.
Traders should not be allowed to book inception profits , i.e., profits at the start of a trade, by marking-to-model. By recognizing inception profits slowly, a longer term, more mature orientation can be inculcated among traders.
Banks must sell clients products that are appropriate for them. Before the sub prime crisis, many wealth management clients seem to have been been sold complex products whose risks they did not fully appreciate.
The possibility of liquidity black holes must not be underestimated. Liquidity problems can crop up more frequently than what models would seem to suggest. Less actively traded instruments will not always sell at close to the theoretical price, as predicted by models. When many market participants are following the same strategy, there might be big market moves leading to a liquidity crisis. So liquidity and market risks should be examined together.
Top management should not approve a trading strategy that they do not fully understand. Otherwise, traders are quite likely to take advantage of the situation.
Caution should be exercised before turning the treasury department of a company into a profit centre. The treasury can become a profit centre only by taking more risk. This implies that hedging will inevitably move towards speculation.
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