Spreading the muck

Spreading the muck
May 17th 2007 From The Economist print edition
Maria Jeeves
Is risk ending up in the right places?
“MONEY is like muck,” wrote Francis Bacon in 1625. “Not good except it be spread.” Today's pin-striped philosophers might swap the word “money” for “risk”. Hold credit risk too long, Wall Street wisdom has it, and it may eventually reek to high heaven. Spread it about, and a hundred flowers of finance will bloom.
It is at least 20 years since such theories began to take root in the world of banking, and there are good reasons why commercial banks that make loans, and investment banks that transform them into securities, have embraced them. Regulation allows banks to hold less capital if they lend to sound and diverse borrowers, so better to sell off the dodgier stuff if they can. The more of their lumpish loans that are converted into liquid securities, the higher the profits that accrue to the middlemen, the investment banks. And regulators too are happier if the banks whose depositors they are meant to be safeguarding have less toxic matter on their books.
But where does that risk end up? And might some of it be sitting undetected on the books of investment banks, the most complex institutions at the centre of the finely spun web of global finance? This survey has sought to test the nuts and bolts of their risk-management machinery to see how solid they are. What it has found is partially reassuring. The top firms trade in such a large number of products, markets and countries that they appear to be better cushioned than ever against problems arising in any one part of their business. Competition—whether caused by the demise of Glass-Steagall in America, the emergence of strong universal banks in Europe or boutique firms such as hedge funds poaching their best people—has sharpened their wits. They are taking more risk, but then risk is their business. Earnings and capital have risen even faster. And they are trying to expect the unexpected, aware of the inherent flaws in the models they use to measure their increasingly complex exposures.
Good times can't last for ever
But with money so cheap and liquidity so plentiful, the investment banks have inevitably become a little complacent. Their willingness to rush headlong into subprime mortgage lending in America is a case in point. As one European central banker puts it: “With all the sophistication of their risk-management systems, a whole series of the most powerful institutions in finance went ahead and made the classic errors of not watching credit quality and overshooting.” And their flair for creating complex instruments in which leverage and collateral are finely balanced may backfire on them—as well as on the industry at large—when big risks resurface and they rush for “safe haven” products. As the BIS's Mr Knight deftly puts it, the trouble with risk is that “now you see it, now you don't.”
Regulators also judge the soundness of the financial system in terms of the safety of individual banks. For all their misgivings, they generally applaud the improvements they have seen in investment banks and in risk management across the financial system as a whole.
But what of the end-users—the pension funds managing the accounts of individuals, who are often beyond the regulators' remit yet may be increasingly exposed to these tail risks? Are they expert enough to assess the soundness of the loans they invest in? Are they as savvy as banks, whose core business is managing risk, and which have close and possibly long-standing relationships with the borrowers?
Avinash Persaud, head of Intelligence Capital, a firm of financial advisers, and an expert on systemic risk, says a new culture has grown up in which risk has become a hot potato, to be passed on as rapidly as possible. Increasingly it is ending up in obscure and unregulated corners. The financial system, he says, has “become better at trading risk and pricing it, but maybe worse at holding it”. Pension funds, for example, currently have an appetite for company loans and bonds. Is that a good thing? Mr Persaud thinks not, because they are long-term investors—and the longer an investor holds a bond, the higher the chance that it will default. Neither should they go after liquid assets: most of their liabilities are long-term, and therefore better suited to higher-yielding illiquid ones.
He believes such concerns have become more serious now that pension providers and governments are increasingly transferring responsibility for risk-taking to individuals, through defined-contribution pension schemes rather than defined-benefit ones in which companies supposedly bear the risk. Jaime Caruana, head of capital markets at the International Monetary Fund, strikes a pessimistic note. “It is not easy to know where all the risks are distributed. But some of them are ending up with the consumer who is taking on the role of shock absorber of last resort. We need to increase his level of financial education so that the consumer better understands what he is taking on.”
When The Economist published a report similar to this one exactly 20 years ago, much of the argument concentrated on the risks posed by securitisation and the proliferation of new instruments, such as (back then) junk bonds and swaps. At the time, Alexandre Lamfalussy, one of Mr Knight's predecessors at the BIS, aired concerns that now sound eerily familiar. “It's not the risk to individual banks I'm worried about but macro-prudential risk...it is much harder to tell who is bearing what risk and where it is ending up.” He continued: “Transparency is diminishing. Some risk-takers simply do not know the risk.”
It is encouraging that in the intervening two decades, when the capital markets have increased hugely in size, scope and sophistication, only two big shocks, one in 1987 (proving Mr Lamfalussy right) and one in 1998, have put the system to the test. For much of that period the markets have enjoyed easy money and lashings of liquidity. When those halcyon days come to an end, it will be not just the bright young things in Wall Street and Canary Wharf who will feel the effects, but widows, orphans, pensioners and everybody else.