Rose Mateus

“THE revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature.” So wrote Peter Bernstein in his seminal history of risk, “Against the Gods”, published in 1996. And so it seemed, to all but a few Cassandras, for much of the decade that followed. Finance enjoyed a golden period, with low interest rates, low volatility and high returns. Risk seemed to have been reduced to a permanently lower level.

This purported new paradigm hinged, in large part, on three closely linked developments: the huge growth of derivatives; the decomposition and distribution of credit risk through securitisation; and the formidable combination of mathematics and computing power in risk management that had its roots in academic work of the mid-20th century. It blossomed in the 1990s at firms such as Bankers Trust and JPMorgan, which developed “value-at-risk” (VAR), a way for banks to calculate how much they could expect to lose when things got really rough.

Suddenly it seemed possible for any financial risk to be measured to five decimal places, and for expected returns to be adjusted accordingly. Banks hired hordes of PhD-wielding “quants” to fine-tune ever more complex risk models. The belief took hold that, even as profits were being boosted by larger balance sheets and greater leverage (borrowing), risk was being capped by a technological shift.

There was something self-serving about this. The more that risk could be calibrated, the greater the opportunity to turn debt into securities that could be sold or held in trading books, with lower capital charges than regular loans. Regulators accepted this, arguing that the “great moderation” had subdued macroeconomic dangers and that securitisation had chopped up individual firms’ risks into manageable lumps. This faith in the new, technology-driven order was reflected in the Basel 2 bank-capital rules, which relied heavily on the banks’ internal models.

There were bumps along the way, such as the near-collapse of Long-Term Capital Management (LTCM), a hedge fund, and the dotcom bust, but each time markets recovered relatively quickly. Banks grew cocky. But that sense of security was destroyed by the meltdown of 2007-09, which as much as anything was a crisis of modern metrics-based risk management. The idea that markets can be left to police themselves turned out to be the world’s most expensive mistake, requiring $15 trillion in capital injections and other forms of support. “It has cost a lot to learn how little we really knew,” says a senior central banker. Another lesson was that managing risk is as much about judgment as about numbers. Trying ever harder to capture risk in mathematical formulae can be counterproductive if such a degree of accuracy is intrinsically unattainable.

For now, the hubris of spurious precision has given way to humility. It turns out that in financial markets “black swans”, or extreme events, occur much more often than the usual probability models suggest. Worse, finance is becoming more fragile: these days blow-ups are twice as frequent as they were before the first world war, according to Barry Eichengreen of the University of California at Berkeley and Michael Bordo of Rutgers University. Benoit Mandelbrot, the father of fractal theory and a pioneer in the study of market swings, argues that finance is prone to a “wild” randomness not usually seen in nature. In markets, “rare big changes can be more significant than the sum of many small changes,” he says. If financial markets followed the normal bell-shaped distribution curve, in which meltdowns are very rare, the stockmarket crash of 1987, the interest-rate turmoil of 1992 and the 2008 crash would each be expected only once in the lifetime of the universe.

This is changing the way many financial firms think about risk, says Greg Case, chief executive of Aon, an insurance broker. Before the crisis they were looking at things like pandemics, cyber-security and terrorism as possible causes of black swans. Now they are turning to risks from within the system, and how they can become amplified in combination.

Cheap as chips, and just as bad for you

It would, though, be simplistic to blame the crisis solely, or even mainly, on sloppy risk managers or wild-eyed quants. Cheap money led to the wholesale underpricing of risk; America ran negative real interest rates in 2002-05, even though consumer-price inflation was quiescent. Plenty of economists disagree with the recent assertion by Ben Bernanke, chairman of the Federal Reserve, that the crisis had more to do with lax regulation of mortgage products than loose monetary policy.

Equally damaging were policies to promote home ownership in America using Fannie Mae and Freddie Mac, the country’s two mortgage giants. They led the duo to binge on securities backed by shoddily underwritten loans.

In the absence of strict limits, higher leverage followed naturally from low interest rates. The debt of America’s financial firms ballooned relative to the overall economy (see chart 1). At the peak of the madness, the median large bank had borrowings of 37 times its equity, meaning it could be wiped out by a loss of just 2-3% of its assets. Borrowed money allowed investors to fake “alpha”, or above-market returns, says Benn Steil of the Council on Foreign Relations.

The agony was compounded by the proliferation of short-term debt to support illiquid long-term assets, much of it issued beneath the regulatory radar in highly leveraged “shadow” banks, such as structured investment vehicles. When markets froze, sponsoring entities, usually banks, felt morally obliged to absorb their losses. “Reputation risk was shown to have a very real financial price,” says Doug Roeder of the Office of the Comptroller of the Currency, an American regulator.

Everywhere you looked, moreover, incentives were misaligned. Firms deemed “too big to fail” nestled under implicit guarantees. Sensitivity to risk was dulled by the “Greenspan put”, a belief that America’s Federal Reserve would ride to the rescue with lower rates and liquidity support if needed. Scrutiny of borrowers was delegated to rating agencies, who were paid by the debt-issuers. Some products were so complex, and the chains from borrower to end-investor so long, that thorough due diligence was impossible. A proper understanding of a typical collateralised debt obligation (CDO), a structured bundle of debt securities, would have required reading 30,000 pages of documentation.

Fees for securitisers were paid largely upfront, increasing the temptation to originate, flog and forget. The problems with bankers’ pay went much wider, meaning that it was much better to be an employee than a shareholder (or, eventually, a taxpayer picking up the bail-out tab). The role of top executives’ pay has been overblown. Top brass at Lehman Brothers and American International Group (AIG) suffered massive losses when share prices tumbled. A recent study found that banks where chief executives had more of their wealth tied up in the firm performed worse, not better, than those with apparently less strong incentives. One explanation is that they took risks they thought were in shareholders’ best interests, but were proved wrong. Motives lower down the chain were more suspect. It was too easy for traders to cash in on short-term gains and skirt responsibility for any time-bombs they had set ticking.

Asymmetries wreaked havoc in the vast over-the-counter derivatives market, too, where even large dealing firms lacked the information to determine the consequences of others failing. Losses on contracts linked to Lehman turned out to be modest, but nobody knew that when it collapsed in September 2008, causing panic. Likewise, it was hard to gauge the exposures to “tail” risks built up by sellers of swaps on CDOs such as AIG and bond insurers. These were essentially put options, with limited upside and a low but real probability of catastrophic losses.

Another factor in the build-up of excessive risk was what Andy Haldane, head of financial stability at the Bank of England, has described as “disaster myopia”. Like drivers who slow down after seeing a crash but soon speed up again, investors exercise greater caution after a disaster, but these days it takes less than a decade to make them reckless again. Not having seen a debt-market crash since 1998, investors piled into ever riskier securities in 2003-07 to maintain yield at a time of low interest rates. Risk-management models reinforced this myopia by relying too heavily on recent data samples with a narrow distribution of outcomes, especially in subprime mortgages.

A further hazard was summed up by the assertion in 2007 by Chuck Prince, then Citigroup’s boss, that “as long as the music is playing, you’ve got to get up and dance.” Performance is usually judged relative to rivals or to an industry benchmark, encouraging banks to mimic each other’s risk-taking, even if in the long run it benefits no one. In mortgages, bad lenders drove out good ones, keeping up with aggressive competitors for fear of losing market share. A few held back, but it was not easy: when JPMorgan sacrificed five percentage points of return on equity in the short run, it was lambasted by shareholders who wanted it to “catch up” with zippier-looking rivals.

An overarching worry is that the complexity of today’s global financial network makes occasional catastrophic failure inevitable. For example, the market for credit derivatives galloped far ahead of its supporting infrastructure. Only now are serious moves being made to push these contracts through central clearing-houses which ensure that trades are properly collateralised and guarantee their completion if one party defaults.

Network overload

The push to allocate capital ever more efficiently over the past 20 years created what Till Guldimann, the father of VAR and vice-chairman of SunGard, a technology firm, calls “capitalism on steroids”. Banks got to depend on the modelling of prices in esoteric markets to gauge risks and became adept at gaming the rules. As a result, capital was not being spread around as efficiently as everyone believed.

Big banks had also grown increasingly interdependent through the boom in derivatives, computer-driven equities trading and so on. Another bond was cross-ownership: at the start of the crisis, financial firms held big dollops of each other’s common and hybrid equity. Such tight coupling of components increases the danger of “non-linear” outcomes, where a small change has a big impact. “Financial markets are not only vulnerable to black swans but have become the perfect breeding ground for them,” says Mr Guldimann. In such a network a firm’s troubles can have an exaggerated effect on the perceived riskiness of its trading partners. When Lehman’s credit-default spreads rose to distressed levels, AIG’s jumped by twice what would have been expected on its own, according to the International Monetary Fund.

Mr Haldane has suggested that these knife-edge dynamics were caused not only by complexity but also—paradoxically—by homogeneity. Banks, insurers, hedge funds and others bought smorgasbords of debt securities to try to reduce risk through diversification, but the ingredients were similar: leveraged loans, American mortgages and the like. From the individual firm’s perspective this looked sensible. But for the system as a whole it put everyone’s eggs in the same few baskets, as reflected in their returns (see chart 2).

Efforts are now under way to deal with these risks. The Financial Stability Board, an international group of regulators, is trying to co-ordinate global reforms in areas such as capital, liquidity and mechanisms for rescuing or dismantling troubled banks. Its biggest challenge will be to make the system more resilient to the failure of giants. There are deep divisions over how to set about this, with some favouring tougher capital requirements, others break-ups, still others—including America—a combination of remedies.

In January President Barack Obama shocked big banks by proposing a tax on their liabilities and a plan to cap their size, ban “proprietary” trading and limit their involvement in hedge funds and private equity. The proposals still need congressional approval. They were seen as energising the debate about how to tackle dangerously large firms, though the reaction in Europe was mixed.

Regulators are also inching towards a more “systemic” approach to risk. The old supervisory framework assumed that if the 100 largest banks were individually safe, then the system was too. But the crisis showed that even well-managed firms, acting prudently in a downturn, can undermine the strength of all.

The banks themselves will have to find a middle ground in risk management, somewhere between gut feeling and number fetishism. Much of the progress made in quantitative finance was real enough, but a firm that does not understand the flaws in its models is destined for trouble. This special report will argue that rules will have to be both tightened and better enforced to avoid future crises—but that all the reforms in the world will never guarantee total safety.