Jan 31, 2006
An eerie stability has prevailed in financial markets for the best part of a decade, John Plender notes in a detailed examination of what might happen once the current glut of global liquidity dries up.
The surge in liquidity has been accompanied by the development of newer markets, such as in Credit Default Swaps, which have encouraged a belief that since risk is now more widely spread across the financial system it is now less of a concern.
Yet central bankers do not believe we are witnessing the end of volatility or the demise of the credit cycle, even if some youthful financiers are prepared to argue the case. Instead, the confluence of speed, complexity and tighter linkages across institutions and markets portends greater toxicity in the system: the chances of a major shock might have got lower, but if and when it arrives that shock is likely to be bigger.
A particular concern is the existence of “embedded leverage,” encouraged by the rise in derivatives trading, and which is impossible to quantify. And, while risk management models may have improved, it remains the case that these models can ignore the potential occurrence of very low-probability scenarios with potentially extreme outcomes.
So hedge funds are encouraged, by their fee structure, to pursue trading strategies that produce positive returns most of the time as compensation for a very rare negative return. And big financial institutions have no incentive to incorporate the potential costs and risks to the system of their own collapse in their market pricing.
Central banks are expected to be there to coordinate bail-outs. But the world is very different now from 1998, when Long Term Capital Management had to be rescued. Putting a failing firm’s bankers in a room and persuading them to do their stuff may no longer be possible.