A new approach to financial risk (2024)

WHEN disaster strikes, it is tempting to look for somebody to blame. In the crisis in world financial markets, the prime suspects are speculative hedge funds. A falling dollar, volatile share prices, US Treasury bonds jumping around: in each case, the finger of suspicion has pointed at you-know-who. Hedge funds make fine scapegoats: mysterious, offshore, unregulated, and run by and for the obscenely rich. Yet hedge funds are not the cause of the markets' woes. The reality is more complex and more troubling.

Investors have turned against risk, with a vengeance. In recent weeks, markets in all but the safest securities have become much less liquid: that is, investors are struggling to find anybody willing to trade with them. Firms that rely on markets for capital are finding the coffers empty, and seeking loans instead. Banks seem to have become far more risk-averse too. The result may be a “credit crunch” that could push America and the world into outright recession.

The world's big banks are reducing their risk for two reasons. One is that markets have become more dangerous than they were: in recent weeks volatility has been twice as large as its historic average. Second, many banks have suffered big losses that have eaten into their capital. (On October 14th BankAmerica made a provision of $1.4 billion against credit losses in the third quarter.) Were hedge funds to blame for either? Banks have lost money on hedge funds, but their exposures are tiny relative to their capital, or to their own trading losses. On the other hand, trading has seemed unappealing because of rumours that the portfolio held by Long-Term Capital Management (LTCM) will be sold—and nobody wants to be on the wrong side of that.

Long-Term consequences

Here, surely, is one hedge fund that is guilty as charged. Certainly, LTCM lost spectacular amounts of money. But it is not a typical hedge fund; it may be unique in its industry (see article) . The reason the Fed intervened was not the losses facing those who had invested in or lent to it, but the fact that many banks had followed similar strategies to LTCM's, and would themselves have been badly exposed had the fund failed. LTCM, you might say, is more typical of banks than of hedge funds. This is what makes its problems so disturbing—and its lessons so important.

In most cases, these investment strategies were believed to involve low-risk arbitrage, based for instance on the assumption that yields on certain securities would converge with US Treasuries. It is pleasant to mock the Nobel laureates who helped to found LTCM, but much of this mockery clouds the truth. The fund, it now appears, did not borrow more than a typical investment bank (LTCM's leverage soared only when its equity was eaten away by losses). Nor was it especially risky. What went wrong was the firm's risk-management model—which is similar to those used by the best and brightest banks.

Until the markets fled from risky investments into safe Treasuries during August, LTCM reckoned its portfolio met international capital-adequacy standards. But the fund's strategy of holding a diversified portfolio of investments failed to offer the hoped-for protection: all risky securities tanked at once. Also, when things went wrong, and the risk-management models flashed red, the firm could not unwind its positions as quickly as the model had assumed. Market liquidity dried up faster than either LTCM's managers or their models had expected.

Regulators have criticised LTCM and banks for not “stress-testing” risk models against extreme market movements. However, the question arises whether recent events are ever likely to be repeated. The markets have been through the financial equivalent of several Hurricane Andrews hitting Florida all at once. Is the appropriate response to accept that it was mere bad luck to run into such a rare event—or to get new forecasting models that assume more storms in future?

One worry is that technology and the growth of global institutions that rely on risk models may increase the chance of further storms. If so, regulators might need to increase sharply the amount of capital that financial firms hold to protect themselves against extreme conditions. The models take a top-down view of risks within a firm, looking at all markets simultaneously. This may work if just one firm is hit. If several are clobbered at once, and all start to reduce their risks simultaneously, it might trigger a vicious liquidity-draining circle.

The case for toughening capital requirements is particularly strong for banks that are implicitly backed by taxpayers, whether through deposit insurance or because they are judged too big to fail. Indeed, regulators might ask whether such institutions should be allowed to indulge in risky proprietary trading at all. Recent events have strengthened the case for “narrow banks”, limiting government guarantees to institutions that make only tightly circ*mscribed investments. But this has its problems too. In the end, an altogether different kind of regulation may be needed (see article).

A more pressing matter is how to restore liquidity to the markets right now. Everybody's favourite plan is big cuts in interest rates. If banks restrict credit, it is argued, lower rates are needed just to keep monetary conditions as they were. But even sharp cuts might not cause banks to loosen credit, if their balance sheets continue to deteriorate. They might even damage confidence by suggesting panic on the part of the authorities. For the moment, in any case, a sustained contraction of bank lending is still a threat, not a fact.

Maximum vigilance is called for, but until the evidence is firmer, the best course may be to let markets try to work things out. Perhaps the turmoil of the past few weeks, by pricking a speculative bubble and making investors reassess risks, has itself sown the seeds of a recovery. Once the belief that prices have hit bottom takes hold, investors will return and liquidity will increase. If history is any guide, the first back in will be hedge funds. They should be welcomed with open arms.