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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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.
Towards integrated risk management: the three ways of managing risk
In a world of risk, it is important not only for banks but also for non banking corporations to manage risks strategically and holistically. Integrated risk management is all about the identification and assessment of the risks faced by a company as a whole, followed by the formulation and implementation of a companywide strategy to manage them. According to Lisa Melbroek[[“Integrated Risk Management for the firm: A senior Manager’s Guide,” Working Paper, Harvard Business School, 2002] companies must learn to use the best combination of three complementary approaches to risk management.
v The first is to modify the company's operations suitably.
v The second is to reduce debt in the capital structure.
v The third is to use insurance or financial instruments like derivatives to transfer the risk.
Take the case of the environmental risk that a heavy chemicals manufacturer faces. Modifying the company's operations could mean installation of sophisticated pollution control equipment. The company could also reduce debt and keep plenty of capital to deal with any contingencies arising out of environmental mishaps. The company can also achieve risk transfer by buying an insurance policy that would protect it in case an accident occurs.
An oil company needs a steady supply of petroleum crude to feed its refinery. Oil prices can fluctuate, owing to various social, economic and political factors. Indeed, they have done so in recent months. The company can set up, or at least tie up, with a large number of oilfields all over the world to insulate itself from volatility. This would limit the damage due to Opec actions, terrorist strikes or instability in Islamic countries. In case of a long recession, the best bet for a company would be to keep minimum debt and maintain huge cash reserves. The company may also resort to buying oil futures contracts that guarantee the supply of crude at predetermined prices.
A company like Walt Disney, which operates theme parks, is exposed to weather risks. If the weather is not sunny, people will not turn up. So, Disney took a decision to set up its second theme park in Florida. Today, the company can buy weather derivatives or an insurance policy to hedge the risks arising from inclement weather.
A similar argument may well apply to the Board of Control for Cricket in India (BCCI). These days, with big money involved, especially in the form of television rights, cricket matches are scheduled all through the year. So the threat of rain is real. If a match is washed off, the losses will be heavy. BCCI has two options. It can stick to the cities where there is little rain. In the long run, it can even explore the possibility of indoor stadia. This is the operational solution. Alternatively, BCCI can take insurance cover. This is the risk transfer approach.
The software giant, Microsoft, operates in an industry where technology risks are high. The company manages risk by maintaining low overheads and zero debt. But Microsoft also has organisational mechanisms to deal with risk. The capacity of a software company is effectively the number of software engineers on its payroll. Excess capacity can create serious problems during a downturn. Right from the beginning, Microsoft’s founder, Bill Gates was particular about not employing more persons than required. So, Microsoft has always maintained lean staffing, depending on temporary workers to deal with surges in workload from time to time. This not only reduces the risk associated with economic slowdowns but also results in greater job security for its most talented workers. In contrast, many Indian software services companies have traditionally maintained a huge “bench.” This has become a major liability during the current downturn.
India’s well known software services company, Infosys maintains plenty of cash. Infosys believes cash gives a lot of comfort in a volatile industry, characterised by swift changes in technology, and shifts in client spending patterns. To sustain operations under adverse conditions, and make investments in marketing and R&D, Infosys depends heavily on equity and keeps little debt on its balance sheet.
Airlines can manage their exposure to fluctuating oil prices by taking operational measures to cut fuel consumption. This might involve better maintenance of the air craft or purchase of more fuel-efficient engines. Another option is to buy financial instruments such as futures to hedge this risk. This is the risk transfer approach.
Various factors determine the choice of the approach to handling risk. Often a combination of these approaches makes sense. The choice between a financial and organisational solution varies from risk to risk. As we briefly mentioned earlier, strategic risks, which are core to the business and are critical to the generation of shareholder value have to be retained. So they invariably need organisational solutions. Where suitable financial instruments do not exist for risk transfer, organizational solutions may be unavoidable. In the case of some risks, organisational solutions may be too complicated, too expensive or may conflict with the company's strategic goals. In such situations, risk transfer solutions such as derivatives or insurance may be more efficient than organisational solutions.
The ultimate strategy for the rainy day is to keep overheads and debt low and hold plenty of cash to tide over uncertainties about which managers have little idea today. Indeed, equity is an all-purpose risk cushion. The larger the amount of risk that cannot be accurately measured or quantified, the more the equity component should be. It is no surprise that technology companies like Microsoft and Infosys keep little or no debt on the balance-sheet. Of course, equity is a more expensive source of funds. Equity holders expect a much higher rate of return, compared to debt providers. But that might well be a small price to pay in a volatile business environment. During a severe downturn, a comfortable capital position can give a company a major competitive advantage by allowing it to pursue an acquisition or a major investment that might well have had to be postponed otherwise.
v The first is to modify the company's operations suitably.
v The second is to reduce debt in the capital structure.
v The third is to use insurance or financial instruments like derivatives to transfer the risk.
Take the case of the environmental risk that a heavy chemicals manufacturer faces. Modifying the company's operations could mean installation of sophisticated pollution control equipment. The company could also reduce debt and keep plenty of capital to deal with any contingencies arising out of environmental mishaps. The company can also achieve risk transfer by buying an insurance policy that would protect it in case an accident occurs.
An oil company needs a steady supply of petroleum crude to feed its refinery. Oil prices can fluctuate, owing to various social, economic and political factors. Indeed, they have done so in recent months. The company can set up, or at least tie up, with a large number of oilfields all over the world to insulate itself from volatility. This would limit the damage due to Opec actions, terrorist strikes or instability in Islamic countries. In case of a long recession, the best bet for a company would be to keep minimum debt and maintain huge cash reserves. The company may also resort to buying oil futures contracts that guarantee the supply of crude at predetermined prices.
A company like Walt Disney, which operates theme parks, is exposed to weather risks. If the weather is not sunny, people will not turn up. So, Disney took a decision to set up its second theme park in Florida. Today, the company can buy weather derivatives or an insurance policy to hedge the risks arising from inclement weather.
A similar argument may well apply to the Board of Control for Cricket in India (BCCI). These days, with big money involved, especially in the form of television rights, cricket matches are scheduled all through the year. So the threat of rain is real. If a match is washed off, the losses will be heavy. BCCI has two options. It can stick to the cities where there is little rain. In the long run, it can even explore the possibility of indoor stadia. This is the operational solution. Alternatively, BCCI can take insurance cover. This is the risk transfer approach.
The software giant, Microsoft, operates in an industry where technology risks are high. The company manages risk by maintaining low overheads and zero debt. But Microsoft also has organisational mechanisms to deal with risk. The capacity of a software company is effectively the number of software engineers on its payroll. Excess capacity can create serious problems during a downturn. Right from the beginning, Microsoft’s founder, Bill Gates was particular about not employing more persons than required. So, Microsoft has always maintained lean staffing, depending on temporary workers to deal with surges in workload from time to time. This not only reduces the risk associated with economic slowdowns but also results in greater job security for its most talented workers. In contrast, many Indian software services companies have traditionally maintained a huge “bench.” This has become a major liability during the current downturn.
India’s well known software services company, Infosys maintains plenty of cash. Infosys believes cash gives a lot of comfort in a volatile industry, characterised by swift changes in technology, and shifts in client spending patterns. To sustain operations under adverse conditions, and make investments in marketing and R&D, Infosys depends heavily on equity and keeps little debt on its balance sheet.
Airlines can manage their exposure to fluctuating oil prices by taking operational measures to cut fuel consumption. This might involve better maintenance of the air craft or purchase of more fuel-efficient engines. Another option is to buy financial instruments such as futures to hedge this risk. This is the risk transfer approach.
Various factors determine the choice of the approach to handling risk. Often a combination of these approaches makes sense. The choice between a financial and organisational solution varies from risk to risk. As we briefly mentioned earlier, strategic risks, which are core to the business and are critical to the generation of shareholder value have to be retained. So they invariably need organisational solutions. Where suitable financial instruments do not exist for risk transfer, organizational solutions may be unavoidable. In the case of some risks, organisational solutions may be too complicated, too expensive or may conflict with the company's strategic goals. In such situations, risk transfer solutions such as derivatives or insurance may be more efficient than organisational solutions.
The ultimate strategy for the rainy day is to keep overheads and debt low and hold plenty of cash to tide over uncertainties about which managers have little idea today. Indeed, equity is an all-purpose risk cushion. The larger the amount of risk that cannot be accurately measured or quantified, the more the equity component should be. It is no surprise that technology companies like Microsoft and Infosys keep little or no debt on the balance-sheet. Of course, equity is a more expensive source of funds. Equity holders expect a much higher rate of return, compared to debt providers. But that might well be a small price to pay in a volatile business environment. During a severe downturn, a comfortable capital position can give a company a major competitive advantage by allowing it to pursue an acquisition or a major investment that might well have had to be postponed otherwise.
The Sub prime crisis and Liquidity Risk
The sub prime crisis was as much about liquidity as about insolvency. Many banks suffered during the sub prime crisis because of a capital structure that relied too heavily on debt.
Markus Brunnermeir[1] points out that a loss spiral arises for leveraged investors because a decline in the value of assets erodes the investors’ net worth much faster than their gross worth. The amount that they can borrow falls sharply. For example, consider an investor with a leverage ratio of 1:10, who buys $100 million worth of assets on 10 percent margin. This investor finances only $10 million with his own capital and borrows $90 million. Say the value of the acquired asset declines temporarily to $95 million. The investor, who started out with $10 million in capital, now has lost $5 million. So there is only $5 million of capital remaining. To prevent the leverage ratio from going up, this investor must reduce the overall position to $50 million. In other words, $45 million of assets must be sold. And this sale will happen exactly when the price is low. These sales will depress the price further, inducing more selling and so on. This loss spiral will get aggravated if some other potential buyers with expertise may face similar constraints at the same time. The spiral will also get amplified if other potential buyers find it more profitable to wait out the loss spiral before reentering the market. Indeed, traders might even engage in “predatory trading,” deliberately forcing others to liquidate their positions at fire-sale prices.
The margin/haircut spiral reinforces the loss spiral. As margins or haircuts rise, the investor has to sell assets to reduce the leverage ratio. Margins and haircuts spike in times of large price drops, leading to a general tightening of lending. A vicious cycle emerges, where higher margins and haircuts force de-leveraging and more sales, which increase margins further and force more sales, leading to the possibility of multiple equilibria.
An increase in counterparty credit risk can create additional funding needs and potential systemic risk. Brunnermeir has illustrated this by an example related to the Bear Stearns crisis in March 2008. Imagine a hedge fund that had an interest rate swap agreement with Goldman Sachs. Say the hedge fund offset its obligation through another swap with Bear Stearns. In the absence of counterparty credit risk, the two swap agreements would together be viewed essentially as a single one between Goldman and Bear Stearns. However, it would be unwise for Goldman to renew the contract if it feared that Bear might default on its commitment. Goldman was asked to increase its direct exposure to Bear after the trading hours on March 11, 2008 when Bear was approaching bankruptcy. Goldman did renew the contract in the morning of March 12. But the delay in response was mistakenly interpreted as a hesitation on Goldman’s behalf and fear that Bear Stearns might be in trouble. This misinterpretation was leaked to the media and seems to have contributed to the run on Bear Stearns.
Indeed, an increase in perceived counterparty credit risk can be self-fulfilling and create additional funding needs. Suppose that Bear Stearns had an offsetting swap agreement with a private equity fund, which in turn offset its exposure with Goldman Sachs. All parties, taken together, are fully hedged. However, each party is aware only of its own contractual agreements. So it may not know the full situation and therefore become concerned about counterparty credit risk. If the investment banks refuse to let the hedge fund and private equity fund net their offsetting positions, both funds have to either put up additional liquidity, or insure each other against counterparty credit risk by buying credit default swaps. This happened in the week after Lehman’s bankruptcy. All major investment banks were worried that their counterparties might default. So they bought credit default swap protection against each other. The already high prices on credit default swaps of the major investment banks almost doubled. The price of credit default swaps for AIG was hit the worst. It more than doubled within two trading days. Such problems are more easily overcome if there is a central clearinghouse which knows who owes what to whom. Indeed, many economists have argued strongly in favour of moving away from OTC to central clearing arrangements for most if not all derivatives.
[1] “Deciphering the liquidity and credit crunch 2007-2008” Journal of Economic Perspectives, Winter 2009, pp. 77-100.
Markus Brunnermeir[1] points out that a loss spiral arises for leveraged investors because a decline in the value of assets erodes the investors’ net worth much faster than their gross worth. The amount that they can borrow falls sharply. For example, consider an investor with a leverage ratio of 1:10, who buys $100 million worth of assets on 10 percent margin. This investor finances only $10 million with his own capital and borrows $90 million. Say the value of the acquired asset declines temporarily to $95 million. The investor, who started out with $10 million in capital, now has lost $5 million. So there is only $5 million of capital remaining. To prevent the leverage ratio from going up, this investor must reduce the overall position to $50 million. In other words, $45 million of assets must be sold. And this sale will happen exactly when the price is low. These sales will depress the price further, inducing more selling and so on. This loss spiral will get aggravated if some other potential buyers with expertise may face similar constraints at the same time. The spiral will also get amplified if other potential buyers find it more profitable to wait out the loss spiral before reentering the market. Indeed, traders might even engage in “predatory trading,” deliberately forcing others to liquidate their positions at fire-sale prices.
The margin/haircut spiral reinforces the loss spiral. As margins or haircuts rise, the investor has to sell assets to reduce the leverage ratio. Margins and haircuts spike in times of large price drops, leading to a general tightening of lending. A vicious cycle emerges, where higher margins and haircuts force de-leveraging and more sales, which increase margins further and force more sales, leading to the possibility of multiple equilibria.
An increase in counterparty credit risk can create additional funding needs and potential systemic risk. Brunnermeir has illustrated this by an example related to the Bear Stearns crisis in March 2008. Imagine a hedge fund that had an interest rate swap agreement with Goldman Sachs. Say the hedge fund offset its obligation through another swap with Bear Stearns. In the absence of counterparty credit risk, the two swap agreements would together be viewed essentially as a single one between Goldman and Bear Stearns. However, it would be unwise for Goldman to renew the contract if it feared that Bear might default on its commitment. Goldman was asked to increase its direct exposure to Bear after the trading hours on March 11, 2008 when Bear was approaching bankruptcy. Goldman did renew the contract in the morning of March 12. But the delay in response was mistakenly interpreted as a hesitation on Goldman’s behalf and fear that Bear Stearns might be in trouble. This misinterpretation was leaked to the media and seems to have contributed to the run on Bear Stearns.
Indeed, an increase in perceived counterparty credit risk can be self-fulfilling and create additional funding needs. Suppose that Bear Stearns had an offsetting swap agreement with a private equity fund, which in turn offset its exposure with Goldman Sachs. All parties, taken together, are fully hedged. However, each party is aware only of its own contractual agreements. So it may not know the full situation and therefore become concerned about counterparty credit risk. If the investment banks refuse to let the hedge fund and private equity fund net their offsetting positions, both funds have to either put up additional liquidity, or insure each other against counterparty credit risk by buying credit default swaps. This happened in the week after Lehman’s bankruptcy. All major investment banks were worried that their counterparties might default. So they bought credit default swap protection against each other. The already high prices on credit default swaps of the major investment banks almost doubled. The price of credit default swaps for AIG was hit the worst. It more than doubled within two trading days. Such problems are more easily overcome if there is a central clearinghouse which knows who owes what to whom. Indeed, many economists have argued strongly in favour of moving away from OTC to central clearing arrangements for most if not all derivatives.
[1] “Deciphering the liquidity and credit crunch 2007-2008” Journal of Economic Perspectives, Winter 2009, pp. 77-100.
Liquidity Black Holes
The most severe liquidity crises occur when we have “liquidity black holes”. In a normal market, when prices fall, some people will want to buy. During a serious crisis, many people may want to sell simultaneously. A liquidity black hole results when virtually everyone wants to sell in a falling market.
The crash of October 1987, on the New York Stock Exchange is a good example. Many traders followed a strategy of selling immediately after a price decline and buying back immediately after a price increase. As a result of this strategy called portfolio insurance, the initial decline in prices fuelled off further rounds of price declines and the market plunged sharply. In fact, the market declined so fast and the stock exchange systems were so overloaded that many portfolio insurers were unable to execute the trades generated by their models.
Herd behaviour, which lies at the heart of liquidity black holes, can cause the market to move completely to one side. Hull[1] has listed some of the reasons for herd behaviour:
Different traders use similar computer models and as a result pursue the same strategy. This can create tremendous selling pressure at the same time.
Because they are regulated in the same way, banks respond to changes in volatilities and correlations in the same way.
People start imitating other traders thinking there “must be something in it.”
Let us understand briefly how a uniform regulatory environment, i.e., similar rules for all market participants, may accentuate a liquidity crisis. When volatility increases, value-at-risk (VaR) will increase. Consequently, all banks will be forced to increase their capital.
Alternatively, they will have to reduce their exposure in which case many banks will try to do similar sell trades. In both situations, liquidity needs will suddenly shoot up and a liquidity black hole may result.
For black holes not to happen, at least some of the market participants should pursue contrarian strategies. Investors can often do well by selling assets when most people are buying and by buying assets when most people are selling. One reason for Goldman Sachs’ seemingly smart recovery from the sub prime crisis in the early part of 2009, seems to be this kind of an approach.
Volatilities and correlations may increase but over time, they get pulled back to the long term average. As such, there is no need for long term investors to adjust their positions based on short term market fluctuations. One way forward is for regulators to apply different rules to asset managers and hedge funds. If regulations are different, there will be diversity in the thinking and strategies of different market participants. Consequently, there is less likelihood of black holes developing.
[1] Risk management and Financial Institutions
The crash of October 1987, on the New York Stock Exchange is a good example. Many traders followed a strategy of selling immediately after a price decline and buying back immediately after a price increase. As a result of this strategy called portfolio insurance, the initial decline in prices fuelled off further rounds of price declines and the market plunged sharply. In fact, the market declined so fast and the stock exchange systems were so overloaded that many portfolio insurers were unable to execute the trades generated by their models.
Herd behaviour, which lies at the heart of liquidity black holes, can cause the market to move completely to one side. Hull[1] has listed some of the reasons for herd behaviour:
Different traders use similar computer models and as a result pursue the same strategy. This can create tremendous selling pressure at the same time.
Because they are regulated in the same way, banks respond to changes in volatilities and correlations in the same way.
People start imitating other traders thinking there “must be something in it.”
Let us understand briefly how a uniform regulatory environment, i.e., similar rules for all market participants, may accentuate a liquidity crisis. When volatility increases, value-at-risk (VaR) will increase. Consequently, all banks will be forced to increase their capital.
Alternatively, they will have to reduce their exposure in which case many banks will try to do similar sell trades. In both situations, liquidity needs will suddenly shoot up and a liquidity black hole may result.
For black holes not to happen, at least some of the market participants should pursue contrarian strategies. Investors can often do well by selling assets when most people are buying and by buying assets when most people are selling. One reason for Goldman Sachs’ seemingly smart recovery from the sub prime crisis in the early part of 2009, seems to be this kind of an approach.
Volatilities and correlations may increase but over time, they get pulled back to the long term average. As such, there is no need for long term investors to adjust their positions based on short term market fluctuations. One way forward is for regulators to apply different rules to asset managers and hedge funds. If regulations are different, there will be diversity in the thinking and strategies of different market participants. Consequently, there is less likelihood of black holes developing.
[1] Risk management and Financial Institutions
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