All about tail risks and negative spillover
We need economic policies that are designed to “lean against the wind” rather than clean up, a closer dialogue between academics and practitioners and a clear distinction by policy makers between tranquil and turbulent times. These are some of the lessons drawn from the financial crisis by Dr Lucjan T. Orlowski, a professor of economics at the J.F. Welch College of Business, Sacred Heart University. Dr Orlowski spoke at a CFA conference in Luxembourg on the topic: “Extreme Risks in Financial Markets and the New EU Financial Regulatory Framework”.
LFF: Professor Orlowski, can you name effective means of identifying, measuring and controlling extreme market risks?
Let me begin from clarifying “extreme tail risks”. These are risks stemming from extreme outcomes, which suggests that time series data distribution of financial market variables is not Gaussian (i.e. normal), but leptokurtic, meaning that it has “fat tails”.
In more simple terms, prevalence of fat tails indicates high concentration of data around the mean at tranquil market periods and wide, disorderly data dispersion at turbulent times. Identification of tail risks is not easy; we can detect them in historical data series by using econometric methods such as extreme-value modeling or generalized error distribution in the autoregressive conditional heteroscedasticity models.
Predictions of these risks are even more complex, because we cannot pinpoint precisely when a turbulent market period arrives on the scene. We have, however, a fairly good knowledge about the factors exacerbating tail risks. They include lax macroeconomic fundamentals - particularly a mix of twin government budget and current account deficits, and far-reaching deregulation of financial markets in the presence of large capital inflows and asset-price bubbles.
It is imperative to have some knowledge about proliferation of tail risks in financial markets and about effective policy responses aimed at abating these risks. It is because severe outbursts of volatility of key financial variables, particularly equity market indexes, all kinds of interest rates, and exchange rates are likely to induce negative spillover effects into the real economy.
Such tail risks may engender a full-fledged systemic risk, and subsequently impair credit, business fixed and financial investment, leading to economic recession.
Do financial institutions need more or better regulation?
I am led to believe that the recent discussions about the magnitude and the scope of financial regulation are somewhat misguided. What we need is an effective regulation, and not a large scale, sweeping regulation. The new regulation shall not hinder banks flexibility and initiatives.
Among other tasks, the new regulation should be aimed at signaling problems with the credit-, liquidity-, default- and types of risks faced by financial institutions. In addition, we need better modeling and forecasting stressful market conditions. The new initiatives of the Basel Committee are commendable, going in the right direction.
Among other modifications introduced by Basel III, I particularly welcome the introduction of the (2.5%) conservation buffer on top of the minimum capital requirements. Such counter-cyclical buffer will help cushion negative effects of extreme tail risks in financial markets on asset/liability and risk management in the banking sector. We also need better supervision of all financial institutions, including all alternative investment companies.
It is imperative that balance sheets and income statements of financial institutions will be accurate and off-balance sheet activities will be minimized and properly reported. We also need stricter regulation of derivative instruments, specifically, subjecting trades in complex derivatives to central clearing.
However in hindsight, I trust that financial institutions have learned good lessons from the recent crisis and will not revive excessive leverage, opaque asset securitization and uncontrollable risk-taking, so there is no need to remind them about these dangers.
The Basel III implementation process: challenge or burden for banks?
The Basel Committee has introduced meaningful improvements to the capital adequacy and to the supervisory review process. Higher minimum capital requirements, the conservation buffer, new stricter definitions of risk weights are all necessary. In my opinion, Basel III gives banks a generous adjustment period to the new standards. National financial supervisory committees are likely to require banks to raise more capital more swiftly.
Some banks will find it difficult in the short-run to comply with the new set of standards, but they will benefit in the long-run from becoming more solvent, less risky and from sticking to the core, less risky commercial and investment banking activities.
What are proper policies for abating tail risks?
Proper policies for abating tail risks ought to have at least two characteristics: counter-cyclicality and flexibility. This pertains to fiscal and monetary policies, as well as macro-prudential regulatory policies. Monetary policy should be “leaning against the wind” (as characterized by the researchers from the Bank for International Settlements).
It means that the policy should be pro-active, aimed at preventing proliferation of financial instability, i.e. the buildup of asset-price bubbles and uncontrollable risk-taking by financial institutions. Ideally, monetary policies should be based on a dual mandate of price stability and financial stability.
For this reason, I advocate a framework of flexible inflation targeting where the goal of low inflation is coupled with the objective of minimizing systemic risk, or in more practical terms, a sovereign risk. Macro-prudential regulations for abating tail risks should contain flexible treatment of capital adequacy ratios for banks, supplemented with contingent capital requirements.
This will lead to higher capital ratios, thus capital accumulation at normal periods, and lower ratios at times of financial distress in order to sustain bank lending. Equally important is the regulation of derivatives instruments, particularly subjecting trades in complex derivatives to central clearing. Disciplined fiscal policies will help mitigate tail risks as well.
Can we say that the latest financial crisis differs from previous crises by its complexity?
The latest crisis has been by far more complex than the previous crises episodes. We have witnessed its proliferation from the U.S. subprime mortgage market, through other credit markets, followed by the collapse of complex derivatives such as collateralized debt obligations, commodity price bubbles and, ultimately, a global economic recession.
Before this crisis, we had limited knowledge about the dangers of excessive leverage, risk-taking, asset-price bubbles. These categories were absent in macroeconomic policy formulas. It will still take some time to learn about transmission channels between various financial and real economy variables along with the adverse feedback loops.
Have lessons been learned from this crisis or is it too early to draw conclusions?
There are numerous lessons from this crisis, some of which have not been fully identified. Their list is quite long, but let me reveal those that seem to be the most perceptible:
1. Large macroeconomic imbalances pose a danger to financial stability and economic growth.
2. It is implausible to finance consumption and economic growth with excessive leverage.
3. Asset-price bubbles do exist, contrary to the opinions of extreme free-marketers and their classical economic theories. Policy-makers should monitor these bubbles and prevent their proliferation.
4. Macroeconomic and regulatory policies have neglected and underestimated destabilizing role of various types of financial risk. Liquidity-, credit-, market-, sovereign- and other risks, in particular extreme tail risks in financial markets should be embedded in policy formulas and reaction functions.
5. Economic policies should be proactive, based on “leaning against the wind” rather than “cleaning” the negative effects of financial instability.
6. We also need a closer dialogue between academicians and practitioners in macroeconomics, finance, law. We need more technically advanced empirical studies, albeit explained with clarity in order to facilitate better dialogue between specialists and politicians.
7. There is room for vast improvement in methodology of economic and financial forecasting. Most of the commonly prescribed forecasting models have underestimated risks and instability of financial markets at turbulent market periods.
8. Policy-makers should make a clear distinction between tranquil and turbulent periods. Policy reaction and instrument functions cannot be uniform for both periods.
Let me also mention that some lessons from the recent crisis have already been forgotten. For example, the U.S. Federal Reserve is disregarding the fact that its liquidity injections in 2003-2005 were fueling asst-price bubbles.
Its current monetary easing is contributing to rising commodity prices (particularly copper, cotton, sugar, etc.) falling dollar, and large capital inflows to emerging markets causing appreciation of their currencies. The recently announced second round of quantitative easing (QE2) will in my opinion further exacerbate these problems.
In the current environment of devaluation of the own currency is there the potential of increasing tariffs, global trade war, foreign exchange market interventions?
Unfortunately, the new wave of protectionist tendencies is a dangerous outcome of this global economic crisis. Expansionary fiscal and monetary policies in highly developed countries have averted a major liquidity crisis and a systemic collapse. But the unprecedented scope of fiscal and monetary stimulus in the U.S. has depreciated the dollar and exerted appreciation pressures on emerging market currencies.
We have seen foreign exchange market interventions and “competitive devaluations” from a number of central banks in emerging markets, as well as protectionist threats in both developed and emerging economies. From a historical perspective, such protectionist tendencies are quite common for post-crises periods. Yet, they ought to be averted by all means, as they may engender another world-wide deep economic recession. CW