The past year seems to have zipped through even more rapidly than these things are wont to. Paul Krugman in a scathing article in September last year introduced the apt and witty phrase ?Market for Lehmans?. Much financial sewage has since flowed under regulatory bridges, and Wall Street is beginning to shakily regain some of its swagger. New financial innovations, very reminiscent of the old days, are coming back in vogue. A recent newsreport described the securitisation of life insurance payouts, including unintended and undesirable consequences on the underlying insurance business, and it is only a matter of time before the next deluge of financial acronyms washes upon us. Investors are once again hungry for alpha and will soon begin to enthusiastically buy into these products.
Writing on the then seemingly catastrophic developments of mid-September 2008, I remember writing on shadow banking systems, the inter-connectedness of financial transactions, disorderly deleveraging, information asymmetry and such other issues then currently the subject of popular discussion. These issues and means of mitigating their adverse impact have since been discussed at weighty forums, unfortunately without much resolution.
So, where do we stand now? Public and political anger in developed countries have focused on salaries and bonuses of Wall Street, ?the privatisation of profits and socialisation of losses?, taxpayer-funded bailouts and the disconnect between Wall Street and Main Street. There are bound to be some curbs on these given political compulsions, but the real issues of concern lie elsewhere.
There will be a whole series of regulatory measures relating to increased capital requirements, the treatment of liquidity, systemic and other risks, counter cyclicality of prudential measures, improvements in scope and consistency of accounting standards, efforts to move OTC instruments to exchange-traded ones, the risks of systemically large financial intermediaries and so on. Each of these has been debated with an increasing intensity as the anniversary drew closer. There is little point in reiterating these, except probably to emphasise my own views of these reform measures.
The argument that untrammelled financial innovation is necessary for the efficient allocation of capital has clearly proved incorrect. The worst financial excesses of the past few years have quite patently resulted in a spectacular misallocation of capital, particularly in mortgages. Second, and tied with this, was a faulty system of incentives that fed the misallocation. A ?policy? response to this latter in the form of caps and clawbacks is being discussed, but this is likely to be misguided or ineffective and unlikely to be implemented.
But any reform requires some quantification of the underlying problem?if you can?t measure it, you can?t improve it. One obvious reform effort will be to migrate as much of current OTC transactions to exchanges, to facilitate price and valuation discovery. But, as much this as migration might happen, it is likely, by the very nature of these transaction structures, that complex financial instruments will largely remain bilaterally customised. These will remain illiquid and amenable to be valued primarily through statistical and computer models.
This leads us to the problem of model risk, which is not as extensively discussed in the media and popular discussions. The gross failure of the current class of models in both pricing, risk valuation and credit ratings was painfully obvious the last time around. There is increased acceptance of the need to model tail behaviour, using more recent developments in ?fat-tailed? distributions and other statistical advances in understanding interdependencies. But while these are certainly likely to be major improvements over the previous generation of models, they will still not be able to capture the complexities of the environment over the lives of the exotic instruments.
Valuing, for instance, one of the more complex exotics?constant proportion debt obligation (CPDO)?requires assumptions over, say, ten years on at least 11 separate credit variables, including near- and long-term spreads of key reference indices, the deviation of their volatilities from averages, the number of credit downgrades in the reference indices, their timing, the number of credit defaults of the components of the reference indices, their timing, the movement of base (and policy) interest rates, and others. While the enormity of this will not be easily grasped by any but the most technical of readers, the litany itself will probably convey the degree of judgement that underlies these models.
The bottomline? Regulators have to be aware of the limitations of mandated restrictions on any of these aspects. More intrusive regulation is almost inevitable, but a better interface between regulators and banks will be the most effective deterrent to a rerun of this crisis.
The author is vice-president, business & economic research, Axis Bank. These are his personal views