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A TELEVISION presenter
broadcasting out of The message was subtle
but clear: The ongoing turmoil in financial markets has exposed weaknesses in
the system, and |
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But no, not quite yet -
not, at any rate, till a number of structures have been put in place. An area that needs to be
looked at in this regard is risk management, or its lack thereof. Inadequate
risk management was one reason American and European financial institutions
took such big, risky bets that have since exploded in their faces. But they
thought they were doing right and their actions were sanctioned by
regulators. Why so? Lending a mortgage worth
$800,000 while the collateral has a market value of $1 million, and is fast
rising, seems conservative. If you don't lend in such circumstances, your
competitors would. Moreover, you are incentivised
to lend because your remunerations are tied to the short-term performance of
your loan portfolio. In short, moral hazard fuelled aggressive lending
practices, which pushed up the value of the collateral too. This bubble
feedback loop made housing prices a bigger systematic risk factor in the The current US housing
crash would have been like any other bubble-bursting story had financial
instruments like collateralised debt obligations (CDOs) and credit default swaps (CDSs)
not been invented. Bundling mortgages into securities and selling them freed
up funds for financial institutions to make more loans. CDOs
and CDSs transformed a 'systematic risk' rooted in
the housing sector into a 'systemic risk' for the entire financial system. It is indeed
mind-boggling that so many financial institutions allowed themselves - and
were allowed by regulators - to be exposed so heavily to the housing sector,
blithely assuming they were properly hedged. What can be done to prevent a
recurrence of such cascading systemic risks ? The modern financial
system has two pillars: a payment system via banking networks and a
securities clearing mechanism via various organised
exchanges and dealers. The current regulatory support system is tilted
towards safeguarding the payment system with facilities like deposit
insurance and central banks serving as lenders of last resort. These safety
nets aren't perfect, but we have witnessed how they worked in stabilising markets amid the current panic. Due to the
gravity of the situation, governments have expanded deposit insurance to
cover more deposits, guaranteed interbank lending, and bought commercial
paper directly. An important part of the
second pillar is organised exchanges through which
stocks, bonds and some derivatives are traded. In the case of stocks and
bonds, the role of exchanges is to facilitate transactions, and they do not
take direct positions. For derivatives like futures and options, organised exchanges facilitate anonymous trading; and the
exchanges serve as the counterparty to both sides and is
thus exposed to credit risk. As a safeguard, trading parties are required to
put up collaterals, known as margin accounts, for settling daily gains or
losses to avoid accumulating large losses. An important component
of the second pillar is the Over-the-Counter (OTC) market for interest rate
swaps, currency forwards, CDSs and other exotic
derivatives. The intrinsic need of businesses for tailor-made contracts is
the driving force behind the OTC market. Market makers often step in as a
party to a trade when a suitable counterparty cannot be found. Trades are
conducted by relying on the credit ratings of participants. Unlike in organised exchanges, it is hard to set up suitable margin
accounts in the OTC market to mitigate credit risks because the derivatives
traded are non-standard and infrequently traded. The systemic risk
inherent in the OTC counterparty arrangements became evident in the near
collapse of Bear Stearns and American International Group, and Lehman
Brothers' bankruptcy. It has been suggested that some of the OTC trading can
be moved to an organised exchange. But it would be
naive to think that organised exchanges can
completely replace the OTC market. The current financial crisis forces us to recognise the vulnerability of this important pillar of
the modern financial system. The time has come to
establish an international agency to guarantee the OTC market makers for
their counterparty exposures, much like deposit insurance. But unlike
domestic deposits in banks, counterparty transactions here can't be confined
to one jurisdiction. This guarantor should be global in nature and be funded
by member states whose voting rights in the agency would be determined by the
size of their contributions. In exchange for the
guarantee, OTC market makers would pay risk-based premiums to the guarantor.
These premiums can be determined by a combination of quantitative and
qualitative measures, in a manner similar to the deposit insurance schemes
that exist in many economies. Asian governments should seize this opportunity
to take leadership in this endeavour. I am of the
opinion that Complacency tends to set
in after any crisis is over. It is probably impossible to avoid future crises
like the current. But at least we can try to reduce their frequency and
contain the damage they cause once they occur. We need to implement better
safeguards. This applies to Asian regulators, and the institutions under
their supervision, as well as to European and American ones. Indeed, even
more so because corporate governance in Asia is still weaker than in Europe
or the Wall Street will change
as a result of this crisis. The broader trends indicate Asian economies are
becoming stronger relative to the developed world. New and better ideas will
emerge from Asian centres of finance. I look forward to the
day when that TV presenter in The writer is the Cycle
& Carriage professor of finance at NUS and director of the NUS Risk
Management Institute. This is the ninth article in the |
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