Lessons from the Credit Crunch

The recent credit crunch has shaken world financial markets. One wonders what lesson bank managers and government authorities monitoring financial stability should draw. The first aspect concerns the function that risk management takes in favorable macroeconomic conditions. Under such conditions, as those prevalent before the start of the subprime crisis in 2007, those who doe operations and generate profitability have a bigger weight than those who have to identify and limit risk. This asymmetry can be partly justified by the different payoffs in the two functions. Those who generate business have potentially very high profits and limited losses. The worst that can happen is not striking a deal and not getting the related bonus. A risk manager has the opposite risk profile: limited profits and potentially unlimited losses. It would be advisable that the incentives for the former as well as the latter were designed to defuse situations of potential crisis, for instance by granting bonuses only after a given period, so that there's time to see potential problems emerge, and perhaps by splitting the bonus with risk managers.

A second important lesson, both for top management in banks and supervisory authorities concerns the issue of liquidity risk. Over the last two decades, attention traditionally focused on financial solidity vis-à-vis the entity of risks taken. This logic saw own capital as safeguard against unexpected losses arising from credit, market, and operational risks. Lesser attention was given to liquidity risk. This reflected the conviction that in an international interbank market which was integrated and liquid, a well capitalized bank would never have liquidity problems, having as it had easy access to short-term credit facilities by borrowing from other banks. This line of reasoning focused on funding risk, rather than non liquidity risk. And it overlooked the possibility that the same assets in which capital was invested suffered a drop in prices as a consequence of a dearth in liquidity on the pertinent market (the so called market liquidity risk), thereby compromising the solvency of a bank. A liquidity crisis that hits the assets of a bank undermines the capital solidity that ensures protection from funding risk, for the simple fact that financial institutions when faced with asset positions of uncertain value are unwilling to lend.

The third lesson is about how to share the burden of responsibility for the valuation of risk. Two important aspects must be kept in mind. The first is about investment policy concerning structured assets: the transformation of illiquid credits into tradable assets having apparently liquid markets should not make anybody forget that the main risk here is credit risk. A financial institution taking strong positions on these assets must perform an in-depth risk valuation. The second aspect has to do with financial supervision and the selling of loans made by banks. Such process improves the allocation of risk in the system and the diversification of banks' portfolios, and it's likely to resume once the crisis is over. This should not make people forget that the competent actors in valuating credit risk are the banks, not the hedge funds, the pension funds, or the insurance firms. Banks should not just stop at origination, and maintain the default risk associated with their loans on the balance sheet. If this weren't so, the incentive for a bank to do a rigorous risk analysis would be lost, with adverse consequences for the allocation of credit in the economy.