Friday, September 2, 2011

BOE’s Paul Fisher Examines Tail Risks and Contract Design


Author: David Schwartz J.D. CPA David Schwartz J.D. CPA

In a September 1, 2011 speech at Clare College in Cambridge, Paul Fisher, Executive Director for Markets of the Bank of England, outlined his thoughts on ways risk taking is executed and how contracts between parties assuming these risks can have “a profound impact on systematic stability beyond the normal consideration of formal regulations.” 

We focus on one aspect of market structure: contracts where, because of a failure to take into account how the financial system as a whole operates, the true value of the contract is different from what it was intended to be – by at least one of the counterparties who struck the contract. This can arise either because in states of the world in which a particular contract is designed to have value there is high correlation with other events or where, in that state of the world, full adherence to the legal structure would cause large unintended consequences in terms of signaling or reputational damage.

Applying lessons learned from the financial crisis, Fisher recommends that parties should structure their transactions with a critical evaluation of contingent exposures, and take into account stress correlations with an eye on capturing tail events properly.  In addition, Fisher also advises that implications of a contract should be clear and the structures should be as transparent as possible. 

To illustrate his recommendations, Fisher looks at two areas where the value of contracts did not match market realities.

“Wrong Way Risk”

Fisher begins with an examination of “wrong way” risk in tail events, where contracts entered into for the purpose of providing insurance ended up adversely correlated with the credit quality of the counterparty providing the “insurance.”  Mr. Fischer addresses a fundamental question of why the correlation problems of these transactions were not apparent before default events occurred. 

If such an insurance contract is worth having, one must be able to envision the tail event happening and what the circumstances might be. Why was it so hard to anticipate what would happen if there were losses on large numbers of bonds insured by monoline insurers which had relatively small amounts of capital?

The primary reason seems to be that the parties involved measured the risk of default events using antiquated, or inappropriately local metrics like VAR and other correlations based on historical averages rather than actual stress tests for different sets of potential market conditions. 

A lot of the surprise seemed to come from the fact that virtually all risk management had been done within a “local” framework, rather than genuinely extreme stress tests. If regulators, rating agencies or, for that matter, bond and equity investors had demanded analysis based on extreme stress tests, many of the repercussions in the system could have been identified. The main point is that a stress test has to be internally consistent.

Secondarily, large numbers of these transactions were entered into, not as genuine hedging transactions, but as portfolio management or “window dressing” measures.  Having the insurance in place made exposure numbers reported to regulators and stakeholders more palatable, and obscured the true magnitude of the risks undertaken.  These window dressing transactions worked together with true hedging contracts to increase systematic risk by creating a highly interconnected web of contingent exposures across leveraged institutions. 

Many of these investor groups are, however, subject to an extensive regulatory framework, making them unable to hold such risks in their portfolios, in many cases even as a very small fraction of total assets. There is a potentially difficult tradeoff here between public policy objectives of appropriate investor protection and systemic stability considerations. That probably deserves to be debated more fully. It is clear, however, that highly leveraged institutions such as banks and hedge funds are not really suited to be the ultimate repositories of extreme tail risk

Reputational Risks in Tail Events

In certain circumstances, “a market participant may voluntarily choose not to enforce a contract that is “in the money” if the reputational repercussions are perceived to  cause more damage than whatever could be gained financially by enforcement.”  According to Fisher, this course may seem irrational on the surface, but is driven by classic time inconsistency, and may make perfect sense in practice. 

Fisher uses the structured investment vehicle (SIV) crisis to illustrate.  In 2007, when the asset backed commercial paper markets closed suddenly, SIVs were starved for funding.  Banks sponsoring the SIVs had only very limited legal obligations to the SIVs, but seeing the reputational damage sinking SIVs would have, most stepped up, collapsed the SIVs, and moved them back to their balance sheets or directly funded them. 

At this juncture, one would think that the optimal economic behaviour for the banks with outstanding SIVs, would be to let the SIVs unwind according to the legal construct in place, rather than accept responsibility. In fact, all the banks except one decided to collapse the structures and repurchase the securities. 

The case of SIVs demonstrates some short-term and long-term thinking on the part of the banks.  In the short term, the bank would absorb the troubled assets of the SIV into its already over-extended balance sheet, but in the long term would signal that the bank was sufficiently strong to do so.

From an investor protection standpoint, one may have drawn a sigh of relief, as any potential issues about misrepresented risk profile disappeared, but from a financial stability perspective, it was obviously disturbing. In a short space of time, billions of assets showed up on already over-extended bank balance sheets.

One may think it somewhat surprising that (almost) all the banks decided to absorb their SIVs, especially since it must have seemed likely that the SIV structure would not come back any time quickly as a viable funding structure. We believe that the main reason for doing this was that not doing so would have sent a distress signal to the market. In other words, if a bank chose not to absorb this problem, the perception would be that they simply could not afford to do it, thus telling the market that they were in even worse shape than previously feared. There may also have been an element of “repeat game”. If one lets one’s investors take the pain, then they may not return for future transactions.

Designing Contracts With Contingent Exposures in Mind

In order to match up the value of a transaction with market realities, participants should perform a rigorous and critical evaluation of contingent exposures and stress correlations.  Capturing tail events properly depends almost entirely on proper design of stress tests. 

A crucial component of this analysis is the proper design of stress tests. Obviously, scenarios have to be rather draconian in order to serve the purpose of challenging the “unthinkable”, but at the same time there are difficult decisions to be made, for example, in deciding how much bank capital (contingent or not) banks should hold – and what the probability is of it being wiped out. We believe that it is better to have a collection of ex ante determined stress scenarios that illustrate banks’ potential weaknesses publicly, even if the actual regulatory capital is not sufficient in all those scenarios. In other words, stress tests should not always be a check list “pass” or “fail” (after all, to make a bank fail or pass a stress test is just a question of scaling the test). Comparable, tail event stress tests could be an important piece in the information set that investors and regulators analyse to determine the relative value and risk profile of the institution.

Fisher advises that contract design features which are exclusively relevant to the extreme tails should be avoided, because these features are never taken seriously.  Fisher also finds fault with market participants for expressing surprise at banks’ exercising the option to absorb SIVs.

Market participants need to make sure that an exercise of an option is seen as just that, a normal exercise of an option. No more and no less. Sophisticated market participants should not be genuinely surprised (or feign surprise) by another market participant trying to optimise its behaviour consistent with a contract. The implications of a contract should be clear and the structures should be as transparent as possible.

Lessons Learned

As the debate about the higher levels of capital banks must hold rages on, it is important also look at how these new levels of capital will be achieved.   Despite the financial crisis, contingent capital instruments remain attractive, and should be evaluated on how they would perform in a crisis.   Whatever is decided in terms of capital requirements, the numbers should be calculated with tail event analysis in mind.

Fisher applies two lessons from the preceding examples to contingent capital instruments.

First it has been suggested to us by market contacts that the trigger point in existing contingent instruments is such that many investors have bought them on the assumption that these contingent capital securities never will be called (or worse, that there will be official support before that point). If that were to be the foundation for this market, we believe that the very purpose of contingent capital may be subverted, creating a risk to financial stability in a crisis situation. The whole point of contingent capital securities should be that the recapitalisation is triggered without any grand repercussions, making it easier than raising fresh capital in the market. If triggering the conversion were to cause the sort of damage reported in our examples above, then the market could be severely disrupted just when it was most needed. The contract design must therefore reflect a need for the trigger to be as smooth as possible.

Second, it is obviously crucial from a financial stability standpoint that contingent capital securities do not end up largely in the hands of other highly leveraged financial institutions, where losses could cause further spill-overs and thus generate financial instability. We believe that regulators could play a constructive role in allowing a broad range of “real money” investors to own sensible amounts of this systemic risk.

The balance between public policy objectives of appropriate investor protection and systemic stability entails some difficult considerations. Over all, however, it is readily apparent that highly leveraged institutions such as banks and hedge funds are ultimately not well suited to be the final repositories of extreme tail risk. 

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