Notes from the Vault
Larry D. Wall
May 2017
The financial system evolves over time like shifting sands so that eventually the environment is very different from what it was a few years ago. This evolution can create new risks for institutions and the system as a whole. Other potential risks may be lurking on the horizon for some time, but if realized could cause large shocks to the financial environment seemingly overnight. Important examples of both types of risk were discussed at the Atlanta Fed's recent Financial Markets Conference, Managing Global Financial Risks: Shifting Sands and Shock Waves.
This Notes from the Vault post reviews some of the discussion related to gradual changes arising from time-varying risk correlations and changes in the regulatory environment. It also summarizes some of the discussion of potential large shocks to the financial system. A separate macroblog post will focus on the conference discussion on the impact of monetary policy on the financial system.
Shifting sands of changing asset correlations and volatility
Many market participants have expressed the concern that financial markets in recent years have been characterized by high correlations in asset returns. The complaint is that returns alternate between risk-on periods when investors crowd into risky assets and a risk-off environment in which investors flee to low-risk assets. In this environment, investors are rewarded primarily for correctly timing shifts from risk-on to risk-off rather than picking the right individual assets. Such an environment may arise, for example, if investors focus on changes in government actions such as monetary policy or changes in regulations intended to reduce potentially excessive volatility.
An important initial consideration in analyzing this issue is evaluating the underlying cause(s) of changing short-run correlations in asset returns. Atlanta Fed economist Nikolay Gospodinov presented a paper in which he observed there are multiple sources of asset co-movements, including long-run fundamental and structural factors, transitory factors such as those showing up in asset risk premia, and spurious co-variation that can arise from data characteristics such as noise and trends in asset prices. Using simulated equity return data, Gospodinov showed how two data series can be completely uncorrelated but still appear to "move together." Through this spurious correlation example and others, he showed that analyzing co-movements at higher frequencies is challenging. On the other hand, he presented evidence that low-frequency co-movements, such as at business cycle frequency, and even more long-ranging demographic changes do appear to exert an influence over returns.
Michael Mendelson, a principal at AQR Capital Management, discussed Gospodinov's paper and the issues associated with asset co-movements. Mendelson observed that asset owners determine the allocation of their assets and these changes happen slowly, albeit the cumulative changes over time can be large. These investors tend to be concerned about the volatility of returns across asset types. However, they tend to view changes in correlation across asset returns as largely spurious, which is consistent with some of Gospodinov's analysis.
The chair of the asset co-movements session, David Zervos, chief market strategist of Jefferies, pushed back a bit on Mendelson, arguing many money managers believe that central banks had moved to backstopping financial markets and were trading accordingly. Mendelson responded by asserting that the amount of money being actively traded is small relative to the total amount of funds invested in these markets. One way of reconciling Zervos and Mendelson's seemingly conflicting views is that slowly changing asset allocations by large institutional investors determined long-run asset co-movements, but that shorter-term price movements were determined primarily by more actively managed funds.
Along with this policy session on asset co-movements, the conference also had an academic paper titled "China's Model of Managing the Financial System" presented by University of Texas at Austin Professor Michael Sockin. His paper was motivated by the Chinese government's interventions in an attempt to dampen excessive volatility in financial markets; however, the paper's theoretical model is not specific to China. Sockin observed that inexperienced investors who trade on nonfundamental signals (often called "noise traders" in the academic literature) can result in markets that have excessive volatility. The paper showed that a benevolent government following an almost perfect strategy could dampen this volatility. However, in doing so it incentivizes those investors who base their trades on information to shift their resources from learning about a firm's fundamentals to learning about the government's intervention policy. Thus, the result of government intervention could be both lower volatility and less informative prices. The paper's discussant, University of Illinois Professor Neil Pearson, observed that although Sockin's model was internally consistent and consistent with the behavior of Chinese regulators, it was difficult to test such a model using existing data. Nevertheless, Pearson posited that to the extent the model's findings were correct, those findings would also apply to intervention by other governments and central banks to dampen volatility, including the Fed.
Shifting sands of prudential regulation
The financial crisis of 2007–09 and the follow-on crises in Europe have led supervisors around the world to adopt stricter prudential regulation and to coordinate better their policies with one another. The merits of the stricter regulation were discussed in a keynote speech by Harvard President Emeritus and Professor Lawrence Summers, and a subsequent policy panel addressed the role of increased coordination.
Summers's keynote (video) observed that prudential regulation has been tightened, especially bank regulatory capital requirements that are based on accounting values, and many policymakers believe these changes have made the financial system safer. However, he noted these increases in regulatory capital ratios have not resulted in reduced volatility of large banks' stock returns, as theory would predict for more highly capitalized firms. Moreover, he also observed that market measures of equity capital relative to risk-weighted assets suggest limited improvement in these banks' financial strength. Summers considered several possible explanations for the discrepancy but concluded that the most plausible and important explanation for these findings is a decline in bank franchise values, a decline he attributed in part to some excessive regulations that do not contribute to financial stability.
The session on international coordination began with an outline of some of the issues by Fabio Natalucci, deputy assistant secretary at the U.S. Treasury. Natalucci observed that one of the goals of the United States in these efforts has been to bring other jurisdictions up to the generally higher standards set by U.S. supervisors.
University of Pennsylvania Professor Richard Herring followed with the presentation of a paper titled "International Coordination of Financial Supervision: Why has it grown? Will it be sustained?" Herring's presentation provided an interesting overview of the history of international coordination of financial supervision, dating back to the failure of a small German bank that disrupted foreign exchange markets in 1974. One consistent pattern brought out by his summary is that efforts to strengthen international coordination and tighten regulation often followed an international financial crisis. This pattern was continued after the failure of Lehman in 2008 when the G-20 leaders (heads of government) agreed that their countries should work together both to strengthen prudential regulation and to develop a credible resolution policy for large banks. However, Herring observed that efforts to develop a credible resolution policy based on fully coordinated resolution run into the problem of getting countries to agree on credible loss allocations in advance. He further observed that most recently there has been a reduced enthusiasm for stricter regulation in many jurisdictions. Herring concluded by referencing past crises as an important motivation for prior international coordination and saying, "Let's hope we don't experience another shock that demonstrates the costs of failing to cooperate."
One of Herring's discussants, Marc Saidenberg (a principal at Ernst and Young) argued that the most important issue in international coordination is that of time consistency. That is, regulators should not set expectations via international agreements they should have known would not be sustained during a crisis. The problem is that market participants act on the expectations set via these agreements. If policymakers do not meet those expectations during a crisis, these market participants are likely to exacerbate the crisis by adjusting their behavior to what supervisors are actually doing. An example Saidenberg gave was that of the definition of capital instruments eligible for inclusion in regulatory capital requirements. The internationally agreed Basel Accords allowed a variety of innovative instruments to be included in regulatory capital prior to the crisis. However, once the crisis started, both regulators and markets focused on a much narrower measure, tangible common equity, resulting in some banks being evaluated based on a much smaller amount of capital.
Barbara Novick, vice chairman of BlackRock, also discussed international coordination from the perspective of someone involved in asset management rather than commercial banking. She observed that her industry and its clients can suffer large losses during a financial crisis and so they are not opposed to cost-effective ways of reducing the risk of a crisis. However, she argued that the "tsunami of regulation already passed is difficult to digest" and harmonization of regulatory data reporting would benefit everyone.
Potential shock waves
While the shifting sands of the ever-evolving financial system pose a challenge for risk managers, the threat of shock waves to the financial system pose another type of challenge. The problem is that financial market participants may believe that the world works one way, only to discover abruptly that the world will be operating in a very different way. This realization creates pressure for market participants to adjust rapidly their positions to their new perceptions of the financial environment. The results of these position adjustments can be large changes in asset prices and in financial quantities (such as bank deposits) that cause some financial institutions to become illiquid and/or insolvent.
Douglas Rediker, executive chairman of International Capital Strategies, gave a keynote (video) in which he stated that the countries around the world have looked to the United States for consistent economic and financial leadership. He argued that doubts may be raised about that leadership when U.S. leaders question key parts of the international economic and financial framework. Moreover, even absent such doubts, the United States cannot be an effective leader if it does not have the staffing at key posts to provide that leadership.
The last policy panel addressed the topic "Identifying Risk: An Abundance of Potential Shock Waves." The participants on this panel did indeed provide an abundance of potential shocks. Robert Kahn, a senior fellow at the Council on Foreign Relations, discussed a wide variety of risks but pointed to several that especially concerned him. Although he felt that Europe "dodged a bullet" in the recent election of Emmanuel Macron as president of France, the rise of European populism will make it tougher to get together to make tough decisions. Kahn said he was "surprised" at how smoothly the United Kingdom's forthcoming exit from the European Union (Brexit) has gone so far, but cautioned that in his view "the best is behind us." He observed that studies had shown that it is "extraordinarily difficult" for a country to grow as fast as China has grown without going through a financial crisis. He also expressed concern about U.S. trade policy, though he noted its impact so far has been limited. Finally, he observed that while those in the international policy community are increasingly worried about the risks, that financial markets do not appear to be particularly concerned.
Session chair Alicia Garcia Herrero, chief economist for Asia Pacific at Natixis, went into greater depth on concerns about China in her presentation. She observed that although the risks from capital outflows appeared to be easing, domestic financial risks were growing. Outside of the largest five Chinese banks, she pointed to both shorter-run concerns about bank liquidity and longer-run concerns about their solvency. She also expressed concern about increased risks from shadow banks.
Ray Stanton, chief information security officer at Redwood Technologies Group, pointed out not all of the risks to the financial system originate in the financial system. He noted that although companies were increasingly relying on interconnected computers to drive growth, that meant they were also increasingly exposed to cyber risks. He observed the response to these risks had to include technology, procedures, and people. He ended his presentation with three questions that attendees (and leaders in other organizations) should be asking themselves about their organization's cybersecurity policies.
In the question-and-answer period, Scott Evans, managing director of geopolitical risk at Discovery Capital Management, took on the difficult question of why, if the world is so risky, the VIX is so low (the VIX is a forward-looking measure of stock price volatility). He gave several, not mutually exclusive, explanations. First, the environment had been uncertain for some time, but we have so far come through it without a crisis. In part, Evans attributed this to a confidence in institutions. Second, he noted the fundamentals still looked strong. Third, he observed that investors can hedge risks in a variety of markets besides the obvious ones that people look at, such as the VIX. Finally, he noted that in some cases the risks were too difficult to trade, so many investors remained on the sidelines. Along these lines, Evans said he likes to find assets with asymmetric responses to potential problems, large potential gains if the problem is realized, but with small losses if problem is avoided.
Conclusion
Financial risk managers have to deal with both shifting sands of evolving financial system and potential shock waves. These shifting sands include changing asset correlations, stricter regulation with increased international coordination, and very low monetary policy interest rates. These shifting sands are accompanied by a variety of potential shock waves originating both from within and outside the financial system. The recent FMC helped highlight some of these key issues.
Larry D. Wall is executive director of the Center for Financial Innovation and Stability at the Atlanta Fed. The author thanks Paula Tkac for helpful comments. The view expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please email atl.nftv.mailbox@atl.frb.org.