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  • Stuart Fowler

‘This sucker could go down’: making sense of systemic risk


This Bushism was apparently referring to the risk to the economy rather than the American banking system but the two are intimately related via the supply of credit and money. As people here start to question whether our banking system could also go down, I thought it may be helpful to set out a plain-English, logical explanation of the different types of risk to cash holdings and how they can be managed or avoided, in normal times (as a permanent aspect of capital stewardship) and in a time of crisis.

I’ve approached this from a standard approach to risk management, separating ‘idiosyncratic’ risks from ‘systemic’ risks. Diversification of exposures deals with the former (as in normal times) but not necessarily the latter (in a time of crisis). In extreme form, which assumes even governments can be overwhelmed by the scale of failures or else that they choose to spread the losses in a way that includes depositors, systemic risks can only be avoided by holding government-issue instruments. A move from banks to short-dated gilts, National Savings and even Premium Bonds is already going on as some people find this is the only way they can sleep at night.

The risks you cannot diversify A fundamental principle of managing risks to your capital is diversification. Modern portfolio theory teaches that it is irrational not to diversify idiosyncratic risks, such as when holding a large proportion of your wealth in one company (unless of course this really is an entrepreneurial rather than investment goal you are managing). That one company can do very badly, or even fail, quite independently of what is happening to other companies or to the economy as a whole, such as due to technological redundancy, fraud or bad management. This is what is meant by idiosyncratic risks.

Portfolio management makes diversification of idiosyncratic risks easy to implement because of the existence of packaged portfolios holding lots of securities, such as unit trusts. The risks you are then left with are those common to all investments of the same type, variously known as market risks or systemic risks. These cannot be diversified away.

It helps to explain this distinction by demonstrating how it works in practice in other components of the household balance sheet than investments in shares in companies.

Property Households have more of a problem diversifying exposure to property markets and so the home we live in tends to bring with it inefficient and uninsurable idiosyncratic risks, such as blight caused by the actions of others. We accept these risks because we cannot easily achieve the benefits of owner-occupation without them.

Buy-to-let investors, on the other hand, make a deliberate choice to hold self-funded investments in a number of properties. Idiosyncratic risks will be partially diversified with every incremental property but the risks are still not comparable with a residential property fund. But the exposure of each to the systemic risks of the property market is the same whatever the means of implementing their strategy.

Cash When it comes to our cash, governments take away the need to diversify exposures to the risk of fraud or default by individual banks when they provide a state-sponsored deposit insurance scheme to guarantee or protect depositors. In the UK, the Government-sponsored guarantee scheme has a limit which is now (post Northern Rock) 100% of the first £35,000 per depositor per separately-regulated deposit-taking entity. Beyond this level, idiosyncratic risk of default by a deposit taker can be avoided, not just diversified, by holding the maximum covered amount in different banks.

Uninsured idiosyncratic default risks can also be diversified by holding money in a money-market fund, whose job it is to diversify credit risk between many borrowers. These may be positioned with equivalent systemic risk as you would yourself prefer, such as lending only on a very short term to strongly-capitalised banks or top-rated corporate borrowers in the ‘commercial paper’ market. For this, you accept that you will never earn more than the typical rate top banks need to pay for deposits.

But money market funds may instead be positioned to chase higher returns than that, such as by depositing with riskier banks, by holding more in lower-rated commercial paper, or by lending for longer average terms and so taking on exposure to interest rate movements. The clue as to which type of fund it is may be in the name (such as ‘Enhanced Cash Fund’). In recent experience, many people did not start to find out which type of fund they owned until after the collapse of two French funds investing in Special Investment Vehicles set up to buy Collateralised Debt Obligations consisting of tranches of sub-prime mortgages. These non-bank vehicles typically funded their portfolios by issuing short-dated paper and rolling it over as it matured. Even some of the most conservative UK institutional money market funds held some exposure to short-dated commercial paper issued by these non-bank entities but no capital was lost. The losses and closure of those French funds (made good by their bank owner), now more than a year ago, mark the start of the current banking crisis.

A money market fund diversifies the idiosyncratic risks of both individual banks defaulting and even clusters of banks failing but they do not avoid these risks. Occasionally, their net asset values will fall below par as they book losses. But it is very occasionally. And if sponsored by a banking group there is a fair chance they will do what the French did and make good the loss. Even with clustering of losses (caused by shared lending errors by bankers on the same or even different banking markets, such as over-exposure to property or emerging markets), the risk of loss in a money market fund could rationally be viewed as a worthwhile contingent cost of outsourcing the job of diversifying exposures. This is really only likely to make sense where the size of total deposits means there is a genuine hassle involved in spreading them around in lots of £35,000.

For most retail savers, money market funds are unlikely to be a rational choice to diversify idiosyncratic risks as they will cost them about 0.5% pa for the privilege of spreading risks they could quite easily spread for themselves. An institutional fund (such as our clients use) ought not to cost more than 0.1% if depositing more than say £5m collectively for clients, which puts a much lower price tag on the hassle factor. When an investor’s cash is part of an investment programme, there may be a more genuine incentive to hold cash in a fund on the same platform as other investments and this could justify the cost. Be aware, however, than advisers and managers may prefer you to hold your cash in a form, such as a unitised cash fund, that enables them to attach a portfolio-based fee to it.

Systemic risks in banking Systemic risks mean slightly different things to different people but we should be able to agree that, whatever else they are, they apply to most participants in a system, such as in national or internationally-connected banking markets. These risks might therefore range from these markets ceasing to be able to perform their function for a time to mass failures in which holders of bank equity and loan capital (but not necessarily depositors) suffer partial loss or are wiped out.

In the US and UK we are at the stage where the interbank market, in which banks deposit with and borrow from each other to balance their books daily, has essentially seized up. So this type of systemic risk has arguably already crystallised.

In both countries, the response from government has been to give banks wider access to central banks’ funds. Central banks are tiny by comparison with commercial banks so they would not be able to do this on a large scale were it not for governments making funds available out of general revenue or debt issues or because the banking system is itself buying short-dated Treasury bills with its liquid assets because it is too scared to hold deposits in other banks.

The US Treasury plan, even before it was voted down, had not changed banks’ reluctance to lend to each other. The interbank market last week and again this week is not functioning properly. In these circumstances, it is relatively easy for banks or building societies to fail because they cannot roll over maturing short-term wholesale borrowings (as did Bradford & Bingley).

Derivatives The systemic risk the US Treasury is concerned about is not just the mortgages on banks balance sheets but also in derivatives based on mortgages. This capital amounts to about $50 or 60 trillion, which is several times larger than the stock of loans themselves. By definition, much of this is offsetting. It is held both outside and within banks.

The logic behind the Treasury plan was to raise the carrying value of the underlying mortgages on which these securitised instruments are piled, like an upside-down pyramid. At the moment, banks that write down their carrying values for mortgages and mortgage derivatives very conservatively risk being (or looking) insolvent so it is likely that, contrary to accounting rules, they are reluctant to do this.

Marking to market This brings us to a new condition in international banking that has not been present in previous banking crises: ‘fair value’ accounting rules. These have been changed, by common consent, to ensure greater public disclosure of changes in values for which there is some acceptable, objective and publicly-referenced benchmark.

In the case of mortgage loans, the existence of traded securitised mortgages makes it difficult to argue that there is no public valuation benchmark. In the case of derivatives, the way risk was transformed by slicing up individual loans into different securities based on the probability of loss (whether of income or principal) does leave open to doubt what the value is. But in either case, there is a fundamental difference between the valuation obtained by forced sellers and the valuation assuming willing buyers and sellers. The former may be only a fraction of the latter.

Since this accounting change has almost certainly increased the probability of bank failures, hence of systemic risk, it is easy to see why the US Treasury would want to use taxpayer money to acquire loans above forced sale prices but not necessarily above their ‘true’ value (on a reasonable assessment of the risk of loss without sale).

The Treasury’s back-door approach to the valuation problem might as well now be replaced by an open debate about the sense of marking financial assets to market when market prices are being set by forced sellers, who are possibly only sellers as a secondary effect of marking down their assets. In the last bear market in the UK we changed the rules for with-profits life insurance companies because they too were forced sellers into weakness. In many previous bear markets and banking crises, solvency rules for both insurers and banks were quietly dropped to stop a downward spiral feeding on itself.

The ultimate in systemic risks This is the failure of banks on such a scale that governments are either unwilling or unable to fund all uninsured depositors.

Such a scale itself implies global integration via common loss experience, which in turn implies governments turn out to be powerless to prevent global recession, falls in security (particularly property) and inability of borrowers to meet their obligations. Such a scale also requires there to be little distinction between the capital strength of banks. In the past, even large-scale clustering of failures led to a flight to sound banks, who did survive, rather than a flight from all banks. It is a moot point whether international banking capital standards have removed this distinction. There are virtually no banks of any size whose business model has depended on a conspicuously stronger and more liquid balance sheet. It requires attracting customers willing to pay in lost interest for that security but that is pointless if you believe depositors will always be bailed out.

‘Unwilling’ suggests governments will be tempted to make a rational trade-off that favours spreading the social cost of losses amongst those who chose to hold uninsured bank deposits (individuals or companies) rather than just tax payers. I would never rule that out.

‘Unable’ suggests governments (or the tax base) may be too small to fund all depositors. Theoretically, this cannot happen if they can issue as much currency as they want. In practice, there may be constraints due to the international standing of a currency. In this respect, I would rather be Britain than America.

Government securities as the last resort Since you cannot physically remove large amounts of notes and coin from a bank, your only means of moving capital out of the banking system as a whole is to use it to buy goods that might act as a store of value alternative to currency or to buy government-issue securities and instruments. Many of these currency alternatives are extremely volatile and may themselves be subject to bubble conditions that will not withstand a slump (gold, art).

‘Real assets’ are, in the long run, better than government securities with anything other than a very short maturity if the way losses are spread across society includes printing money and, eventually, higher inflation. I would assume such a capital flight would target short-dated conventional gilts and index linked gilts.

Is this already happening? Yes. One multi-family office we have invested with for some private equity exposure has written to say it ‘has decided to put all client cash balances over which it has discretion into UK government securities’. I shall be interested to read the letter they write when they decide to move back to banks.

Ironically, it is government’s role as borrower of last resort rather than lender of last resort that is having most impact in this crisis. I wonder if they are tempted to try to stop performing that role, as issuer of government bills, and force banks to use the interbank market.

In most market crises, there comes a point at which participants reach the same conclusion at the same time that ‘you are screwed if you do and screwed if you don’t’ and so choose whichever route might lead back to sanity. Several major bear markets have ended with versions of this enlightened self-interest. Today that route is banks lending to each other.

Guessing the odds I have been asked to say what chance I think there is of losses being borne by or shared by depositors. Apart from saying I do not know, I have also said it not a question of odds so much as the level of fear being experienced. In the case of the family office above, it may also be a question of agency risk or advantage: being seen to be prudent. If you are having trouble sleeping at night and find yourself avoiding the evening news, gilts can be rational even if costs you tens of thousands of pounds of insurance in interest foregone.

People who do this also have the same problem as the family office: when to go back. If the risk of integrated failure were limited to a short-term problem of the interbank market drying up, you would know what to look for. But if the problem is in fact common exposures to a global recession, as both households and companies compete to reduce debt, you might be we waiting for years to discover the scale of the losses that threaten the banking system.

Note too that it is inconsistent to worry about the security of the money in your bank and to be worried about missing out on a recovery in stock markets. These cannot possibly have equivalence in a rational approach to investment decisions.

Blame In this item, I have not dealt with blame but I will return to this. In the firing line:

  • my own industry, fund management, which acts as ‘fiduciary’ shareholders in banks and which failed to check the perverse pay incentives dreamed up by management;

  • the banking managers, who gamed the system we let them create;

  • bank supervisors and accountants, whose constant fiddling with the rules has undermined traditional banking principles;

  • commission-paid mortgage brokers, who fed the banks’ ‘originate and distribute’ business model and the public’s irrational beliefs about house prices;

  • the politicians who bought economic growth at the price of unsustainable debt;

  • and last (but by no means least) gullible, greedy and disengaged customers

In seeking balance, I shall be mindful of a message of my book, written after a series of different crises in financial services, that we get the industry that we deserve.

#cash #risk

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