We are on the brink of experiencing the next financial crisis, says leading financial authority

Satyajit Das, former banker, now risk consultant, warned about the risks of financial derivatives years before the Great Meltdown of 2008.

No 1706 Posted by fw, June 19, 2016

“My accountant says I did this at a very bad time. My stocks are down. I’m cash poor or something. I got no cash flow. I’m not liquid, something’s not flowing. They got a language all their own.” (Woody Allen character, Isaac Davis, in the movie Manhattan).

I immediately thought of the above line from the Woody Allen film as I struggled to understand the article by Satyajit Das, reposted below.

Satyajit Das

When asked by a Globe and Mail reporter in a January 2016 interview, “Is there anything about the global economy or markets that keeps you up at night? Das replied:

“The risk that policymakers could make a catastrophic error. I don’t think they understand that they’re in a very deep hole. They just assume that their [usual] models and ways of thinking are somehow going to work. And I worry that they’re going to miscalculate really badly.”

Das’ answer to the reporter about policymakers not understanding they’re in a deep hole, that and the Manhattan quote, “They got a language all their own”, provide a perfect lead-in to Satyajit’s article, featured in today’s post. In his article, Das does have “a language all his own” – a financial guru’s language for financial nerds.

To navigate this unfamiliar territory, I ended up creating a glossary of terms – 27 terms – which I have listed at the end of this article. Alas, definitions alone did not bring clarity: the definitions of “soft” financial terms, unlike definitions of “hard” scientific terms, can vary considerably, presenting a serious barrier to understanding for neophytes – like me.

If Das’ article verges on the incomprehensible for average folks, why did I decide to repost it? Perhaps for no other reason than its turgid language style communicates the daunting complexity of the subject matter, making it difficult, even for financial experts, to explain the entanglements among the numerous variables. As Das himself concludes: “The exact sequence of events is unpredictable because of the complexity of transmission pathways. But once these feedback loops start, they are very difficult to control.”

If Das can’t foresee how the next financial crisis will unfold, then what chance is there for our political masters to understand that they’re in a very deep hole,” which could lead to their making “a catastrophic error”?

The subheadings added to the repost of this article are intended to help readers grasp the daunting complexity of financial capitalism. It’s the very complexity that creates the risk, especially the risk of unforeseen feedback loops. To read the original piece, without the glossary, click on the following linked title.

Note, the underlined terms in the reposted article indicate that they can be found in my glossary at the end of the article.

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This is how the next financial crisis will spread around the world economy by Satyajit Das, Independent (UK), May 15, 2016

We are on the brink of a new economic crisis

A new economic crisis, which I believe we are on the brink of experiencing, will have similarities, and differences, to 2008. The problem of crowded trades – where market participants all have the same basic positions and strategies, and identical risk models – will be familiar.

New regulations designed to minimize risk will create new problems

The effect of new regulations, ironically designed to minimize the risk of a new crash, and a reduction in trading liquidity will create new problems. Extra capital, while welcome, does not alter the level of risk, but merely who bears it.

Regulators have approved risky financial instruments to boost banks’ liquidity

To recapitalize banks, regulators have approved risky hybrid securities, such as contingent capital and bail-in bonds. In the event of a systemic crisis, losses will be transmitted to insurance companies, pension funds and private investors; bailing them out may be politically necessary or expedient.

So-called bankruptcy-proof agencies have added complexity, thus creating new instability

With simpler solutions proving politically difficult, attempts to reduce the risk in the chains of derivative contracts have focused on Central Counter Parties (CCPs), a theoretically bankruptcy-proof guarantor of transactions and collateral. CCPs have added complexity, creating new instability; CCP risk management is unproven under conditions of stress.

Reliance on collateral entails three risks —

1/ The reliance on collateral is likely to prove troublesome under conditions of real stress. The emphasis shifts from the borrower or counterparty’s creditworthiness to the collateral, creating different risks.

2/ Government securities now are not risk free. It assumes liquid markets for the collateral, which must be realized in case of default.

3/ Unexpected changes in the amount of collateral needed create liquidity risks. Collateral use also entails significant modelling, operational and legal risk.

Reduced number of trading dealers has negatively impacted market liquidity for investors looking to readjust portfolios

Trading liquidity in markets has also diminished markedly since 2008. Traditionally, market makers act as shock absorbers in periods of stress allowing investors to readjust portfolios at a price. But consolidation – through bankruptcies, mergers or acquisition or withdrawal – has reduced the number of dealers.

Higher trading costs increases market volatility

Higher capital charges and specific prohibitions on trading, such as the Volcker rule or narrow banking, have increased the cost of trading.  The amounts that can be transacted without moving prices materially have fallen, meaning shocks will be rapidly transmitted.

From here on, Das launches into an explanation of the complexity of relationships among variables – well beyond my grasp

The decline in liquidity is exacerbated by the changing structure of many markets. There is increased participation by high frequency traders (“HFT”), retail and private investors either directly or through funds. Paralleling the decline in the number of dealers, the number of major asset managers through whom these funds are deployed is small.

The combination of size, the nature of the underlying assets and the redemption feature may prove especially toxic. It is simply not possible to transform highly illiquid instruments, using financial engineering into liquid equivalents. This lack of liquidity is not reflected in pricing, with the premium for liquidity risk in most segments having fallen to 2007 levels of below.

As the following scenario outlines, these changes in market structure likely help to create instability in any new crisis. The key drivers will be higher liquidity reserves for banks, more stringent calculations of risk in derivative transactions and use of government securities to lower capital requirements as collateral. Given pre-existing exposures to government bonds via repurchase transactions, investments or trading inventories, the regulations increase bank exposure to sovereign bonds. This coincides with the deterioration in the quality of government securities and unprecedented low rates driven by policy, creating a dangerous source of instability, which will feed market volatility and transmit losses across different markets.

Where rating downgrades or deteriorating credit quality result in falls in the value of sovereign securities, banks suffer losses on their holdings. Where the securities are used as surety for funding or derivatives, banks need to lodge additional collateral, draining liquidity from markets. The deterioration in a sovereign’s credit quality will affect risk calculations, requiring additional capital as well as collateral.

Banks may hedge this risk, usually by purchasing default protection on the sovereign or shorting government bonds. This will exacerbate losses as the sovereign bonds’ value falls further. Market constraints may necessitate use of proxies for the sovereign, including shorting or buying insurance on equity indices or major stocks. Banks may short sell the currency as a de facto hedge. Proxy hedges transmit the volatility into other asset markets. They create additional risk where volatility is high and correlation between major asset classes becomes unstable, such as in a risk-on risk-off trading environment.

Second round effects focus on the financial position of banks adversely affected by losses on government bond investments and reduced ability of the nation to support its financial institution. The increased default risk of affected banks sets off a chain reaction of additional capital charges, increase and loss exposures across international active banks who deal with them, requiring further hedging, compounding the negative spiral.

The reduced demand for the affected sovereign’s bonds result in higher funding costs and reduced market access, which is transmitted to banks and other firms in the country. Higher counterparty risk or downgrades may trigger more collateral calls.

Financial market shocks flow through into the real economy, affecting the supply of credit, growth, investment and employment. In turn, this feeds back into further sovereign and financial sector weakness.

The exact sequence of events is unpredictable because of the complexity of transmission pathways. But once these feedback loops start, they are very difficult to control.

Satyajit Das is a former banker and the author of ‘A Banquet of Consequences: The Reality of our Unusually Uncertain Economic Future’

Glossary of terms

1. asset management — broadly defined, refers to any system that monitors and maintains things of value to an entity or group. It may apply to both tangible assets such as buildings and to intangible assets such as human capital, intellectual property, and goodwill and financial assets. Asset management is a systematic process of deploying, operating, maintaining, upgrading, and disposing of assets cost-effectively.
2. bail-in bonds — a bail-in forces the borrower’s creditors to bear some of the burden by having part of the debt they are owed written off
3. capital – capital consists of any produced thing that can enhance a person’s power to perform economically useful work
4. contingent capital – are intended to provide a buffer for the financial institution issuers during times of stress. Commentators note that traditional hybrid securities, which were important financing tools for banks during the last decade, failed to absorb losses effectively during the crisis. Moreover, during times of stress, banks and other financial institutions found it difficult to access the market in order to bolster regulatory capital levels. Contingent capital instruments are intended to have loss-absorbing features.
5. counterparty risk — counterparty risk is the risk to each party of a contract that the counterparty will not live up to its contractual obligations. Counterparty risk as a risk to both parties and should be considered when evaluating a contract.
6. default protection – seller of protection agrees to pay the buyer against the default of some reference loan
7. derivative contracts – A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. The derivative itself is a contract between two or more parties based upon the asset or assets. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.
8. financial engineering – the use of mathematical techniques to solve financial problems. Financial engineering uses tools and knowledge from the fields of computer science, statistics, economics and applied mathematics to address current financial issues as well as to devise new and innovative financial products. Financial engineering is sometimes referred to as quantitative analysis and is used by regular commercial banks, investment banks, insurance agencies and hedge funds.
9. hedge a risk — hedging against investment risk means strategically using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another.
10. hybrid securities – a single financial security that combines two or more different financial instruments. Hybrid securities, often referred to as “hybrids,” generally combine both debt and equity characteristics. The most common type of hybrid security is a convertible bond that has features of an ordinary bond but is heavily influenced by the price movements of the stock into which it is convertible.
11. liquid asset – an asset that can be converted into cash quickly and with minimal impact to the proce received
12. liquid markets – a market with many bid and ask offers, low spreads and low volatility. In a liquid market, it is easy to execute a trade quickly and at a desirable price because there are numerous buyers and sellers. In a liquid market, changes in supply and demand have a relatively small impact on price. The opposite of a liquid market is called a “thin market” or an “illiquid market.”
13. liquidity risk – arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade for that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade.
14. market makers — is a broker-dealer firm that assumes the risk of holding a certain number of shares of a particular security in order to facilitate the trading of that security. Each market maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares, and once an order is received from a buyer, the market maker immediately sells from its own inventory or seeks an offsetting order.
15. market structure – refers to way that suppliers and demanders in an industry interact to determine price and quantity. There are four main idealized market structures that have been used in trade theory: perfect competition, monopoly, oligopoly, and monopolistic competition.
16. modelling risk – type of risk that occurs when a financial model used to measure a firm’s market risks or value transactions does not perform the tasks or capture the risks it was designed to.
17. narrow banking — restricts banks to holding liquid and safe government bonds. Loans would be made by other financial intermediaries. That is, the deposit taking and payment activities would be separated from financial intermediation activities.
18. operational risk – a form of risk that summarizes the risks a company or firm undertakes when it attempts to operate within a given field or industry. Operational risk is the risk that is not inherent in financial, systematic or market-wide risk. It is the risk remaining after determining financing and systematic risk, and includes risks resulting from breakdowns in internal procedures, people and systems.
19. proxy hedge — involves the use of a forward contract between the home currency and a currency that is highly correlated with the foreign asset’s currency.
20. rating downgrade — a negative change in the rating of a security. This situation occurs when analysts feel that the
    future prospects for the security have weakened from the original recommendation, usually due to a material and fundamental change in the company’s operations, future outlook or industry.
21. recapitalize banks – Since the credit crunch, the banks have lost money. This means that their liabilities are greater than their assets. Therefore, they technically owe more to other people than assets they own. the credit crunch meant that banks were no longer willing to lend to each other. This means that they had a shortfall in their balance sheets and were left with losses. If consumers asked to withdrawal all their savings, then the bank would not be able to meet the demand to withdraw deposits. Therefore, this created the need for recapitalisation – so that banks had enough money to pay back depositors who have savings in their bank.
22. risk-on risk-off trading – an investment setting in which price behavior responds to, and is driven by, changes in investor risk tolerance. Risk-on risk-off refers to changes in investment activity in response to global economic patterns. During periods when risk is perceived as low, risk-on risk-off theory states that investors tend to engage in higher-risk investments. When risk is perceived as high, investors have the tendency to gravitate toward lower-risk investments
23. second round effects — policy makers are concerned about so-called second-round effects, when companies increase prices and boost wages to compensate for higher costs, entrenching faster inflation.
24. short sell — the practice of selling securities or other financial instruments that are not currently owned, and subsequently repurchasing them (“covering”). In the event of an interim price decline, the short seller will profit, since the cost of (re)purchase will be less than the proceeds which were received upon the initial (short) sale.
25. sovereign bonds – a debt security issued by a national government. Sovereign bonds can be denominated in a foreign currency or the government’s own domestic currency; the ability to issue bonds denominated in domestic currency tends to be a luxury that most governments do not enjoy. The less stable of a currency denomination, the greater the risk the bondholder faces.
26. surety — a promise by one party to assume responsibility for the debt obligation of a borrower if that borrower defaults. The person or company providing this promise is also known as a “surety” or as a “guarantor”.
27. systemic crisis — the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy. Systemic risk was a major contributor to the financial crisis of 2008. Companies considered a systemic risk are called “too big to fail.”

SEE ALSO

The Biggest Bank Heist Ever, posted on You Tube February 13, 2012

MUST WATCH — Satyajit Das appeared in the 2011 award-winning documentary film Inside Job, about the 2008 financial crisis. In this 49-minute segment from the film, the 8:24-minute Das interview begins at the 32:55-minute point and ends at 41:19. (Fast forward to watch the segment). Derivatives expert Das explains how derivatives amplified market losses, which led to the fall of Lehman Brothers. In a not-to-miss section of the interview, he talks about his experience with employees from Icelandic banks who started to attend his London-based course in the late 1990s, providing a great insight into how Iceland became a completely financial economy with devastating results. The interviewer also asks Das, who meets with a lot of bankers, what bankers say about the crisis. His response is a real eye-opener. Little wonder there’s another looking financial crisis.

For more information about Satyajit Das — http://www.financialsense.com/contributors/satyajit-das

For articles by Das in the UK’s Independent newspaper — http://www.independent.co.uk/author/satyajit-das

For articles by Das in Nouriel Roubini’s EconoMonitor — http://www.economonitor.com/blog/author/sdas3/

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