Paul Fisher: Tail risks and contract design from a financial stability
perspective
Speech by Mr Paul Fisher, Executive Director for Markets of the Bank of England, at Clare
College, Cambridge, 1 September 2011.
* * *
The paper is co-authored with Patrik Edsparr, Visiting Fellow, Bank of England.
The authors would like to thank Ravi Mattu (PIMCO, Newport Beach), Morten Hviid (UEA) and colleagues at the
Bank of England for their comments on a draft of this paper. The views represented in this paper are those of the
authors and should not be taken as the policy of the Bank of England or to represent the views of any other
person at the Bank.
The wider theme of this conference is about what we have learned from the recent crisis.
There have been many lessons. Some are not new but just a re-learning of old lore: "banks
need to hold adequate capital"; "real-estate prices can fall dramatically"; "financial institutions
need to avoid excessive risk taking". The authorities are pursuing a long list of regulatory
initiatives to address the externalities arising from risks in banks and markets, including
Dodd-Frank in the US, the European Market Infrastructure Regulation (EMIR) in Europe, the
Independent Commission on Banking (ICB) in the United Kingdom and the various Basel
capital and liquidity rules internationally. And the Financial Stability Board has taken on a role
in co-ordinating much of the other international effort. Academic research also has a large
part to play in this process, in both identifying the issues and proposing or evaluating policy
responses.
A lot of discussion is taking place around disentangling different forms of complexity in the
market place. For example, regulators are promoting more transparency around funding and
legal entity structure within complex financial institutions. And there is also a growing body of
work that is exploring clearing houses and exchanges as important structural vehicles to
mitigate the increased inter-connectedness driven by the growth of derivatives1.
The approach taken in this paper is to look at some of the details of how risk-taking is
executed and the underlying market structures. These micro-foundations can have a
profound impact on systemic stability beyond the normal consideration of formal regulations.
In particular, we focus on one aspect of market structure: contracts where, because of a
failure to take into account how the financial system as a whole operates, the true value of
the contract is different from what it was intended to be - by at least one of the
counterparties who struck the contract. This can arise either because in states of the world in
which a particular contract is designed to have value there is high correlation with other
events or where, in that state of the world, full adherence to the legal structure would cause
large unintended consequences in terms of signalling or reputational damage.
Tail risks with counterparty risk correlation
The first category of contracts falls under the broad headline of "wrong-way" risk in tail
events, and is purely statistical in nature. The particular issue is focussed on contracts that
can be perceived of as providing insurance yet, in a stress scenario, when the contract is
sufficiently in the money to be worth calling, there is a significant conditional probability that
the insurance provider is no longer in business to pay out. In what follows, we look how such
problems arise using practical examples and consider what lessons should be drawn.
When investor "A" decides to buy protection from bank "B" on exposure to a third company
"X," she may or may not explicitly take into account that in the event of default by X, B may in
fact also be in trouble. Whether or not she does so would depend on the reason for the trade.
If A wants default protection then that default correlation certainly should be taken into
account2. But if, for example, the goal is just to reduce the price volatility of holdings of a
certain corporate bond issued by X, this default correlation may not be seen as that relevant.
As a practical example, take the case of a pension fund managing its corporate bond
portfolio. Suppose the pension fund owns a large amount of a particular corporate bond and
wants to reduce this holding, but the liquidity for outright sales is limited. The fund may take a
view that it will have less price impact by gradually selling the bond in the cash market over a
period of a few months but, at the same time, it would prefer to take off the market risk
immediately. If that is the case, the fund may take out a standardised CDS (Credit Default
Swap) contract with a bank, probably written on a basket of corporate bonds issued by the
same corporate. There would be basis risk from any mismatch in the bonds, so the CDS is
not an exact hedge, but in most scenarios, holding the bond and the CDS contract together
will ensure a substantial reduction in the net value of the market position, compared with
holding the bond alone. The fund could then unwind the CDS contract simultaneously with
slowly selling the cash bond. In short, the superior liquidity of the more homogenous CDS
market (which benefits from relatively elastic gross supply) enables the pension fund to
reduce the execution costs of its portfolio management whilst not sacrificing its nimbleness in
terms of market risk management.
In this example, the strategy seems reasonable. The probability that the corporate defaults in
the few months the strategy takes to execute is probably pretty low, and the joint probability
of the corporate and bank defaulting is even less. In essence, the CDS protection is not
really being used to insure against default but to reduce market price volatility.
Let us now turn to a second example of a bank hedging its corporate lending. Banks lend
to a broad range of companies. In many cases they would be expected to hold these loans
on their books until maturity (as opposed to selling them off to other investors). In order to
reduce its measured outstanding credit risk, a bank may choose to purchase off-setting CDS
protection, probably on a portfolio of loans. By so doing, the bank can make greater use of its
internal credit risk limits and may get regulatory capital relief. In most cases, another
leveraged market participant (bank or hedge fund) would write the CDS. (In some cases the
insurance provider may be an unlevered institution, for which most of the concerns below
would be reduced.)
In the first example, the pension fund was concerned about short-term price swings. In this
second example, the bank should be concerned to protect itself against clusters of defaults.
But if the risk management of the ensuing portfolio of loans and CDS is not done with serious
attention paid to the joint risk profile of the corporate borrowers and the providers of the CDS
protection, the true net risk position might be worse than it appears. That could fool
regulators as well as the bank's own risk management function. Any risk management
framework that is driven by the correlation structure of short-term moves alone would most
likely be proven too rosy in the event of clusters of defaults. The issue is that the correlation
structure locally may be very different than that in the tail of the distribution. Of course, there
are many practical problems in analyzing what could happen statistically in the tails, since
these scenarios are, by definition, rare and the pay-offs may be non-linear3.
Taking this second example a little further, assume that most big banks follow similar
strategies. Most banks will then end up with a more diversified credit portfolio than if each
bank was only holding the loans it originated itself, but they may also end up with similar
portfolios of risk. In such a scenario, the system can easily absorb small shocks, but because
of the diversification, a really big shock may threaten to bring down all of them instead of just
the ones that happened to have originated the most problematic loans. In a very
interconnected financial system, it can be almost self-fulfilling that when the market starts to think
some of the banks are in trouble, in fact all of them are4.
A third example in this section is the dynamic hedging strategy of a bank's credit risk arising
from its derivatives portfolio (Credit/Counterparty Valuation Adjustment: CVA hedging).
This normally refers to the credit risk of a counterparty that is not directly offset by some form
of collateral5. Suppose a corporate has issued a fixed rate bond because investor preference
makes that the best value, but really it wants to have a floating rate liability. A bank will
accommodate this by providing an interest rate swap. If interest rates go up, that swap may
generate a net value owing to the bank. Receiving that value depends on the corporate not
defaulting and so the bank will have a credit exposure to the corporate. But the corporate
cannot be expected to post collateral - it will just regard its debt as having been converted to
floating rate (and typically it won't hold any collateral it could post anyway). A bank that is
active in these interest rate swaps will end up with a large number of such mark-to-market
exposures. Collectively, the resulting exposures constitute a credit portfolio which changes
with the mark-to-market values of the underlying derivatives contracts. To manage the credit
risks embedded in this so-called CVA portfolio, most banks will hedge dynamically in the
CDS market. This is usually a very effective risk management technique during periods when
CDS markets function normally. But it is worth emphasizing that the embedded "jump to
default" risks in credit products, coupled with liquidity issues during times of extreme stress,
can make it very difficult to execute a dynamic hedging strategy in stressed conditions.
In addition, and as already noted, CVA hedging is likely to be undertaken by buying CDS
from another bank or a hedge fund. In this example we have tail-risk correlation not just with
corporate and counterparty risk but with CDS market liquidity. If proper consideration to the
correlation structure is not applied, the danger is clearly that the realized outcome in extreme
scenarios would look very different from what was expected by senior management,
regulators, etc., based on local analysis.
A fourth example from the recent crisis was the
"super senior" credit exposure from
pools of US mortgage loans reinsured with monoline insurance companies (MBIA, FGIC,
AMBAC, etc) or other insurers such as AIG. Banks and other originators of leveraged credit
risk (either in cash form of CDOs or CLOs, or in its synthetic forms) needed to warehouse
excess "super senior" tranches, which were considered virtually risk free, to support the
origination business. After the volatility experienced in 2005, banks started to worry about
controlling the mark-to-market volatility, even though the fundamental risk initially continued
to be considered negligible. The idea came to lay off a significant portion of this negligible
economic risk to reduce the short and medium term price volatility. Similar risk reduction
processed largely worked for traditional corporate credit risk, but proved disastrous in the
case of super-senior risk backed by US sub-prime mortgages. Insurance by the monolines
proved practically worthless as they successively failed. And reinsurance with AIG would
have proved worthless if AIG had not been rescued by the US Government. The problems
affected other securities in unexpected ways - at one point, US municipal debt wrapped by
monolines was trading at a discount to the same debt without the wrap.
Once a default event has occurred, the correlation problems with such contracts become
obvious. The question is why they are not apparent ex ante. The normal motivation for
insurance is risk aversion to large losses arising through tail events. If such an insurance
contract is worth having, one must be able to envision the tail event happening and what the
circumstances might be. Why was it so hard to anticipate what would happen if there were
losses on large numbers of bonds insured by monoline insurers which had relatively small
amounts of capital?
One reason why such risks may not be appreciated ex ante is over-reliance on local risk
measures such as VaR (Value at Risk) or other historical average correlations, and not
enough on severe stress tests over different horizons. For example, in the United States it
was widely believed that house prices would not fall significantly nationally (it had never
happened after the Great depression in the 1930s). We assert that, if one had stressed bank
capital in the US with the explicit assumption that national residential real estate prices could
go down 30 to 40%, and in some local markets more, most of the losses for US banks could
have been correctly predicted (at least if the complexities of structured credit products were
properly assessed6). The collapse of functioning inter-bank money markets and other
"runon-the-bank" phenomena obviously added further costs, but the first-order effect was caused
by residential house prices falling. The key, however, was to correctly predict what that kind
of price drop would do to other market participants, and market structures, as well as to the
individual firm. Extreme stress tests have served a crucial purpose after the crisis to
re-establish confidence in banks, and might usefully play a wider role in more aspects of
on-going bank oversight.
An additional concern is that many of the transactions suffering from this risk may have been
entered into for portfolio management reasons (such as the pension fund example) or
regulatory capital relief and other "window dressing" purposes rather than genuinely to
protect against default. Net exposure numbers quoted on earnings calls, or stress losses
reported to regulators, can all be made to look more palatable if the insurance is apparently
in place, while the true risks in the event of default may not have changed much.
These issues raise general questions for market structure with tradeoffs that are far from
trivial. Is it beneficial for, say, banks to lay off sovereign risk with other banks and other
leveraged financial institutions such as hedge funds, or does the ensuing web of contingent
exposures across leveraged institutions increase the systemic risks? It seems that many of
these arrangements increase diversification in the case of small and medium size stress
scenarios, but may actually exacerbate the systemic implications in the case of very large
shocks7. These arrangements also highlight the delicacy of the appropriate regulatory
structure. In many instances, subject to sufficient diversification, these tail risks might be
better borne by so-called "real money" investors, i.e. insurance companies, pension funds
and traditional long-only bond and equity funds, as these investor categories operate with
little or no leverage. In case of massive shocks, these investors could be better suited to
absorb the losses, as there is limited leverage to trigger further spillovers through defaults or
panic driven asset sales. Many of these investor groups are, however, subject to an
extensive regulatory framework, making them unable to hold such risks in their portfolios, in
many cases even as a very small fraction of total assets. There is a potentially difficult
tradeoff here between public policy objectives of appropriate investor protection and systemic
stability considerations. That probably deserves to be debated more fully. It is clear,
however, that highly leveraged institutions such as banks and hedge funds are not really
suited to be the ultimate repositories of extreme tail risk8.
What does all of the above tell us? The answer may seem trivial ex post but if these issues
had been highlighted and subjected to more transparency, we believe that the ultimate
outcome probably could have been different. A lot of the surprise seemed to come from the
fact that virtually all risk management had been done within a "local" framework, rather than
genuinely extreme stress tests. If regulators, rating agencies or, for that matter, bond and
equity investors had demanded analysis based on extreme stress tests, many of the
repercussions in the system could have been identified. The main point is that a stress test
has to be internally consistent. As an example, if you stress test a 30-40% fall in US
residential real estate prices and that shows your institution would be in trouble, you need to
make consistent assumptions about the deteriorating credit conditions of your counterparties,
anyone that provides reinsurance and general market conditions.
At some level, there is always a stress scenario that forces bankruptcy. Perhaps the greatest
sin in the years preceding the financial crisis was blatantly ignoring what really would happen
if the "unthinkable" drop in US house prices actually happened9. Some major institutions
seemed to have had no grasp of how risky their exposures really were, despite spending
millions on risk management and while being inspected by regulators on an ongoing basis.
By addressing these issues, the stress tests implemented by the Federal Reserve in the
United States, and by the European Banking Authority in Europe, could play a key role in
re-establishing confidence in the banking system.
Reputational risks in tail events
The second category of contracts we want to examine can be put into more of a game
theoretic framework, where the perceived pay-off in the tail event is offset by "unforeseen"
costs. In this section, we are focusing on behaviour that, at first glance, may seem irrational,
but is best understood as being driven by classic time inconsistency. In particular a market
participant may voluntarily choose not to enforce a contract that is "in the money", if the
reputational repercussions are perceived to cause more damage than whatever could be
gained financially by enforcement.
During the crisis, banks moved a significant amount of their mortgage-based assets
offbalance sheet into Structured Investment Vehicles ("SIVs"). Most of the funding for these
SIVs came from publicly sold asset-backed commercial paper ("ABCP") and other
mediumterm notes ("MTN"). There was a small amount of equity in the form of a junior "capital note,"
which split the excess return with the asset manager. From their invention by Citigroup in
1988 and until the crisis, there was sufficient spread between the assets and the funding to
generate a reasonable return to attract investors to buy the capital notes. In addition, there
was typically a partial liquidity back-stop facility provided by the originating bank. When all
the capital notes had been sold, there was no economic risk retained by the originating bank
except the back-stop facility, and only a management fee continued to accrue to the asset
manager (typically, the originating bank).
When the crisis hit in autumn 2007, one of the first casualties was the closure of the ABCP
markets and funding for the SIVs dried up. Beyond the liquidity lines, banks generally had
very limited legal obligations to the SIVs (eg for credit losses on the assets) but most decided
to accept responsibility for the assets and absorbed them back on balance sheet or at least
fund them directly. This was obviously done for reputational reasons and was viewed as less
costly to the franchise than walking away.
Part of the explanation for banks' behaviour was that these structures were not necessarily
designed to be profit centres, but rather to enhance capital efficiency for the bank. There was
essentially a massive maturity mismatch between the banks' underlying assets and their
funding. And the SIV structure effectively enabled the bank to isolate that mismatch and
hence support its other businesses with the embedded lending in the assets that were being
put into the SIVs.
The perception was that the quality of the underlying assets was so good that the risk of a
real loss (as opposed to some shorter-term mark-to-market fluctuations) was negligible, and
that the returns accruing to the capital note holders and the asset manager were largely due
to the funding arbitrage. Another way of explaining it would be that, because of the difference
in liquidity, the "buffers" in the structure, the capital notes and the liquidity back-stop provider
were effectively earning a risk premium for absorbing this liquidity mismatch between assets
and liabilities. This view of the world made most of the capital note holders believe that the
risk of any loss was very limited.
We now know all of that changed when sub-prime mortgage assets had become a significant
portion of the assets in a typical SIV. The US housing market had started to slide and the lax
underwriting standards started to show their impact on recovery rates. Suddenly, investors in
the ABCP market came to realize that the risk of actual loss was very real and that a game of
"musical chairs" was unfolding in the roll-over process of the short-term debt. At this juncture,
one would think that the optimal economic behaviour for the banks with outstanding SIVs,
would be to let the SIVs unwind according to the legal construct in place, rather than accept
responsibility. In fact, all the banks except one decided to collapse the structures and
repurchase the
securities10.
From an investor protection standpoint, one may have drawn a sigh of relief, as any potential
issues about misrepresented risk profile disappeared, but from a financial stability
perspective, it was obviously disturbing. In a short space of time, billions of assets showed
up on already over-extended bank balance sheets.
One may think it somewhat surprising that (almost) all the banks decided to absorb their
SIVs, especially since it must have seemed likely that the SIV structure would not come back
any time quickly as a viable funding structure. We believe that the main reason for doing this
was that not doing so would have sent a distress signal to the market. In other words, if a
bank chose not to absorb this problem, the perception would be that they simply could not
afford to do it, thus telling the market that they were in even worse shape than previously
feared. There may also have been an element of "repeat game". If one lets one's investors
take the pain, then they may not return for future transactions.
It seems plausible that if the SIV crisis had transpired during a time when most other markets
had remained functioning, the decision making process might have been very different.
"Signalling" is at its most powerful when the level of uncertainty in the system is highest.11
We now want to turn to an example of a structure that did at least partially survive the crisis:
UK RMBS master trusts. These are versatile structures that allow an issuer to transform a
portfolio of assets into a very different investment product. In principle, the master trust
purchases mortgages from the bank and issues tailored bullet-maturity securities. The assets
and the liabilities can be very different, e.g. the demand for the securities may be stronger in
US dollars than in sterling, so an FX swap converts the cash-flows into dollars. Or most of
the mortgages may be floating rate, whereas investor demand is stronger for fixed-rate
product, and an interest rate swap(s) converts the cash flows accordingly. Mortgages
typically pay down somewhat randomly and relatively quickly, whereas investors prefer
straight-bullet maturities. The master trust can accommodate this by allowing on-going
reinvestments of the pay downs and conversely allowing the trust to put assets back to the
bank if the cash-flows are not sufficient to make a particular principal repayment. The
downside is clearly that the on-going linkages between the issuer and the trust remain very
strong, and it is thus hard to identify where economic risks ultimately reside.
RMBS master trust securitisations are designed to be called on their bullet maturity date and
that is how they were priced and traded. In one case that didn't happen: in November 2008 it
was announced that the £40bn "Granite" master trust had failed a non-asset trigger12 which
meant that Northern Rock would no longer provide new mortgages to the structure and it
went into pass-through mode (early amortisation). Instead of owning bullet securities, the
investors ended up holding potentially long-dated pass-through notes. Trading in the
securities effectively ceased and, because of the maturity extension, the securities issued by
"Granite" fell precipitously in price - even though there had been no material credit losses.
The subordinated securities would only be paid off after enough cash had come in to first pay
off the senior bonds. As Northern Rock had already been nationalised, the dynamic around
the decision to run-off "Granite" was obviously quite different from what other banks were
grappling with at the time. This event clearly "burnt" a number of investors, many of whom
have indicated that they will not return to purchase any master trust structure in future. In
pure economic terms, it might have paid other banks also to not call RMBS when funding
pressures were at their highest. But this would have destroyed the market and damaged
relations with investors, possibly beyond repair.
Another example is the existence of break clauses in derivatives contracts. These clauses
enable either counterparty to a derivatives trade to call for cash settlement of the
mark-to-market of their contract at a particular future date. The main reason for this "break
clause" is that it reduces the contingent credit exposure. Think in terms of a simple
fixed-forfloating swap for 10 years. (This transaction could be to convert a company's fixed-rate bond
issue into a floating-rate liability for example.) The bank pays a fixed rate in exchange for
receiving a floating rate (say, LIBOR) from the corporate that issued the bond. If no break
clause exists, the bank's credit department would price the contingent credit exposure to the
corporate over the full life of the contract. This could be very high: a substantial rise in
shortterm interest rates would make the bank effectively owed a significant amount of money by
the corporate. The bank needs to factor in that with this "gain," there is an associated risk of
default of the corporate. In reality, one can think of all these contingent credit exposures as
the modern derivatives book's "loan portfolio". It is equivalent to a traditional loan book,
except that it dynamically changes in line with market prices. The credit risk is obviously
bigger when the creditworthiness of a company is lower and when the maturity is longer.
The bank's credit department will therefore calculate a credit spread that it will charge on top
of the "risk free" swap level (that would be charged between financial institutions that fully
collateralize any mark-to-market swings). For a longer-dated swap, this charge may be very
large. Introducing a break clause allowing either counterparty to terminate the contract
effectively shortens the maturity of the swap, since the bank (or the company, in case it is
owed money and the bank's credit appears more shaky) can demand payment at that time.
In reality, most corporates do not expect such a break clause ever to be exercised.
The concern would be that, if the corporate expects the bank to ignore the break clause
regardless of the circumstances, exercising the clause would be a surprise for which the firm
may not have put appropriate contingencies in place - perhaps even making default more
likely. Or that the market may start to interpret the enforcement of "break clauses" as a sign
of weakness on the bank's part. In other words, such behaviour could be seen as so
antagonizing to customers that a bank would only do it if it is absolutely desperate. Yet if the
bank cannot in fact enforce the break clause, its credit pricing and risk management has
been faulty.
Another example, comprising elements of the break clause and the SIV problem, is the
behaviour of managers of money market funds when faced with the prospect of "breaking
the buck".
A money market fund calculates its net asset value (NAV) on a daily basis. The NAV is its
price per share, which reflects the total value of the fund's investment holdings. Traditional
money market funds seek to maintain a constant NAV (CNAV funds) ie they invest with the
explicit goal of maintaining a stable NAV of $1.00 per share. Investors like this because it
avoids any market price fluctuations in their investments.
A CNAV money market fund is said to "break the buck" when its NAV falls below $1.00 per
share (or the equivalent in a fund's respective currency). This is a rare event. Prior to the
crisis, it had not happened to a US money market fund since the Community Bankers
US Government Fund broke the buck in 199413. The conventional perception was that the
principal should be "safe". When money funds came under pressure during the crisis, more
than 60 asset managers (among others, Wachovia and Legg Mason) unilaterally made up
more than $12 billion of losses14.
On 16 September 2008, the Prime Reserve Fund, the oldest U.S. money market fund, wrote
off 3 cents of losses on Lehman Brothers. Not being able to make up the losses, the fund
was left with a NAV of $0.97, triggering a "run" in the money markets. On 19 September
2008, the U.S. Treasury announced the establishment of a temporary one-year guarantee
program to protect investors in money market funds. The funds that were eligible had to pay
a fee to participate in the program, and any fund that had already "broke the buck" could not
participate.
This example raises several interesting issues. In keeping with previous examples, it
illustrates the extreme non-contractual lengths some of the asset managers were willing to
go to in order to protect their reputations. It also shows how the equivalent of a "bank run"
can happen in the shadow banking system. And it shows the potential importance of public
sector support - another complicating factor that makes the true risks in a tail event difficult
to assess.
As a final example in this section, we have Deutsche Bank's decision in December 2008 not
to call a lower tier 2 subordinated debt issue (a €1bn 2004/2014 bond with a call date of
Jan 16 2009), despite the fact that it was customary for banks to call such bonds at the first
possible date. The reason that this is interesting is that it was actually economically rational
in isolation for Deutsche Bank not to call, and it was fully within its right not to do so, but still,
investors became infuriated and the consequent short-term adverse reaction almost certainly
cost Deutsche and its shareholders a multiple of the gain it received from not calling the
bond. Despite that initial investor reaction, however, Deutsche was able to keep market
access and to successfully issue further capital instruments in the months thereafter.
The theme we have encountered in these examples is that many of the decisions taken
during times of extreme pressure seem to be affected by (apparent) considerations outside
of the immediate financial contract - at least, rejecting options which were perceived to be
acceptable when the original contract was struck. Or that the financial consequences of
particular decisions were more adverse for the decision maker (or more generally the
markets) than anticipated. In that sense they are classic examples of time inconsistency. We
have tried to illustrate how acting narrowly rationally when it is perceived to be outside the
realm of "what is normally done", can carry massive risks. The problem that this creates is
that when we are dealing with tail events and disaster insurance, it is hard to determine
ex ante what such insurance contracts (or options delivering insurance) are worth. How
should investors and regulators evaluate these contracts? If the reputation and signalling
implications of exercising are too damaging in case of extreme stress, it would be naive to
attribute full value to them when determining the risk profile and hence the appropriate
capital buffer. It is also worrying from a financial stability perspective if these considerations
force possible systemic implications to be more extreme rather than less.
Stress tests and contract design considerations
So what have we learned? The first set of examples above highlighted the need to critically
evaluate contingent exposures: without true stress correlations, tail events will not be
captured properly. We believe more emphasis should be put on th