Paul Ingram-20100326-RoyalBankScotland

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					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?

 The Financial Crisis


• 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.

 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

 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

 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.




                                                                                      China holding of US debt
                                                                                      Total externally held US debt














 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.

 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
• 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

 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.

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 short-
  term 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.

                                                                         | 15
 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)
• 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?

                                       Belief that “boom and
                                        bust” was over
 Low interest rates

High risk appetite                        Consistent asset

  Increase in product complexity
                                     Perception that property
   without an increase in investor
                                      was a “safe” investment

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The Financial Crisis

So what were the warning signs?

         Capital was highly          Lack of proactivity in
          model driven                risk management

Overall levels of                       High level of herd-
 capital were                            behaviour
 historically low

   Regulatory and risk
                                  Increase in liquidity
    management practices
    accorded with the view that
    risk was low
                                                              | 18
 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
• 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

                                    | 20
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

                                    | 21
    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
•    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
•    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
•    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

                             | 25
 The Financial Crisis

Current regulatory response

• More capital

• More conservative modelling

• More transparency

• More independent challenge

                                | 26
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

• Understand the investment

• 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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