The leading edge of this economic down cycle's tsunami is just beginning to hit individual financial institutions. How widespread the effects will be cannot yet be determined, but it is clear they will be devastating for some financial firms.
One thing that makes this down cycle dramatically different from previous ones is the degree to which risks have been spread outside the banking system.
This is the result of the increased use of structured instruments and other capital markets tools to mitigate risk, provide liquidity, and, in many cases, enhance fee income.
The market for these instruments has grown with only minimal governmental involvement. An unspoken partnership has evolved over the past 15 years which is a credit to both regulators and bankers. Regulators have monitored the increasing use of the instruments - using, where appropriate, more sophisticated examination techniques and capital markets-trained staff - and bankers, with only few exceptions, have used the instruments responsibly.
Some observers of this phenomenon have cheered it as a reflection of the free market at work, spreading and lowering risk as innovations evolve and markets deepen and broaden. They emphasize their view that the risk-mitigating gains have been obtained because there has been only modest governmental oversight, suggesting that increased oversight might make markets riskier.
Others have decried the developments and asked for a great increase in supervision. This group claims that untested arrangements and untested players will lead eventually to a rush to the cash markets that could cause a systemic collapse, since there will not be enough room for everyone to get out the door at the same time.
As is so often the case, there is some truth in both of these diametrically opposed views. Within a reasonable risk environment - two or three standard deviations from the mean - the new instruments and markets have been shown to lower the consequences of a shock to the system. However, when we get into a highly volatile environment that goes materially beyond these stress-test parameters, the new structured instruments can magnify risk.
Put another way, the real risk for financial institutions today is in the tails of the risk distributions. We are seeing some of this today in subprime lending generally and the housing markets in particular.
What should a financial institution do to protect itself from serious fallout from the coming down cycle, particularly the risk that its structured portfolio will not perform as advertised when volatilities increase? Let me suggest the following steps to be taken right away.
- Closely monitor structured portfolios, residuals, and hedging positions to ensure that counterparties can stand for the risk transferred; counterparties will perform on the instruments used to transfer risk; all optionalities are fully understood; and the risks intended to be transferred are actually transferred.
- Have your legal team re-review your rights and obligations under various structured arrangements. Counterparties under stress have been known to pursue a "default now, sue me later" strategy if contracts give them any room at all to do so. Overly legalistic interpretations of one's own obligations can be extremely misleading in a stressed environment when plaintiff's attorneys, attorneys general, and others look to your balance sheet for redress.
- Create or refine plans to manage down risks as the market becomes more volatile.
- Be rigorous about meeting periodically with top managers to review positions and mitigation strategies in light of changes in macro- and microeconomic environments. These meetings should include repeated reworking of scenarios in light of the changed circumstances. Scenarios change rapidly when the cycle changes direction and momentum for the new direction picks up, and it is essential to factor these changes into risk mitigation strategies.
- Take strong action to mitigate risks (e.g., unwind positions) when it appears that risks are likely to exceed expected stress scenarios. I have seen on multiple occasions that tail risks have been mitigated when immediate action was taken as the tail fattened. I have also seen catastrophic losses become baked into a firm's financials when the firm was not willing to take more modest losses earlier in the cycle.
- Monitor more vigorously areas where your risks are heavily concentrated or otherwise unusually large, given the size of your balance sheet. This monitoring should include, importantly, your own sales practices and those of agents acting on your behalf. I have seen not just retail sales practices, but also wholesale sales practices, challenged and stiff penalties paid when purchasers could claim that they were misled.
