ST-NUS BUSINESS SCHOOL SERIES ON THE FINANCIAL CRISIS
By Duan Jin-Chuan
A TELEVISION presenter broadcasting out of New York recently began his programme by saying: 'Welcome to the financial capital of the world...I believe...still.'
The message was subtle but clear: The ongoing turmoil in financial markets has exposed weaknesses in the system, and New York is facing a rapid loss of credibility as the nexus of global financial markets. This has led to talk of financial centres elsewhere in the world, including Asia and the Middle East, stepping in and playing a bigger role.
But no, not quite yet - not, at any rate, till a number of structures have been put in place.
An area that needs to be looked at in this regard is risk management, or its lack thereof. Inadequate risk management was one reason American and European financial institutions took such big, risky bets that have since exploded in their faces. But they thought they were doing right and their actions were sanctioned by regulators. Why so?
Lending a mortgage worth $800,000 while the collateral has a market value of $1 million, and is fast rising, seems conservative. If you don't lend in such circumstances, your competitors would. Moreover, you are incentivised to lend because your remunerations are tied to the short-term performance of your loan portfolio. In short, moral hazard fuelled aggressive lending practices, which pushed up the value of the collateral too. This bubble feedback loop made housing prices a bigger systematic risk factor in the United States, while simultaneously inducing financial institutions to lend more.
The current US housing crash would have been like any other bubble-bursting story had financial instruments like collateralised debt obligations (CDOs) and credit default swaps (CDSs) not been invented. Bundling mortgages into securities and selling them freed up funds for financial institutions to make more loans. CDOs and CDSs transformed a 'systematic risk' rooted in the housing sector into a 'systemic risk' for the entire financial system.
It is indeed mind-boggling that so many financial institutions allowed themselves - and were allowed by regulators - to be exposed so heavily to the housing sector, blithely assuming they were properly hedged. What can be done to prevent a recurrence of such cascading systemic risks ?
The modern financial system has two pillars: a payment system via banking networks and a securities clearing mechanism via various organised exchanges and dealers. The current regulatory support system is tilted towards safeguarding the payment system with facilities like deposit insurance and central banks serving as lenders of last resort. These safety nets aren't perfect, but we have witnessed how they worked in stabilising markets amid the current panic. Due to the gravity of the situation, governments have expanded deposit insurance to cover more deposits, guaranteed interbank lending, and bought commercial paper directly.
An important part of the second pillar is organised exchanges through which stocks, bonds and some derivatives are traded. In the case of stocks and bonds, the role of exchanges is to facilitate transactions, and they do not take direct positions. For derivatives like futures and options, organised exchanges facilitate anonymous trading; and the exchanges serve as the counterparty to both sides and is thus exposed to credit risk. As a safeguard, trading parties are required to put up collaterals, known as margin accounts, for settling daily gains or losses to avoid accumulating large losses.
An important component of the second pillar is the Over-the-Counter (OTC) market for interest rate swaps, currency forwards, CDSs and other exotic derivatives. The intrinsic need of businesses for tailor-made contracts is the driving force behind the OTC market. Market makers often step in as a party to a trade when a suitable counterparty cannot be found. Trades are conducted by relying on the credit ratings of participants. Unlike in organised exchanges, it is hard to set up suitable margin accounts in the OTC market to mitigate credit risks because the derivatives traded are non-standard and infrequently traded.
The systemic risk inherent in the OTC counterparty arrangements became evident in the near collapse of Bear Stearns and American International Group, and Lehman Brothers' bankruptcy. It has been suggested that some of the OTC trading can be moved to an organised exchange. But it would be naive to think that organised exchanges can completely replace the OTC market. The current financial crisis forces us to recognise the vulnerability of this important pillar of the modern financial system.
The time has come to establish an international agency to guarantee the OTC market makers for their counterparty exposures, much like deposit insurance. But unlike domestic deposits in banks, counterparty transactions here can't be confined to one jurisdiction. This guarantor should be global in nature and be funded by member states whose voting rights in the agency would be determined by the size of their contributions.
In exchange for the guarantee, OTC market makers would pay risk-based premiums to the guarantor. These premiums can be determined by a combination of quantitative and qualitative measures, in a manner similar to the deposit insurance schemes that exist in many economies. Asian governments should seize this opportunity to take leadership in this endeavour. I am of the opinion that Singapore is an ideal location for this international guarantee agency.
Complacency tends to set in after any crisis is over. It is probably impossible to avoid future crises like the current. But at least we can try to reduce their frequency and contain the damage they cause once they occur. We need to implement better safeguards. This applies to Asian regulators, and the institutions under their supervision, as well as to European and American ones. Indeed, even more so because corporate governance in Asia is still weaker than in Europe or the US.
Wall Street will change as a result of this crisis. The broader trends indicate Asian economies are becoming stronger relative to the developed world. New and better ideas will emerge from Asian centres of finance.
I look forward to the day when that TV presenter in New York says: 'Welcome to one of the world's financial capitals.'
The writer is the Cycle & Carriage professor of finance at NUS and director of the NUS Risk Management Institute. This is the ninth article in the ST-NUS Business School series on the financial crisis.