Implications of Credit Trading for the Risks of Banks - Additional Thoughts
After completing my previous post, I came across a speech by Timothy Geithner on Credit Market Innovations and Their Implications.
(http://www.newyorkfed.org/newsevents/speeches/2007/gei070323.html) He doesn’t come to any firm conclusions (central bankers are, by nature, cautious folks.) Nevertheless, he does offer a useful summary of arguments on both sides of the question of how credit market innovations have affected systemic risk. I would be interested in your views on the merits of these arguments.
In brief, Geithner’s points are as follows:
THEORETICAL CONSIDERATIONS: Credit market innovations have resulted in credit risk being spread more broadly across a variety of risk takers. They have made it possible to trade and price credit risk, offering greater opportunities to manage and hedge it. These innovations should make credit markets both more efficient and more resilient. A broad, deep and well-functioning capital market, complemented by a well capitalized banking system that can provide liquidity in time of stress, represents a more efficient financial system than one dependent on banks alone.
HISTORICAL CONSIDERATIONS: Financial innovation is not new. Growth in loan syndication, increasing provision of credit directly through the capital markets, development of various asset-backed securities and segmentation of different aspects of credit risk have been occurring for over two decades. The performance of the economy and financial markets during this period is broadly encouraging. The US financial system absorbed the surge in corporate defaults in 2001 and 2002 remarkably well, with no near-default of a major bank.
Credit market innovation has not resulted in a significant increase in corporate leverage as some predicted. Non-financial corporate leverage in the US is relatively low by recent historical standards. Default rates have not risen and recovery rates have not fallen as these historical innovations unfolded.
Finally, while many factors have been in play, GDP volatility has actually moderated at the same time as these credit market innovations occurred. While this greater economic stability cannot be attributed to such innovations, experience offers some reassurance that these innovations have not caused the opposite to occur.
Some aspects of the latest wave of credit market innovations can reasonably be considered different in substance from earlier ones. This may imply potentially different consequences. Three aspects of this latest wave deserve consideration.
INCREASED ROLE OF UNREGULATED ACTORS: Recent innovations have reduced the share of non-farm non-financial sector credit held by banks from over 30% twenty years ago to around 15% today. A much larger share of credit exposure is held by non-bank financial institutions that mark to market and often assume considerable leverage. In a period of stress, the process of meeting margin calls and hedging against further losses can lead to a positive feedback loop that deepens the impact on credit markets. This effect may be mitigated by the greater spread of the risk among diverse institutions and the reduced moral hazard associated with banks’ access to the public safety net.
INCREASED COMPLEXITY OF NEW INSTRUMENTS: Managing the new array of credit risky assets is complicated by their very complexity. Appropriate hedge ratios among tranches of CDOs, for example, are notoriously uncertain. Recent innovations also have increased the distance between originators of credit and those who ultimately hold the exposure. This gives rise to a classic principal-agent problem. The usual checks and balances designed to control such problems rely fundamentally on the ability to understand the nature of the underlying risks involved. To the extent that the risks are more opaque because of complexity, imbedded leverage and short loss histories, these checks and balances may be less effective.
THE MECHANICS OF DEALING WITH A FAILURE: The very complexity and shear volume of transactions and counterparties could prolong the uncertainty created by the default of a large institution. This could well be exacerbated by the failure of infrastructure to keep pace with the growth of the underlying volume and complexity of transactions.
April 25th, 2007 at 6:26 am
I agree with Timothy Geithner’s Reasons for Optimism part.
-Steven Burda
April 26th, 2007 at 6:59 am
I gather from Steven Burda’s restricted endorsement that he does not agree with the accompanying reasons for caution. I must say that I find some cause to be less sanguine. Of particular concern is the apparent thrust toward complexity for complexity’s sake. I have yet to hear a compelling case supporting the fundamental need for CDO-squared (not to mention CDO-cubed) types of structures. It smacks all too much of, “If you can’t convince them with cogency then baffle them with BS.”
There was a similar experience that many of us remember from more than a decade ago when Bankers’ Trust sold a LIBOR-squared swap to Gibson Greeting Cards that led to significant losses when rates spiked in early 1994. I reviewed this in more detail in “The dangers of complexity” in the April 2005 issue of Risk magazine. (See: http://www3.sungard.com/SunGardFinancial/menus/documents/risk_managers/200504%20the%20dangers%20of%20complexity.pdf )
As I stated in that column, complexity often is a necessary accompaniment to progress. To paraphrase John Kenneth Galbraith, “Much to its discredit, the world is a complicated place.” (See “In defense of exotics” at http://www3.sungard.com/SunGardFinancial/menus/documents/risk_managers/200009%20in%20defense%20of%20exotics.pdf ) Nevertheless, complexity can be used gratuitously to confuse the less well informed. The ease and the rewards of doing so are especially seductive when markets are in a process of rapid innovation. The Bankers’ Trust – Gibson Greeting Cards fiasco triggered a singularly ill informed public and political backlash against the whole concept of derivatives. A similar blowup in the credit derivatives market could do comparable damage today. While such damage almost certainly would be temporary, it can be avoided if dealers maintain an appropriately professional concern for their customers’ needs and priorities.
May 15th, 2007 at 7:31 pm
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