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Subprime Crisis: The Yin and Yang of Market Development And Movement David Chow, Ph.D. Adjunct Professor, SooChow Univ. and National Chengchi Univ. (Formerly.

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Presentation on theme: "Subprime Crisis: The Yin and Yang of Market Development And Movement David Chow, Ph.D. Adjunct Professor, SooChow Univ. and National Chengchi Univ. (Formerly."— Presentation transcript:

1 Subprime Crisis: The Yin and Yang of Market Development And Movement David Chow, Ph.D. Adjunct Professor, SooChow Univ. and National Chengchi Univ. (Formerly CRO at China Development Financial Holdings Co.) June 30, 2008 Second Annual Risk Management Conference Risk Management Institute, National University of Singapore Panel Discussion: Issues in Credit and Liquidity Risks in Volatile Markets in Asia

2 The Seasoning of Finance As A Business Sector Since the 1990’s, finance was lifted by deregulation, globalization and technological innovation, these forces have made capital more readily available to the economy and made finance lucrative. –In the U.S., financial-sector profits accounted for 13% of pretax profits in 1980, it was 27% in 2007 –In 1980, GE garnered 92% of its profit from manufacturing, finance workers made about 10% more than comparable workers in other fields, –By 2007, GE’s financial businesses generated over 55% of its total profit, finance worker’s compensation premium is 50% (according to Prof. Thomas Philippon of NYU) –The brightest minds diverted to finance from other economic sectors After the crisis, governments are moving to make tighter controls over the finance industry and to require financial firms to hold bigger capital cushions against the credit they extend. 1.Initial adjustments to the new framework means re-focusing of businesses and massive lay-offs 2.Lower leverage, inevitably, means smaller play ground, lower profits, and less employment opportunities as a whole in the medium run

3 The Securitization Market Pendulum Securitization is a financial innovation that has made the capital more accessible, the associated markets more competitive and more flexible On the other hand, some financial products have become overly complex and less transparent, which will affect market efficiency in the long run. Years of benign economic financial conditions and abundant liquidity have made market participants and regulators became complacent about all types of potential risk But securitzation is not a free lunch: 1.It requires an in-depth understanding of credit risk not only for financial institutions but also for the common market participants 2.Firms that rely on models to assess valuation and risks should properly understand their limitations and to have sufficient commitment to form contingency plans in time to back it up 3.Regultors also often failed to highlight contingent credit risk requirements when liquidity becomes an issue

4 Incentives That Created A Food Frenzy Areas where banks were most willing to increase lending during the boom years have since seen the biggest rise in defaults –Places where it became easier to obtain a mortgage also saw declining income and employment growth compared with nearby districts –Districts with the highest level of mortgage rejections in 1996 subsequently have enjoyed the largest increase in the rate of approvals between 2001 and 2005 This suggests that the issuing banks, knowing that they aren’t totally responsible for the outcome once the loans are out of their possession, tend to treat the suspected mortgages with roughly the same care as a second-hand car salesman Firms that actively packaging and selling credit exposures retained increasingly large pipelines of these exposures, without adequately considering or managing their pipeline risks Originators that do not have contractual obligations still provided voluntary support to off-balance sheet financing vehicles, such as SIVs and ABCP’s

5 Innovations That Says Buyers Beware Credit default swaps (CDS) allow two parties to exchange credit risks of an issuer or an underlying company. As a derivative contract, this types of transactions can be done without owning the underlying entities and can generate huge gains or losses through leveraging Through CDS, banks found partners in hedge funds, where lightly regulated pools of capital are looking for high returns (as well as insurance companies and pension funds that were also seeking high yields as interest rates hit historically lows) Shedding exposure to credit risk also means for banks not having to reserve as much capital for potential losses, that allows banks to free up capital for other businesses or to make even more loans Transactions such as the ones illustrated above tie up the regulated part of the institutions together with the unregulated entities. On the OTC market, When everyone is cross-insured, who is the last resort when the system is insolvent? For now, regulators are proposing additional capital requirements on liquidity and modeling risks

6 Risk Management That Has Developed Tunnel Vision During Stress One of the most serious shortcomings of traditional risk management is its silo-based risk framework, where communication among risk, finance, and operations are insufficient –The Basel-based risk management excludes “strtegic risk” and divide risks into “market risk”, “credit risk”, and “operational risk” –Under a strong profit-focused environment, banks usually view risk management as a cost center, its operation is independent yet lacks interaction and support from other departments –Thus, while many financial institutions are good at quantitative analysis and financial modeling, the risk governance often becomes fragmented and disconnected from risk measurement ERM is often defined as an organization-wide approach to the assessment, identification communication and management of risk. –The division of “banking book” vs “trading book” has created loopholes, where credit risks in trading books have been ignored –Since mitigation strategies don't always work as well as planned, it is important to measure exposure on both an integrated (ERM) and residual basis –For banks, that entails the coordination of risk management between disparate but vital areas of finance, including operations, credit, interest rate and markets.

7 Is Value-at-Risk at Risk? VaR captures how bad things can get 99% of the time, but the real trouble is caused by the outlying 1%, the “long tail” of risk –The data used to estimate VaR are drawn generally from both periods of expansion and periods of fear, but it happens that the latter usually occur in a far shorter period than the former, which is driven by a slow but cumulative build-up of euphoria –Hence VaR itself is programmed to instil a false comfort bacause of the limited historical data it uses –Common sense suggests that the risk of a blow-up will increase, not diminish, the farther away one gets from the last one Yet VaR acts as an amplifier when trouble does hit. –Episodes of volatility would send VaR spiking upwards, which triggers moves to sell, creating further volatility –In general, VaR’s passive and pro-cyclical feature has been known but accepted –There is likely more emphasis on using non-statistical ways of thinking about risk, we should be more rigorous about imagining what could go wrong and thinking through the causal effects

8 Basel: I, II and III: Frameworks for Pandora’s Box? The 1988 Basel Accord first created the opportunity for regulatory arbitrage –A capital discipline designed to improve risk management had the unintended consequence of help creating a new market sector The 2007 Basel II allows qualified banks with sophisticated risk management systems to use risk assessment based on their own models in determining the minimum amount of capital they are required to hold –It has created perverse incentives for banks to underestimate credit risk in order to minimise required regulatory capital –In many banks the internal risk models, especially when pricing low- probability credit risks, performed poorly and greatly under-estimated risk exposure As reflect in the new Financial Stability Forum, Basal II will receive a major facelift in order to bring the unforseenable risks into order –The old rules are lacking in dealing with systems whose complexity and lack of transparency caused the market seize-up –Can we count on another set of rules such as Basel III as a cure-all for today’s problems?

9 Can Financial Bubbles Be Micro-Managed? The Fed’s traditional approach to fight bubble formation is under attack. Can monetary policy known as “leaning against the wind” be used to fight bubbles? –But it is difficult to judge whether you are seeing a bubble or not. Usually one does not know until afterwards –Bubble dynamics are too powerful to be arrested by anything other than very large increases in interest rates that its effects could be devastate to the economy Mr Bernanke is tempting to use regulation selectively and aggressively to target specific excesses –Using regulation as separate tool to ensure that asset prices are not widely out of line with fundamentals. –But heavy-handed requlation can have severe consequences, the lesson learned from Sarbanes-Oxley was not to rush The U.S. Treasury is also proposing a new “macro-prudential” powers – the ability to regulate large banks according to specific regulations –The proposed macro-prudential authority would allow the Fed to order any financial institution to alter behavior it believed jeopardized overall financial and economic stability

10 Boom-and-Bust Market Swings That Reflected Excesses And Misalignments What we are witnessing is not just a collapse of faith in a few institution or even an asset class. It is a loss of trust in the whole style of modern finance that reflected in the following areas: –The complexed slicing and dicing of risk into ever-more opaque forms that left buyers in the dark when shocks occur –As a result of financial innovation, banking itself has also become complex and opaque –Unexpected chain reactions can happen from shocks that occur in an obscure corner of finance People now are too focused on subprime and missing the broader storm coming: –Separate from subprime, we could see diminished ability for consumers to spend in an inflationary scenario, banks might slow their funding, and the economy could falter –The tsunami that started with subprime may not be ended in financial and housing sectors alone -- what about inflation and oil crisis?

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