Systemic Risk and Central Banker Humor

Felix Salmon has some central banker humor:

RGE - Geithner on hedge funds: Geithner's speech is long, and I'm not going to to précis it. But I'll leave you for the weekend with a bit of very, very dry central-banker humor:

If individual dealers to a very large hedge fund each operate with adequate knowledge of the risk profile of the fund, if they each make conservative judgments about their potential direct exposure to the fund in a stress scenario, if they limit the overall exposure of the firm as a whole to the broader market distress that might accompany that failure of a major hedge fund, if they compensate for the uncertainty in making these judgments by charging appropriate risk premia or building in a greater cushion against adversity, and if the supervisory constraints on the core institutions adequately offset the moral hazard that comes with that relationship, then the financial system as a whole will be less vulnerable to distress in the hedge fund sector.

That's humor as in "Dr Strangelove", of course. Geithner knows, and Geithner knows that we know, that none of these things is plausible, let alone likely. Geithner runs the institution which had to coordinate the bailout of LTCM, and I read this speech as Geithner saying that although certain risk-management systems might have improved since LTCM collapsed, there's still as much systemic risk from the hedge-fund industry now as there ever was – if not substantially more. What's more, a tweak to margin requirements won't change that. Reading between the lines, Geithner seems to be saying that if margin requirements went up, the main effect would be that banks' Tier 1 capital would just go down to compensate. In financial-sector regulation, there are no easy answers any more.

Comments

[Jon Fernquest]

Balance sheets of corporations and nations become less transparent making control more difficult, like landing a 747 on a jungle airstrip with with the dashboard covered. Is spunky overconfidence in free markets always enough?

"...the very improvements in risk management that have spread risk far and wide make it harder to know where risk is concentrated or how risks might combine to threaten the system's overall health."

"So far central banks have concluded that the system is more robust than it was. But the trading models that have propelled Goldman will be tested one day. At worst, the bank itself—or, more likely, a second-tier rival or a hedge fund—might fall into the kind of dramatic spiral that killed off Long-Term Capital Management (LTCM), a hedge fund, in the late 1990s. Financial markets have always been subject to crises."

http://www.economist.com/opinion/displaystory.cfm?story_id=6855910

[christofay]

The risk is concentrated in the tax-paying class of Americans. Those are the guys that are going to be paying when JPMoregain or Goldman Sacks goes bust. Otherwise withdraw the socialist too big to fail policy and then watch the bankers get conservative. Just canceling the too big to fail policy would probably be enough for some banks to start cratering.

[joan]

Bankers get conservative? You have got to be kidding. Banking is by its nature is a heads I win, tails you lose game. Government intervention transfers loss from customers to taxpayers.

[John Emerson]

The time may be coming when the populist struggle is between management and finance on the one side, and on the the other the stockholders who are the nominal owners of the managed companies.

I can just see infuriated coupon-clippers in their overalls and mud boots, pitchforks in their hands, getting out of their little Beamers and forming their little lynch mob.

[Big Al]

Not a slippery slope but a rotting ladder.

[JM]

If they did all those thing, they'd be a bank or a mutual fund, with similiar returns.

[Cranky Observer]

The US English word "risk" has a well-understood colloquial meaning, a technical meaining in failure engineering, and a technical meaning in bond pricing. Perhaps a few other highly-constrained technical meanings as well. But the pervasion, overuse, perversion, and manipuluation of the word throughout all areas of financial analysis and reporting over the last 10 years have rendered it essentially meaningless . When I hear "risk management" used to describe both the antics of LTCM and basic project managment skills at the $20,000 project level, I know for certain that it is just a buzzphrase devoid of all meaning. Let's find some terms that are both more precise and more accurate, eh?

Cranky

[Walt]

JM: What do you think "individual dealer to a very large hedge fund" means? He means investment banks.

[spencer]

One of the most dangerous things in the world is an intelligent banker.

[Buyside Monkey]

http://www.theonion.com/content/node/52708

Geithner did not cover all the risks out there. Complacency reigns.

[Buyside Monkey]

http://www.theonion.com/content/node/52708

Geithner did not cover all the risks out there. Complacency reigns.

[John Emerson]

http://www.theonion.com/content/node/48757

The Onion anti-Hilary rant is good too.

[shander]

Basically the Society is paying the premiums for free "puts" for the fincacial institution potentially at risk, but such behaviour may not be societally irrational...the gain in tax revenues and avoidace of socitetaly costly things like higher unemployment are probably well worth "paying" insurance for the others.

There is a hidden issue and it is the "morral hazzard" presented yet I don't think that it is that dicey hedge funds or banks being rewarded, so much but that rationality in risk taking in penalized and that harder capital becomes systematically under-rewarded while situational advantage capital(basically access to capital as an a valuable asset in itself) is accentuated.

If you worry the inconvenient truths, you'll overcharge, lose the agency buisness to comptetitors who figue someone else will foot the bill... as they usually have.

If Greenspan had let the banks feel the Pain instead of juicing money supply in late 1998 after the secret deal was struck, the banks would have stopped rolling over lines of credit, assets would have fallen into hands of folks like Buffett at rates that would provide IRR like non leveraged, returns in the 11 to 12% range.. we'd probably not have had the internet bubble, and we'd probablly not have the myriad of techonlogical advaces we've had... proably aggegated years of unemployment far far higher than the last 8 have been. Hard to imagine all the lasting homes beeing developed.

So Moral? I dunno. I suspect the real problem might be a sense of Nihilism and the innefficiencies prevalent in beauocratic systems that might become rampant. .... but the higher the toll those things take the lusher the pockets of profit to be broken open by end running entrepeneurs... the market will correct them even if it makes the hardworking educated people at large firms into crooks or dummies.

[MIA]

One thing that has surprised me about the Bush II era vs. the Clinton administration has been the relative tranquility of the global financial markets.

This was a major worry for me for a long time -- I did not want to ponder the spectacle of John Snow trying to navigate the "Asian Contagion," but I'm somewhat more confident in Hank Paulson.

Still, the question remains, why the change? Have we been lucky?

[JM]

Cranky,
Oops and thanks. Gotta remember to read (comprehend)the first sentence. I'll go back to my hovel now...

[JM]

Sorry Walt...Argh!