Comments on
“Three Glass Tragedy
Beginning to Rethink (US)
Financial Policy”
David A Westbrook
Andy Haldane
Bank of England
The Westbrook Thesis
• It has been a tragedy – but not a uniquely US
one
• “Portfolio” approach to financial management:
– May reduce risk
– But increases uncertainty
• Risk is idiosyncratic; uncertainty is systematic
• Systematic risk has gone up
• Uncertainty manifests as:
– “Indeterminate” asset prices
– “Downward biases” in asset prices
Different regulatory structures,
same outcomes
Chart 2: The percentage decrease in equity prices from 01/01/2007-10/12/2008
0
Per cent
-10
Mexico
-20
Hong Kong
-30
Germany
-50
USA
Singapore
UK
-40
China
New Zealand
Australia
Sweden
Spain
France
Poland
Portugal
T urkey
Japan
Netherlands
Italy
-60
Norway
-70
Integrated
regulator
S o urc e : Da ta s tre a m a nd B a nk c a lc ula tio ns
Objective based
Institutional
Functional
Systematic risk rises…
(b)
Per cent
80
70
60
50
40
30
Average
since 1998
20
10
0
Jan. Apr.
2007
Jul.
Oct. Jan. Apr.
08
Jul.
Oct. Jan.
09
…and implied losses exaggerated
Roots of Uncertainty
• Among the primary causes of uncertainty
are:
– Contract design (eg CDOn)
– Industrial organisation of finance (eg
securitisation)
– Myopia (eg VAR)
– Network topology (eg CDS market)
Financial contract design – ‘Russian Dolls’
CDO
FINANCIAL ECONOMY
ABCP
Senior
ABS/CDO
tranches
Senior
AAA
Leveraged
loans
Capital
Notes
CDO2
Senior
Mezzanine
Equity
CDO
mezzanine
tranches
Mezzanine
tranche
Equity
CDO
equity
tranches
Corporate
assets
Mezzanine
Equity
HY bonds
CDO of ABS
HEL ABS/CMBS
Senior
Senior
CPPI on CDO equity
Principal
protected
notes
Leveraged
loans
Mezz/second
lien debt
HY bonds
MTNs
(and
bank debt/
capital)
LBO’d company
BBB- rated
HEL ABS/
CMBS
or
synthetic
Sub-prime
mortgages/
Mezzanine Commercia
(often BBB-) l mortgages
Mezzanine
Equity
Equity
• Current episode borne of leveraging developments over the previous few years.
REAL ECONOMY
SIV
Sub-prime securitisation chain
Pre-crisis VaR
25
Percent
VaR Pre Crisis
20
15
10
5
0
1
2
Institution
3
4
5
6
7
8
9
Post-crisis VaR
25
Percent
VaR Post Crisis
VaR Pre Crisis
20
15
10
5
0
1
Institution
2
3
4
5
6
7
8
9
Post crisis CoVAR
25
Percent
Median CoVaR Post Crisis
VaR Post Crisis
VaR Pre Crisis
20
15
10
5
0
1
2
Institution
3
4
5
6
7
8
9
So Where Next?
• Roll back innovation/liberalisation?
– 1945-1971 versus 1971-2007
• Address the identified market failure?
– Recognising uncertainty:
• Network information - “Leontief matrices” for financial claims
– Rethinking financial contracts
• Creative destruction of the CDOs and SIVs
– Rethinking financial networks
• OTC versus centrally traded/cleared
• Partitioning the public good activities of the financial system
– Regulation targeted at systematic risk
• Countercylical regulation (“common shock”)
• Systemic regulation (“network shocks”)
Financial Crises – Past and
Present
Year
1881-1913
1919-1939
1945-1971
1973-1997
Probability of
Crisis (%)
5
13
7
12
Depth of crisis
(cumulative %
GDP loss)
9.8
13.4
5.2
8.3
Average GDP
growth (%)
1.93
0.98
2.13
2.43