The Financial Crisis and the Future of Risk Management
Paul Ingram- Global Head of Market Risk, RBS
University of Essex
26 March 2010
The views expressed in this presentation are the views of the author and
do not necessarily reflect the views or policies of RBS Group
The Financial Crisis
Who do you blame for the recent market crisis?
The Banks?
The Regulators?
The Government?
Risk Managers?
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The Financial Crisis
Background
• In this presentation I will highlight some of the contributory factors
that led to the recent market crisis, and
• promote discussion regarding what could be done to reduce the
severity of any future crises.
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The Financial Crisis
Sowing the seeds
• A very low interest rate environment persisted throughout the early
2000s. This was Chairman Greenspan’s response to the bursting of
technology bubble and 9/11
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The Financial Crisis
Sowing the seeds
• During the 2000s, Global financial imbalances increased, China
became a more significant exporter and a more significant influence
in global financial markets, as it sought to invest its current account
surplus.
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The Financial Crisis
Sowing the seeds
• Surplus nations (e.g. China) sought to invest their excess funds into
liquid marketable securities. This permitted the US to issue a
significant amount of debt at historically low spreads.
4,000
3,500
3,000
2,500
China holding of US debt
2,000
Total externally held US debt
1,500
1,000
500
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
0
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The Financial Crisis
Sowing the seeds
• The demand for US Treasuries from surplus nations, the low Federal
Funds rate and low inflation meant that the real yield on highly-rated
securities was low.
• Investors demanded securities that provided enhanced yields but
had high external credit ratings
• Banks were therefore keen to provide new securities which had the
same ratings as Treasuries, but provided an enhanced yield.
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The Financial Crisis
Sowing the seeds- Asset Backed Securities (ABS)
• Agency (Fannie Mae/ Freddie Mac) mortgages in the US had long
been structured into ABS in order to facilitate the growth in home
ownership.
• Packaging mortgages into bonds with an implicit US government
credit protection proved very popular with investors.
• As the agencies had fairly strict lending criteria, the demand for these
securities was strong and hence yields were not significantly above
Treasuries.
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The Financial Crisis
Motivation for non agency RMBS
• As investors continued to chase yield there was a demand for ABS
collateralised upon mortgages to riskier borrowers.
• This increased the supply of mortgages to portions of the US
economy that had never previously been homeowners (often at
artificially low “teaser” rates)
• Banks who facilitated the original mortgage loans were less
concerned about the ability of the borrower to repay, as they were
transferring the credit risk onto the investors.
• Furthermore, the perception was that house prices would continue to
rise, permitting homeowners to refinance with the increased equity in
their homes.
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The Financial Crisis
Boom and Bust
• This was mirrored by a perception that the UK economy had
reached a stable equilibrium
• “As I have said before Mr Deputy Speaker: No return to boom
and bust.”
Gordon Brown, Chancellor of the Exchequer- March 2006
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The Financial Crisis
A move toward sub prime
• “Sub prime” (and Alt-A) mortgages had previously constituted a
reasonably small proportion of total mortgage issuance, however
with the demand from investment banks, this issuance grew
significantly through the middle of the 2000s
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The Financial Crisis
Sowing the seeds- Bank Regulation
• Regulation of banks and other financial institutions had moved away
from an intrusive assessment of risk, to a principles-based approach
where regulators placed more trust in institutions internal controls
• Determination of the required levels of capital became increasingly
calculated based on models which were calibrated to current market
conditions (which were benign) and did not cover all sources and
nuances of risk that banks were exposed to
• Capital ratios across the banking industry were permitted to reduce
over time to a level at which the whole banking industry was at risk in
the event of a systemic event.
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The Financial Crisis
Sowing the seeds- Leverage
• The amount of capital issued by banks (especially the investment
banks) did not grow in line with their balance sheets. i.e. they
became more highly leveraged over time
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The Financial Crisis
Sowing the seeds- off balance sheet assets
• Many banks also set up special purpose companies whose role it
was to facilitate the creation of highly rated assets for investors.
Examples of this included
• Securitisation vehicles
• Structured Investment Vehicles (SIVs)
• Conduits/ Asset Backed CP vehicles
• The size of these off balance sheet vehicles were significant, more
significantly many of the structures funded illiquid assets with shortterm debt that needed to be rolled over regularly
• SIVs reached a peak of $425bn,
• The ABCP market peaked at $1.2trn
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The Financial Crisis
Sowing the seeds- off balance sheet assets
• Derivative Product Companies were set up to be AAA rated
derivative counterparties- the motivation was that banks would
reduce their capital requirements through entering into derivatives
with a AAA rated entity
• Additionally AAA rated firms (monolines, insurers etc) that were not
regulated in the same manner as banks were able to sell credit
protection to banks in very large volumes.
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The Financial Crisis
Growth in lending to riskier counterparties
• In order to continue to meet very high Return on Equity targets,
banks increased their leverage, and also extended credit to riskier
counterparties than previously often with very thin spreads
• These loans were often secured against collateral that had escalated
in value significantly (Commercial Real Estate, Residential property)
or had mechanics that made full repayment contingent upon ever
increasing asset values (e.g. leveraged loans, payable in kind (PIK)
notes)
• Banks also warehoused significant volumes of assets on their
balance sheet for onward securitisation into ABS and retained the
economic risk of the most senior portions of securitisations (often
through derivative transactions)
• This could be seen as the start of the breakdown of the “originate to
distribute” banking model.
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The Financial Crisis
So what were the warning signs?
Low interest rates
High risk appetite
Increase in product complexity
without an increase in investor
sophistication
Belief that “boom and
bust” was over
Consistent asset
growth
Perception that property
was a “safe” investment
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The Financial Crisis
So what were the warning signs?
Capital was highly
model driven
Overall levels of
capital were
historically low
Regulatory and risk
management practices
accorded with the view that
risk was low
Lack of proactivity in
risk management
High level of herdbehaviour
Increase in liquidity
mismatches
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The Financial Crisis
What happened next?
• In late ‘06 several research notes were published
regarding the US sub prime market.
• Several market participants became more active in
the CDS markets, betting on the failure of sub prime
bonds (ABX).
• Through to the middle of ‘07 these doubts continued
and the lack of confidence spread to the funding
markets, where funding spreads started to rise
• Liquidity popped in Aug ‘07, this caused significant
issues for institutions that relied on wholesale
funding
• General mistrust in the valuation of illiquid
structured assets, and the liquidity of counterparties
continued to raise the costs of funding
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The Financial Crisis
The scale of the market movements
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The Financial Crisis
The scale of the market movements
TED spread, i.e. the
spread between
US 3m T-bills
and US 3m
LIBOR rose
significantly
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The Financial Crisis
What happened next?
•
•
Doubts over valuation and liquidity continued
to mount in early 2008 and the market turned
its attention to banks that were most affected.
Northern Rock had to turn to the UK
government for liquidity in Sep ’07 and was
nationalised in Feb ‘08
•
In March ’08 JP Morgan rescued Bear Stearns
from bankruptcy with the assistance of the US
government
•
Throughout the summer of 2008 banks rushed
to issue capital to shore up their balance
sheets, losses continued to mount as Alt-A
borrowers, commercial real estate and
leveraged loans started to show weakness
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The Financial Crisis
Panic and the rescue
•
Lehman Brothers was the next most
vulnerable institution and after rescue
talks with the Korean Development
Bank, then BoA and lastly Barclays fell,
it was forced into bankruptcy on 15 Sep
’08
•
The house of cards started to tumble
with Merrill’s selling itself to BoA,
Wachovia to Wells Fargo, HBOS to
Lloyds. Morgan Stanley and Goldman
Sachs came very close to losing their
independence
•
Governments had to step in to rescue
RBS, AIG and the Icelandic banks and
then provide capital for many major
financial institutions.
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The Financial Crisis
Pre-crisis characteristics
• Crises share similar factors, a
fundamental mis-pricing of risk
driven by a combination of:
• A new “paradigm”
• Disconnect with the
underlying economics
• Greed and hubris
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The Financial Crisis
Pre-crisis characteristics
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The Financial Crisis
Current regulatory response
• More capital
• More conservative modelling
• More transparency
• More independent challenge
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The Financial Crisis
Crisis intervention
• Moral hazard
• Loss of confidence
• Loss of legitimacy
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The Financial Crisis
Ideas for improvement
• Countercyclical capital measures- ensure banks hold more capital
when markets are benign
• Penalise excessive leverage or funding mismatches
• Focus on bespoke risk management- ensuring that practices are fit
for the institution
• Take action on systemic liquidity risk
• Intervene in markets to control macro-economic risk?
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The Financial Crisis
Thoughts for investors
• There is no such thing as a free
lunch
• Understand the investment
proposition
• Consider what could happen in a
stress event
• Who will provide you with liquidity?
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The Financial Crisis
Key learning from all crises
• DON’T:
• believe in new paradigms
• buy or sell anything you don’t understand
• rely entirely on models, ratings or market prices
• assume you can sell at the market price, or at all
• assume anything will remain the same forever
• get carried away- think about the underlying economics!!
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