Author: Avinash Persaud
G7 policy makers chant three things about international Finance: more market-sensitive risk management, stronger prudential standards and improved transparency. These are likely to be a positive force in the long run when markets are better at discerning between the good and bad. But in the short run there is growing evidence that market participants Find it hard to discern between the good and the unsustainable, they often herd, and contagion from one crisis to another is common. The problem is that in a world of “herding”, tighter market-sensitive risk management regulations and improved transparency can turn events from bad to worse, creating volatility, reducing diversification and triggering contagion.
How can this happen?
The growing fashion in risk management, supported by the Basel Committee, is a move away from discretionary judgements about risk and a move to more quantitative and market-sensitive approaches. This is well illustrated by how banks now tend to manage market risks by setting a DEAR limit – daily earnings at risk. DEAR answers the question: how much can I lose with, say, a 1% probability over the next day? It is calculated by taking a bank’s portfolio of positions and estimating the future distribution of daily returns based on past market correlation and volatility. Both rising volatility and rising correlation will increase the potential loss of the portfolio, increasing DEAR. Falling volatility and correlation will do the opposite. Banks set a DEAR limit: the maximum dollar amount they are prepared to put at risk of losing with a 1% probability. When DEAR exceeds this, the bank reduces exposure, often by switching into such things as US dollar cash.
By herding behaviour I mean that banks or investors like to buy what others are buying, sell what others are selling and own what others own. They do this because, First, the best way of exploiting the information of others is by copying what they are doing. Second, bankers and investors are often measured and rewarded by relative performance so it literally does not pay a risk-averse player to stray from the pack. Third, investors and bankers are more likely to be sacked for being wrong and alone than being wrong in company.
Imagine that over time a herd of banks have acquired stocks in two risky assets that have few fundamental connections, say, Korean property and UK technology stocks. Imagine too that some bad news causes volatility in UK tech stocks and the banks most heavily invested there Find their DEAR limits are hit. As these banks try to reduce their DEAR by selling the same stocks (Korean property and UK tech) at the very same time, there are dramatic declines in prices, and rises in volatility in both markets and in the correlation between Korean and UK markets. Rising volatility and correlation triggers the DEAR limits of banks less heavily invested in these markets but invested in others. As they join the selling milieu, volatility, correlation and contagion rises.
Further assume that a country has recently signed up to the Special Data Dissemination Standard (SDDS) – one of the lasting responses of the 1995 Tequila crisis – and the 1999 Code of Good Practice, and as a result, has started publishing its foreign exchange reserves daily. In this case bankers and investors with more modest exposures would observe that as risks grow – prices are falling and volatility rising – other bankers and investors are leaving the country rapidly. In this heightened environment they will view the country’s loss of reserves as doubly increasing the risk that they are left wrong and alone. This will trigger a further exit.
The predominance of herding behaviour with the practice of DEAR limits may explain why the 1990s was such a decade of Financial dislocation: the Financial system was in crisis for 40 out of the 120 months.
Evidence for more frequent Financial crises and for Financial contagion can be found in the forex markets. If we define a crash as a 10% fall in the real exchange rate over three months, there have been 78 across 72 countries since the EMS crisis began in September 1992. These are not distributed evenly over time or distributed with deteriorating fundamentals, but they cluster. Contagion is rife, with 70% of crashes in just three years. This contagion does not move predictably along lines of trade, but along lines of shared investors. The lines of the most recent crisis, for example, were from Thailand and Indonesia to Korea, on to Russia and then to Brazil. These share very little trade. Furthermore, crashes are invariably preceded by booms as the herd assembles. The chart shows forex crashes per year across 72 countries as bars and annual cross-border portfolio Flows into emerging markets as a line. Note how investors rushed into emerging markets in 1995 and 1996, before the 1997 and 1998 crashes.
The paradox is that if one or two banks followed a DEAR limit and others did not, those banks would have an effective risk management system that at the margin would support the Financial system. But if every bank were to follow the same approach, given that these banks follow each other into and out of markets, the DEAR limit would contribute to systemic risk.
Herding presents a classic example of the need for intervention. The individual incentives of herding investors create systemic risks. Moreover, if regulators were so co-ordinated that they behaved like one global regulator, they would be best placed to intervene. Through the privileged information they have as a regulator of bank balance sheets they know when banks are herding. This requires a different focus. Today regulators are warned by their peers when banks in their jurisdiction have exposures that threaten themselves, not whether banks worldwide have exposures that together threaten a foreign market and could become contagious.
However, if this information were made public, in the context of herding investors, random shocks could quickly evolve into Financial crises. So how should regulators respond if they notice herding in a particular market? They should require the bank to put aside extra capital for “strategic risk” without specifying which markets carry that risk. Applying tighter risk management requirements for those specific markets in which the herd has appeared will only make the stampede more vicious when negative news strikes. Collateral requirements are like a tax on banks and are very unpopular. However, banks could be given the choice of either putting up strategic collateral from time to time, or by buying liquidity options from the central bank during good times.
The concept of market-sensitive risk management practices needs to be seriously reconsidered and the authorities should rethink their extension to the use of credit rating agencies and the risk management of long-term investors.
Indeed, there is a role for one unregulated investor who is encouraged to buy near the bottom of markets through the absence of risk, capital disclosure and credit concerns. Such investors would make the system safer but should be restricted to those who can afford to lose. If they had to be invented they would resemble hedge funds. Interestingly, as the hedge funds have been undermined by bank disclosure and credit policies, market liquidity has fallen and volatility has risen. Just as the big macro hedge funds fade away we may Find they supported the market as much as they exploited it.
There are other flows that do not herd so much, foreign direct investment for example. Further, during the Mexican and Asian crises, equity portfolio Flows also revealed less herding than bond Flows. It would appear that bond investors are keen to get out before they are held in by a debt moratorium or orderly work-out. This raises interesting questions for those trying to build burden-sharing and orderly work-out provisions into bonds.
Transparency in data and governance is clearly good in the long run. Governments should be encouraged to disclose more information monthly and quarterly, but not daily. In an herding environment, there is not a good case for insisting on release of reserve data with such high frequency. It is telling that during the EMS crisis, many of developed countries that had just adopted the Code of Good Practice on Transparency found it helpful to delay monthly publication of reserves or to camouflage information for several months. Small vulnerable emerging markets will Find it even more helpful to delay publication.
A full version of this essay by Avinash Persaud, managing director, global trading and research at State Street, is available through www.statestreet.com. It won first prize in the Institute of International Finance’s Jacques de Larosière awards in global finance, 2000
