## Wednesday, November 11, 2015

### A blueprint for overcoming systemic risk

by Avinash Persaud.

It is a testament to the need of getting financial regulation right, that almost ten years since the emergence of a crisis in sub-prime mortgages in the US, those countries most affected by the unfolding credit crunch are still struggling to put it behind them. Yet, recent announcements over the amount of capital banks are required to hold against risky assets and what constitutes capital reveals that the fundamental flaws that plagued the last approach to regulation remain. The Financial Stability Board, created by the G20 nations, announced on November 9, 2015, that the most systemically important lenders must have a total loss absorbing capacity, including bail-in securities, equivalent to at least 16% of risk-weighted assets in 2019, rising to 18% in 2022. Financial regulation has yet to find its compass.

Too many financial supervisors consider regulation to be an exercise in “de-risking”. They seek to curb risk by requiring banks to put up biting amounts of capital against risks. However risk shares much with the first law of thermodynamics: energy can neither be created or destroyed, just transformed. When we effectively tax risk in one place it shifts to where it is un-taxed, like shadow banks. When we find it there and tax it again, it merely shifts once more, perhaps to non-financial institutions and so on. The logical extension of this approach is that risk will keep on shifting until it ends up where we can no longer see it. That is not a good place for risks to be. The exercise should instead be about incentivising risk to flow out of dark corners, to where it is best absorbed.

Another fundamental flaw is the notion of risk-sensitivity on which the recently announced capital requirements are built. This idea suffers from the post hoc ergo propter hoc fallacy. Banks don’t topple over from doing things they know are risky; but from doing things they were convinced were safe before they turned risky. Against loans they think are risky, banks demand extra guarantees, collateral, interest and repayment reserves. Against their reported risk-weighted assets, they were never as well capitalised as just before the crisis. Its not the things you know are dangerous that kill you. And under the risk-sensitive approach they had the least capital against those assets the models thought were safe before they turned bad.

If that was not bad enough, in their practice of risk-sensitivity, banks, corralled into using the same risk models and data sets, ended up buying the same assets that the models calculated had the best yield to safety ratio in the past. They were then forced to exit these crowded trades at the same time when there was a disturbance in volatilities and correlations. What has been generously called the Persaud Paradox of market-sensitive risk management – the observation of safety creates risks – reveals the common fallacy of composition of regulation: Trying to rid individual financial institutions of risk does not make the financial system safe.

A further fundamental error is the treatment of different risks as if they can be added up together and the aggregate amount of risk hedged with capital independently of how it is made up. The inconvenient reality is that different types of risk require different hedges and capital is not always the best hedge. Moreover, the right hedge for one risk may make another risk greater. For instance, the way to hedge liquidity risk (which is the risk that were you forced to sell an asset tomorrow it would fetch a far lower price than if you could wait to find an interested buyer) is by having long-term funding to tide you over. If markets became illiquid and you were short-term funded, no tolerable amount of capital would save you. Credit risks, on the other hand (the risk that someone defaults on payments to you) rise the more time you have. Matching credit risk to long-term funding would increase credit risks. The way to hedge credit risks is diversify across assets, not time, and have capital to make up the possible short-fall.

The solution to these three fundamental flaws to the current approach to regulation is presented in my recently published book: Reinventing Financial Regulation. The key mechanism of any solution is incentives. Although many see bad and unethical behaviour in the crisis, most of the behaviour that contributed to the crisis was incentivised and would have taken place anyway because of these incentives. Banks sold credit risks to institutions that had no capacity to hedge or absorb credit risks, because they had to put up capital against credit risks and the special purpose vehicles, insurance firms and hedge funds that bought them did not. In place of the credit risks that banks could have diversified across their customers, banks bought illiquid instruments that they could not so easily hedge when markets froze, like long-term mortgages, loans to private equity investments and indecipherable combinations of credit instruments. They did so because illiquid assets had higher yields but regulatory capital was driven off the credit rating. Locking up bankers is a satisfying rallying call but will not work to moderate the booms that lead to the busts if we do not also address the incentives.

Financial institutions should be required to put up capital or reserves against the mismatch between each type of risk they hold and their innate capacity to hold that risk. Risk capacity is not risk appetite. It is not determined by your ability to measure the economic cycle, which collectively we have proven to be bad at, but the ability to naturally hedge a risk. Risk-sensitivity needs to move over for risk capacity. Institutions with long-term funding or liabilities like life insurers or pension funds would likely end up not having to put up capital for liquidity mis-matches but against the lack of diversity of their credit risks. Banks with their short-term funding would probably have to put up a lot of capital against maturity mismatches, but little additional capital if their credit risks were well diversified.

The consequence would be that banks would be incentivised to sell good-quality credit but low-liquidity assets, like infrastructure bonds, to insurance companies and buy in liquid but low-quality credit risks, like corporate bonds, that they could hedge better than others. We would get risk transfers that strengthened the financial system, the exact opposite of those we had in the run up to the financial crisis when risks ended up where there was least capacity to hold them, amplifying the inevitable crisis. The economy as a whole would be able to take more risks, more safely. This would not require onerous levels of capital or bond investors that are somehow supposed to be better at gauging risks than bankers, because risks would be where they could be absorbed and where if they blew up, they would not take down the entire financial system.

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