15 Aug 2007  Op-Ed

3 Steps to Reduce Financial System Risk

By using complex derivative products, banks are better able to manage risk. But this "credit risk transfer" technology is transferring risk to a new set of investors inexperienced in this arena and posing exposure problems for the international financial system as a whole, argues Harvard Business School professor Mohamed El-Erian. Here's how to fix the problem. Key concepts include:

  • Regulatory authorities must address 2 challenges to contain a new source of systemic risk in international finance: the increasing migration of complex market activities to unqualified supervisory bodies, and the growing threat of politically motivated changes to regulatory regimes.
  • If left unchecked, systemic risk in the international financial system will increase and much of the initial beneficial impact of credit risk transfer technology may be negated.
  • 3 steps can mitigate this new component of systemic risk: greater cooperation among supervisory bodies; encouragement of rating agencies to improve their modeling of derivative products; and inducement of new investors to evaluate the ratings issued by the agencies against improved internal risk management capabilities.

 

Regulatory authorities face 2 challenges that need to be addressed forcefully if they are to contain a new source of systemic risk in international finance. First, the increasing migration of complex market activities to supervisory bodies that lack the necessary sophistication to oversee them; and, second, a growing threat of politically motivated changes to regulatory regimes.

There has been much talk recently about the extent to which the proliferation of derivative products has allowed banks to manage their balance sheets better. By enhancing the ability to hedge and shift various risks, advances in what is called "credit risk transfer" technology have lowered the vulnerability of the international financial system to any individual bank crisis.

There has been less discussion about where the transferred risk has ended up and why. Increasingly, it is being borne by a new set of investors who previously had limited access to complex derivative products. These include insurance companies and public and private pension funds. They see the products as a way to earn higher yield.

The growing purchase by such investors of "structured products" is, in itself, acting as a catalyst for the creation of these products by banks. Indeed, given the considerable fees involved, banks' business models are being reorientated away from the traditional structuring and holding of individual loans. Instead, the emphasis is now on originating and quickly distributing structured products.

New investors, new risk

For the purposes of analyzing the implications for systemic risk, the new investors bring 2 important characteristics into play. First, many rely on external risk assessments rather than in-house due diligence, with a particularly heavy dependence on rating agencies; and second, they are supervised by bodies lacking the financial sophistication inherent in structured products. Both point to an increase in risk for the international financial system.

Recent analytical work raises concerns as to whether rating agencies' (and others') modeling of structured products has kept up with the massive growth in the volume and complexity of these products. The recent experience with U.S. subprime products adds to such concerns. Worries center on the "correlation modeling" that underpins rating designation. Given the leverage in many of the products, even a small change in correlation specifications can have a large impact on ratings.

There has been less discussion about where the transferred risk has ended up and why.

Meanwhile, the responsibility for supervising the transfer in balance sheet risk increasingly falls outside the purview of those best equipped to handle such a complex task. Especially when compared with bank regulators and boards, bodies overseeing insurance companies and pension funds have had limited exposure to the structured products that increasingly populate the balance sheets they supervise. These concerns come at a time when politicians are looking more actively at the investment vehicles that, directly or indirectly, facilitate risk transfer to insurance companies and pension funds. Political activity will increase further should some of the new investors find themselves in the midst of large derivative-related losses.

In a recent Financial Times interview, Lloyd Blankfein, chief executive of Goldman Sachs, sounded a cautionary note based on something that he picked up at Harvard Law School. He remarked that politically inspired changes triggered by a reaction to a specific situation or an individual firm can have unintended negative consequences for the system as a whole.

Fixing the future

What about the future? If left unchecked, systemic risk in the international financial system will increase owing to the combination of insufficient internal due diligence, excessive dependence on rating agencies, uneven supervisory coverage, and politically driven legislative reactions. In the process, much of the initial beneficial impact of credit risk transfer technology may be negated.

3 steps can mitigate this new component of systemic risk: first, stimulate greater cooperation and sharing of expertise among the spaghetti bowl of supervisory bodies; second, encourage rating agencies to improve their modeling of new and complex derivative products; and third, induce new investors to evaluate the ratings issued by the agencies against improved internal risk management capabilities.

The longer action is delayed in these 3 areas, the higher the likelihood that costly clean-up operations will be needed.

This article was first published by the Financial Times on July 10, 2007.