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Quiet financial markets permit greater leverage and risk taking, helping lower volatility further — until a large shock arrives. Then, hold on to your hats… Plus: Fed raises bar on stress tests; why the exercise is an opportunity for banks.
March 21 -
Insurers, private-equity firms and others could swoop in and take underwriting and syndication business (and employees) from banks held back by new capital requirements.
March 19 -
Banks are going to have to work harder next year if they want to continue to pass the Federal Reserve Board's annual stress test exercise.
March 19
Quiet financial markets should arouse suspicion.
That's the gist of a recent strain of thinking and research on low volatility, some of which has begun to filter into regulatory policy discussions about systemic risk. The concern extends beyond the prospect that tranquility might indicate complacency.
Instead, low volatility, tight interest rate spreads, and small haircuts on repurchase agreements facilitate and encourage risk taking behavior.
The point is in some ways axiomatic. "You might say that anyone who has spent a week on a trading desk could have told you that," said Richard Berner, the director of the Office of Financial Research in a
Framed as the "
At the root of the concern is the concept that low volatility can be self-reinforcing.
"If volatility has dropped by a third, why not take one and a half times the leverage?" wrote Bookstaber, a writer, investor, and risk manager who has since gone to work for the Office of Financial Research. As levered entities provide more liquidity to the market, spreads tighten, hedging becomes easier, and volatility drops even further.
Academic research demonstrates how the feedback loop works in practice.
As part of a 2012 paper on
"The capacity of intermediaries to take on risk exposures depends on the volatility of asset returns," the authors wrote, arguing that volatility must be considered an endogenous trait of markets. In other words, it is produced by the markets, not simply a condition that affects them.
"This isn't something that is too subtle," says Bookstaber, who is looking at how low volatility can set the stage for rapid deleveraging and short-term funding runs. "The very time the waters seem the smoothest is the time that risk is building up."
One regulatory solution to this would be to rely more on "simpleminded leverage ratios" than on sophisticated risk weights to measure banks' capital, Bookstaber says.
Regulators have considered other approaches touching on low volatility. A May 2012 paper on trading capital by the Basel Committee on Banking Supervision suggests that bank regulation should consider effectively setting a sort of
An argument can be made that low volatility can destabilize markets in other ways, too. Karen Shaw Petrou of Federal Financial Analytics argues that it encourages the reach for yield by diminishing the ability to make money as a financial intermediary.
"In a low-volatility market, you can't make it by being a really sharp trader," she says. "The market doesn't afford you the in and the out in which you can buy and sell. You have to do something else."
A case can be made that the effects of prolonged low volatility may overlap with those of prolonged low interest rates. As Federal Reserve Governor Jeremy Stein noted this month, the lengthening maturities of bank securities portfolios suggest that it would be reasonable to
In addition to fueling risk taking, low interest rates may ultimately reduce volatility, feeding into the feedback loop Bookstaber described.
In a 2012 Federal Reserve discussion paper focused on commodity markets, authors Joseph Gruber and Robert Vigfusson showed how low interest rates allow intermediaries to
"By decreasing inventory holding costs, lower interest rates encourage the use of inventories to smooth prices," the authors wrote in a paper cited by the
Apply that same logic to financial assets and volatility, and there's cause for yet more concern about leverage when a source of volatility reemerges or interest rates rise. Either one could contribute to fire sale conditions.
Considering the perils of low volatility is a natural response, Petrou says.
"Just because market conditions seem stable, no one should be comforted that there is no risk," she says. "Regulators are trying to nip a repeat of the crisis before it occurs, and more power to them."