Systemic risks in the global markets can be best identified and measured by looking at some select key parameters which, between them, indicate the extent of asset bubbles and the corresponding under-pricing of risks. In other words, it is not so much high volatility, which is the ‘effect', that should be a cause for concern as persistent and excessively low volatility, which is the ‘cause', and was the hallmark of the pre-crisis period.
It is very instructive to look at the readings on parameters such as (i) TED Spread (3M LIBOR – 3M Treasury Bill), (ii) 3M LIBOR – 3M OIS, (iii) 3M LIBOR – Effective Fed Funds Rate, (iv) VIX Index and (v) CDX Crossover index. Pre-crisis these were about 48 bps, 12 bps, 27 bps, 24 per cent and 154, respectively. This was the time when there was a veritable bubble across credit and equity markets and global policy makers were already warning about huge under-pricing of risks in the run up to the crisis. But unfortunately, nothing, in terms of pre-emptive, proactive and credible policy response, other than these warnings, was delivered.
WRITING ON THE WALL
If one looks at the recent readings (from September 2010 to July 2011) on these five parameters, on parameter No. (i) at 13 bps, we were at almost quarter the level, on parameter No. (ii) at 9 bps, we were almost there, on parameter No. (iii) at 11 bps, we were less than half, on parameter No. (iv) at 14.62 per cent we were roughly at half and on parameter No. (v) at 146, we were at slightly lower level. There is thus incontrovertible evidence that there is yet again a huge under-pricing of risks in the financial system and, therefore, it is not a question of if, but when, the generic asset bubble caused by manifold increases in balance sheets of central banks will burst.
Specifically, currently global liquidity has become a bigger concern than it was in pre-2007 period what with ultra-low and near-zero policy rates and major central banks' balance sheets 1.50 to 3 times their pre-2007 levels, adding about $4 trillion in incremental central bank liquidity.
Worse, US banks are reportedly keeping excess reserves of $ 1.5 trillion with the Fed rather than lend to small businesses and households. Alongside, non-financial corporations in the US are reportedly sitting on cash and liquid assets worth $2 trillion which they do not know what to do with ! As of September 14, 2011, the over-valuation of gold — what we can also call gold bubble - with reference to seven competing asset classes varied from 84 per cent against highly correlated metal prices proxied by LMEX, 90 per cent against WTI crude, 123 per cent against US Treasuries proxied by JP Morgan index, and roughly 250-300 per cent against Credit Default Swap index, Dow Jones, the US dollar index DXY and the US home price Case-Shiller index.
Perhaps, if this swamp of liquidity and monetary easing are not unwound appropriately, and in an orderly, and timely manner, the next crisis might well be a veritable “financial and economic nuclear winter”!
SLEEPING AT THE WHEEL
Huge losses at global banks running to about $2 trillion were not because existing best practices, risk management and internal controls failed but because those responsible for implementing, and enforcing them, failed them! From 1990s to 2011 and from Nick Leeson of Baring Brothers to Hamanaka of Sumitomo Corporation to Kerviel of Societe Generale to Adoboli of UBS AG, the underlying story has remained just the same!
The crux of the matter is what we need is not more or less regulation and governance but good regulation and governance which simply means actually doing what must be done!
By way of example, in the US, the traditionally very healthy AAA-rated AIG and mono-line bond insurers MBIA and Ambac changed their business model from insuring only their staple products and strayed into insuring CDOs and ABS and writing CDS. While this went unnoticed by insurance regulators, Pershing Square, a hedge fund, spotted trouble and started shorting both equity and credit risk of these two companies. But even after this, regulators failed to take notice and corrective action with the two companies being eventually downgraded several notches and AIG having to be bailed out by the Fed and US government.
Rather than take timely notice of, and act on, early warning signals coming from financial markets, like stock and CDSs markets, regulators chose instead to shut themselves to these early warning signals themselves by banning short selling which act effectively amounted to shooting the messenger for the unpalatable message it had to convey!
THE ETF THREAT
Another development that portends build-up of systemic risk is a rather rapid growth of ETFs with $1.5 trillion in assets under management (AUM) which has close parallels, in terms of complexity and opacity, with the CDO market, including its ‘squared' and ‘cubed' variants. Financial Stability Board and Financial Services Authority have already raised concerns what with emergence of synthetic ETFs, inverse, or short, ETFs and leveraged ETFs. In particular, there are concerns with synthetic ETFs which depend upon a swap with parent bank to track return of an index against collaterals which considerably deviate from the index being tracked.
This gives rise to the possibility that banks may be using ETFs to finance their riskier and illiquid assets cheaply than they would be able to do in a standard repo market. The synthetic ETFs also introduce counter- party risk not present in plain vanilla ETFs. However, that leaves out the non-ETF financialised commodities as a significant component of the total global financial assets worth $ 242 trillion (banking assets: $ 104 trillion, equity: $ 47 trillion and bonds: $ 91 trillion), of which there is no estimate in the Global Financial Stability Report of IMF; above-ground gold itself is worth about $10 trillion at current prices!
Specifically, regulators/policy-makers need to deliver counter-cyclical prudential measures like selectively increasing capital charge for riskier categories of assets by increasing risk weights for asset classes where bubbles exist, or are in the process of building. In addition, they need to be complemented by fixing the maximum absolute leverage (not allowing for risk weights for assets) in addition to risk weighted asset-based capital prescription. These regulatory measures obviate the need of monetary policy tightening which is a blunt tool indiscriminately affecting all sectors of the financial markets and the real economy.
Besides, significantly, the credit crisis has also thrown into sharp relief a “strong connect” between “liquidity risk” and “opaque off-balance sheet exposures” of whatever description. The appropriate supervisory and regulatory response to these risks would, therefore, be to insist on full disclosure and transparency of off-balance sheet commitments/exposures and supervisory insistence on an appropriate mix of “stored” and “purchased” liquidity and appropriate capital charge for liquidity risk; the higher the “purchased liquidity” component, the higher the capital charge and the higher the “stored liquidity” component, the lower the capital charge.
In fact, in India the Committee on Financial Sector Assessment almost presciently focused on this critical risk in May itself, much before the liquidity and credit crunch of August 2007. We have had remarkable financial stability, not fortuitously, but thanks to pre-emptively and pro-actively delivered prudential measures like increase in risk weights for exposures to commercial real estate, capital market, venture capital funds and systemically important non-deposit accepting Non Banking Finance Companies . Recently, to contain potential systemic liquidity risk, the Reserve Bank has capped banks' investments in Fixed Income Mutual Funds to 10 per cent of their net worth.
(Excerpts from an address at the Second Pan-Asian Regulatory Summit, organised recently by Thomson Reuters in Singapore.)
(The author is Executive Director, Reserve Bank of India. The views are personal.)