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Co-ordinated bailouts may no longer be possible
The Credit Business
Is More Perilous Than Ever
By John Plender
Financial Times, London
Friday, October 13, 2006
The losses of the troubled Amaranth and Vega hedge funds have led to predictable calls for more hedge fund regulation. So too will the decision by Philippe Jabre, heavily fined by the Financial Services Authority, to set up a hedge fund in Geneva.
Yet whatever the faults of hedge fund managers, the critics are shooting the messenger. If the real worry is systemic risk, a more fundamental threat comes from the change in the structure of banking whereby credit risk is packaged into tradeable IOUs or hedged via credit derivatives and shunted off bank balance sheets.
Not all central bankers worry about this. Some see financial innovation as a boon, arguing that transferring risk from banks to non-bank investors makes the system more robust since the risk is diversified and better managed. Up to a point they are right.
Yet there is an immutable law of insurance that says that while hedging can reduce the risk to the individual party taking out the insurance, it increases the risk for the system as a whole because of moral hazard.
That is, the mere existence of insurance means people become less risk-averse. And that, complete with the marked decline in risk premiums and in lending standards, is the story of credit markets this decade.
The mechanics of moral hazard in the exponentially growing newer financial markets entail the destruction of the old relationship between banker and borrower. This is because banks no longer retain the credit risk in much of their lending. They originate and distribute; and where the intention is to distribute, the lender is inevitably less bothered about loan quality.
As Raghuram Rajan of the International Monetary Fund argues, bankers now feed rather than restrain the appetite for risk. In a relatively benign monetary policy environment the markets remain stable, leading to an intensification of moral hazard: The longer the market's superstructure proves reliant, the more reliance will be placed on it, even though it has not been tested in really difficult times.
Mr Rajan adds that the incentive structures governing hedge fund behaviour encourage the taking of risks with a small probability of severe adverse consequences. This contributes to financial system stability most of the time, but with the possibility of huge instability in bad times.
In fact, the new financial system is increasingly a game of pass the parcel. At some point the music will stop, because in finance it always does. The interesting question then will be whether a co-ordinated bailout of the kind mounted for the Long-Term Capital Management hedge fund in 1998, or a lifeboat operation such as the secondary banking rescue in Britain in the 1970s, would be possible any more.
The answer is probably not. Crispin Odey, a London-based hedge fund manager, points out that banks are now smaller than the securitised loan market. Having expunged so much risk from their balance sheets, he adds, bankers have little equity in the bad debts they originated.
It follows that being invited by central banks to throw good money after a small amount of potentially bad money in a protracted workout will be a less than compelling proposition. Especially if the lending banks' proprietary traders are taking aggressive positions to exploit the vulnerability of the failing financial institution.
The conflicting interests of competing banks have always made it difficult for central banks to corral people into bailouts. Today the collective action problem is likely to be supremely difficult because most, perhaps even all, banks will feel their interest lies in walking away. There is also a widespread assumption among bankers that the so-called London Rules for sharing pain in private-sector workouts are largely history for the same reason.
This problem of crisis management will be even more difficult because of the globalisation of banking. Financial stability can no longer be managed at national level. Yet it remains to be seen how well any memorandum of understanding for international crisis co-operation of the kind adopted in the European Union between central banks, finance ministers. and regulators will stand up to a financial hurricane.
It is easy enough to share data. Fiscal burden-sharing is another matter. If, for example, an insolvent bank that poses an EU-wide systemic threat has more deposits outside its home country than in, few local politicians will want to spend taxpayers' money on voteless foreigners, including global banking giants in London's financial adventure playground. Lenders of last resort will in future be more elusive. And banking crises will be messy.
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