Risk can’t be measured. Competition is destructive. Oh, and that bonus… you didn’t deserve it.
Three cursory observations from rating agency Moody’s (by their own admission, now measurers of the unmeasurable) sent out in a note to clients on Monday. And that’s before we get onto the “Faustian pact” Pierre Cailleteau, chief international economist at the agency, says is behind it all. What matters this financial endless toil/when at a snatch crisis should end the coil?
Risk traceability has declined, probably forever. It is extremely unlikely that in today’s markets we will ever know on a timely basis where every risk lies.
This is brave stuff. Moody’s are barring no holds. They paint a picture of a market where risk is unquantifiable and the value of products unknowable - papered over by sky-high bonuses.
Here, from “Archaeology of the Crisis”, are a few highlights - all worthy of extensive discussion in their own right:
On risk:
The combination of financial innovation, opacity and leverage is generally explosive.
Information asymmetries are the source of profits for some and, at the same time, of mispricing and excessive risk-taking for others. The “originate-and-redistribute” model for banks has entailed some degree of system-wide information loss once banks have started transferring risk that they would have preferred not to keep on their balance sheets.
Financial innovation often leads to an uneven distribution of the information available to the different parties at risk - usually until a crisis forces a more equal and adequate sharing. The problem in the case of extreme complexity of interconnecting financial systems is that it is hard to see how the level of information could reach levels adequate to enable reasonable risk management standards.
On competition and stability:
… a second, somewhat disquieting, reason: in the financial industry, in contrast with other businesses, there is a point beyond which increased competition is not stability-enhancing, but rather potentially destabilising.
Heightened competition is beneficial in terms of providing a better service and eliminating poor performers in the industry; however, past a certain point - difficult to identify - more competition means more, and perhaps socially undesirable, risk-taking.
On bonuses and compensation:
In plain English, it is not clear that existing compensation mechanisms effectively ensure that traders take into account the long-term interests of the bank for which they work - i.e. its survival. A recent policy announced by several banks to cap wages at a “moderate” level and pay the rest of the compensation in the form of stock is an acknowledgement of this problem. However, such “good intentions” do not generally survive a boom period, and in any event typically have unintended consequences of their own.
On asset valuation (and why your bonus was to blame):
The mark-to-market approach has obvious and compelling advantages in terms of apparent neutrality, timeliness and transparency. It is in tune with the explosion in the tradability of financial claims. It is also clearly superior to highly subjective mark-to-model accounting and apparently retrograde historical accounting systems.
However, somewhat like democracy, it is only the “worst system after all the others”.
The key issue is whether the market value corresponds to the economic value of an asset. One could, of course, retort: what is the economic value if it is not the tradable value of the asset.
At the same time, however, pretending that the economic value is necessarily equal to the market value ignores the possible existence of bubbles, overshooting, panic, mis-alignments… Or simply the fact that the “price” in question is only the fortuitous offspring of a handful of transactions.
In the credit market, an imperfect valuation paradigm has combined with misaligned incentive structures. In boom times exuberant market prices led to excessive investor returns; in bust times, doomsday valuations are feeding perverse market dynamics. In a way, inflated boom-time profits fuel individual remunerations (and risk-taking), whilst pessimistic spirals call for public intervention.
The road to a “perfect” valuation paradigm in credit mar-kets is not in sight, and it is not at all clear that equity or exchange rate markets have reached this point either. However, relying on a valuation system based on efficient market theory is - unless it is accompanied by other types of safeguards - a recipe for trouble.
Credit cycles are redundant concepts:
The idea of the “end of the cycle” at the end of the 1990s for instance proved to be an illusion - even if cycles now appear to be more moderate. Sorting out what in the recent decade is cyclical and what is structural is a most complex question and one on which a considerable volume of investments depend.
The difficulty of measuring risk over time is compounded by the way in which regulation is designed. Modern banking regulation aptly requires a proportionate increase in capital when risk increases. But all depends on what “risk” means. If the measure of risk accompanies the business cycle - i.e. risk is perceived as lower at times of boom and higher at times of downturn - the odds are that regulation will be pro-cyclical. Indeed, contrary to casual perceptions, risk in fact increases during boom times and simply “materialises” during the downturn.
And finally, the subprime crisis, and what the rating agencies were “supposed” to do:
As it happened, risk transfer has not been information-neutral: in other words, the final holder of a financial claim has probably less information than the originator of the claim. Rating agencies were supposed to bridge some of the information asymmetries, but this proved to be some-what unrealistic when the incentive structure of (sub-prime) loan originators, subprime loan borrowers, and market intermediaries also shifted in favour of less information.
So what to do about all this? The trouble of course, is that Moody’s can talk only in the most general terms. The problems are deeply ingrained… bust follows boom. With that in mind then, better the devil you know.
Commentary elsewhere:
Official: risk can’t be measured anymore
