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The Actuary The magazine of the Institute & Faculty of Actuaries

Financial economics: Markets in crisis

Among the many volumes of commentary and analysis on the financial crisis, there is one contribution which stands out prominently for its brevity, quality and candour: the British Academy’s response to a question from H.M. the Queen as to why the crisis had not been foreseen. To quote from the response: “Everyone seemed to be doing their own job properly on its own merit. And according to standard measures of success they were often doing it well. The failure was to see how collectively this added up to a series of interconnected imbalances over which no single authority had jurisdiction. This, combined with the psychology of herding and the mantra of financial and policy gurus, lead to a dangerous recipe.”

There is an important missing ingredient in this conclusion: any explanation of why some markets failed so totally in the crisis. We know that financial markets are prone to do so from time to time; numerous instances may be cited from history. The answer to this fundamental question is based in uncertainty, and has been well stated by Stirling University’s emeritus professor of economics, Ken Loasby. Essentially, in order to exploit the gains to trade from markets, it is necessary to adopt a convention where uncertainty in our knowledge is ignored, and indeed denied.

In this position, risk management cautions are challenges to convention and the team ethos; they are likely to be ignored until the uncertainty faced is overwhelmingly obvious. It is also possible that, to reduce the dissonance arising from such warnings, risk managers will be ‘domesticated’ by management; that is, invited to offer cautions in all circumstances only to be ignored and treated rather like a household pet. In this context, Chuck Prince’s infamous “We’re still dancing” line is understandable.

The obvious question that follows is: what does it take to wake management from its denial reveries? To which the usual answer is liquidity and its close surrogate, collateral. To illustrate this latter point, let us consider the case of Bear Stearns. At the end of February 2008 Bear Stearns reported that it held $303bn of collateral, of which $211bn had been used to generate cash or substitute for delivery of cash. So funding of the order of 50% of the Bear Stearns’ balance sheet was conducted in a predominantly day-to-day market; in street jargon, this practice of using customer collateral as security for further loans is known as ‘(the right of) re-hypothecation’.

With securities lending, title, but not ownership, passes to the borrower. The lenders of funds did not know whether the securities offered to them as collateral were beneficially owned by Bear Stearns or by one of its clients. When rumours of distress and difficulty abound, focus on exposures and the legal minutiae of agreements is warranted and usual practice. Advancing funds against securities to which Bear Stearns had legal title but perhaps not unconditional beneficial ownership now carried a material risk of entanglement in dispute if the beneficial owner sought recovery. When competing claims to securities develop, the consequence is potentially far larger than might be provided for by any pragmatic margin or ‘haircut’ arrangement. In these circumstances, it is unlikely that the borrower will be able to secure further funds — almost regardless of the interest rate they are willing to pay.

Collateral is now widely offered in support of long-term bilateral contracts that may involve material and changing credit exposures. The existence of collateral provision agreements lowers concerns over a counterparty’s credit standing, but at the cost of introducing path dependency, funding liquidity requirements and higher costs for that counterparty. Demands for collateral do, though, unequivocally focus the attention of management upon the situation at hand, where denial is not an option.

This far, those who have considered the ‘drying-up’ of funding liquidity available to the distressed institutions have overwhelmingly ascribed this to a ‘rational run’, founded only in rumour — a description which stretches credulity by assuming that financial institutions act on rumour alone. The description here attributes the situation to exposure of the unspoken convention with regard to uncertainty and challenge to that convention.

In fact, there is now a much more general requirement for a comprehensive analysis of the role of collateral and collateral management practices, together with their induced path dependencies and their interactions with financial markets and contracts. This is particularly relevant in the context of the proposed central clearing house arrangements for derivatives instruments, where, of course, risk management is dominated by margin collateral techniques.

Con Keating is head of research and a founding team member of BrightonRock