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Part One
Background
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Chapter 1
Introduction
The 2008 global credit crisis is by far the largest boom-bust cycle since the Great Depression (1929). Asset bubbles and manias have been around since the first recorded tulip mania in 1637 and in recent decades have become such a regularity that they are even expected as often as once every 10 years (1987, 1997, 2007). Asset bubbles are in reality more insidious than most people realize for it is not the massive loss of wealth that it brings (for which investor has not entertained the possibility of financial ruin) but because it widens the social wealth gap; it impoverishes the poor. The 2008 crisis highlighted this poignantlyâin the run-up to the U.S. housing and credit bubble, the main beneficiaries were bankers (who sold complex derivatives on mortgages) and their cohorts. At the same time, a related commodity bubble temporarily caused a food and energy crisis in some parts of the developing world, notably Indonesia, the fourth-most-populous nation in the world and an OPEC member (until 2008). When the bubble burst, $10 trillion dollars of U.S. public money was used to bail out failing banks and to take over toxic derivatives created by banks. On their way out, CEOs and traders of affected banks were given million-dollar contractual bonuses, even as the main economy lost a few million jobs. Just as in 1929, blue-collar workers bore the brunt of the economic downturn in the form of unemployment in the United States.
The ensuing zero interest rate policy and quantitative easing (printing of dollars by the Fed) induced yet other bubblesâcommodity prices are rising to alarming levels and asset bubbles are building up all over Asia, as investors chase non-U.S. dollar assets. We see home prices skyrocketing well beyond the reach of the average person in major cities. The wealthy are again speculating in homes, this time in East Asia. In many countries, huge public spending on infrastructure projects that is meant to support the headline GDP caused a substantial transfer of public wealth to property developers and cohorts. The lower income and underprivileged are once again left behind in the tide of inflation and growth.
The danger of an even larger crisis now looms. The U.S. dollar and treasuries are losing credibility as reserve currencies because of rising public debt. This means that flight-to-quality, which has in the past played the role of a pressure outlet for hot money during a crisis, is no longer an appealing option.
If there is a lesson from the 2008 crisis, it is that asset bubbles have to be reined in at all costs. It is not just John Keynesâ âanimal spiritsâ at work hereâthe herd tipping the supply-demand imbalanceâbut the spirit of âmammonââunfettered greed. There is something fundamentally dysfunctional about the way financial institutions are incentivized and regulated. Thus, a global regulatory reform is underway, led by the United Kingdom, the European Union (EU), and the United States, with target deadlines of 2012 and beyond. Our narrow escape from total financial meltdown has highlighted the criticality of systemic risks in an interconnected world; we can no longer think in isolated silos when solving problems in the banking system. The coming reregulation must be holistic and concerted.
One major aspect of the reform is in the way risk is measured and controlled. The great irony is that our progress in risk management has led to a new risk: the risk of risk assessment. What if we are wrong (unknowingly) about our measurement? The crisis is a rude wake-up call for regulators and bankers to reexamine our basic understanding of what risk is and how effective our regulatory safeguards are.
We start our journey with a review of how our current tools for measuring financial market risks were evolved. In this chapter, we will also give a prelude to two important concepts that grew out of crisis responseâextremistan and procyclicality. These will likely become the next buzz words in the unfolding regulatory reform drama. The final section offers bubble VaR, a new tool researched by the author, which regulators can explore to strengthen the safeguards against future financial crises.
1.1 THE EVOLUTION OF RISKOMETER
Necessity is the mother of invention.
âPlato, Greek philosopher, 427â347 BC
Ask a retail investor what the risks of his investment portfolio are, and he will say he owns USD30,000 in stocks and USD70,000 in bonds, and he is diversified and therefore safe. A lay investor thinks in notional terms, but this can be misleading since two bonds of different duration have very different risks for the same notional exposure. This is because of the convexity behavior peculiar to bonds. The idea of duration, a better risk measure for bonds, was known to bankers as early as 1938.
In the equities world, two different stocks of the same notional amount can also give very different risk. Hence, the idea of using volatility as a risk measure was introduced by Harry Markowitz (1952). His mean-variance method not only canonized standard deviation as a risk measure but also introduced correlation and diversification within a unified framework. Modern portfolio theory was born. In 1963, William Sharpe introduced the single factor beta model. Now investors can compare the riskiness of individual stocks in units of beta relative to the overall market index.
The advent of options introduced yet another dimension of risk, which notional alone fails to quantify, that of nonlinearity. The Black-Scholes option pricing model (1973) introduced the so-called Greeks, a measurement of sensitivity ...
