Multiplying Risks In An Uncertain World

Multiplying Risks in an uncertain world: Moving away from the fundamentals By: Procyon Mukherjee Zurich I chanced upon a brilliant article by R.Rajan, while I was going through the FY2008-09 Annual Report of BIS (Bank of International Settlement), which referenced this article written in 2005. Unfortunately the whole world ignored the analysis he did about chances of increased risk with the risk mitigation efforts launched by the financial instruments, CDS, Derivatives, et al. I have summarized his findings and those from the BIS paper as follows: 1. The incentives to take "tail risks": The investment managers were actually selling in this case disaster insurance to produce positive return most of the time as compensation for a very rare negative return, since true performance could only be ascertained over a long period; they never got evaluated as the horizon fell outside the average fund managers' incentive time period. Chan et al had proved in 1999 that a hedged position can turn completely un-hedged when catastrophe strikes taking the Russian debt example. BIS paper proves that most distributions were not normal distributions as envisaged by the experts and such fat tail distributions had higher propensity of carrying tail risks. 2. Herding: Originally Herding was meant to insulate against under-performing but that increased the ability to move asset prices away from the fundamentals (this has happened in stocks and commodities and whole exchanges or indexes); the fund managers (who did not want to be part of the herd) who wanted to move the prices back to the fundamental were challenged with the up heal task of fighting against the enormous mass of 'herd managers' who were pursuing the trend, with no rationale what so ever. 3. Incentives and Low Interest Rates: Excessive tolerance for risk in a low interest rate regime. With markets completely integrated this is a prescription for risk multiplication. With liquidity freely flowing in the markets, the chances of risk explosion is almost positively confirmed by studies. The financial market explosion triggered by macro-economic imbalances (like current account imbalances, low interest rates and credit boom) and micro-economic factors like de-regulation, incentives and risk measurement got the trigger from much higher risk taking that was originally meant for mitigating risk taking efforts. Why did the discerning public, the corporate houses and their risk management cells fail to decipher that within the confines of this strategy of risk mitigation was embedded a much higher propensity of risk as with crowding and bundling of products that made risk trading to be possible and sometimes profitable as well, there was this high probability that when crisis would strike, like a pack of cards there would be no end in sight before bankruptcies would loom ? This apparent ignorance of the situation is well in evidence by the herding community who were irrational par excellence when they drew money from the bank at high interest rates to invest in stocks when the stocks were already over-valued (some of them are my friends in India, where interest rates are relatively high) or in mortgage products where the high prices already broke all bounds of rationality. In the root of this ignorance is the fundamental principle on which all stock markets thrive, if every man strikes the same belief as the collective, then every man either believes that the stocks should move up or move down. In the former case it helps to move it up and in the latter it brings it down. If every man thinks differently to the collective wisdom, he counteracts to the cause. The environment created more positive connections to the collective wisdom and helped to make the market buoyant. It was just the opposite of what supply and demand curves would do in Classical Economics, the market moved away from the fundamentals.

The banks created clones of intelligentsia that pervaded into corporate cells that preached the same gospel, take more risk by methods that were never applied before. I heard about the word hedging only in the year 2004, just five years before, and now it seems to be the catchword without which almost nothing can be done. But if one would plot the volatility of assets subject to hedging by various constituents, one would see the relationship only far too well. The increased activity in hedging risks in assets actually made them more volatile and therefore subjected them to tail risks disproportionately. ************** This environment has now turned and the current fund managers are trying to get on terms with the changed scenario, risk aversion on tail risks, being more cautious on herding against herding is still being played out and the incentives are slowly changing forced by the regulatory environment. But public memory is short and the same mistakes could be made again guided by faith in instruments that may or may not be capable enough to be resilient in all situations. It is most likely that the markets would move back to "fundamentals driven" approach rather than be a reflection of irrational herding mentality, as neither liquidity would support it nor would the incentives be same as before. But this remains to be seen what happens to volatility.

Procyon Mukherjee Dated 3rd July 2009, Zurich, Switzerland