Jean-Claude Trichet: (Under-)pricing of risks in the financial sector
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the Coface
Country Risk Conference 2009, Paris, 19 January 2009.
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I. Introduction
Ladies and Gentlemen,
The current juncture presents us with a particularly important moment to conduct a deep
analysis of the pricing of risk - and the mis-pricing of risk - in the financial sector. It is no
exaggeration to say that, for several decades, there has been no more relevant moment for
this topic than today.
In my view, the appropriate identification, assessment and handling of risks in the financial
sector are the key issue to be considered most carefully amid the current global financial
turmoil. Looking back, the main factor that I would identify as underlying the turmoil is the
broad-based under-appreciation of risk. This under-appreciation of risk has been observed
across financial institutions, across markets and across economies. Looking ahead, the main
lesson I believe we need to draw is therefore for the financial sector to establish a much
more rigorous identification, assessment and handling of risk.
Against this background, I am very pleased to participate in this major conference on risk
analysis today. It brings together specialists from France and abroad from the banking and
corporate sectors as well as from academia. In my remarks, I would like to share with you
some thoughts on three areas: the fundamental causes of the financial turmoil, the main
avenues for financial sector reform and some of the broader lessons to conclude from the
current episode.
II. Under-pricing of risk
Let me begin with the causes of the turmoil: in the four years to August 2007, macro-financial
conditions were very favourable on the surface. Economic growth was exceptionally strong
and stable, liquidity in capital markets was abundant and the financial sector was providing
remarkable returns: profitability was high, many asset prices were rising, implied volatilities in
equity markets, bond markets, credit markets and foreign exchange markets were all very
low by historical standards, and finally: risk premia were extraordinarily small. At the same
time, the world economy was growing vigorously, in an overall low inflation environment and
stable macroeconomic environment as a whole. The only warning sign, which was brushed
aside by many economists, consisted of the significant build-up of imbalances at various
levels in the global economy and the global financial system.
Against this apparently favourable economic background, innovation was rapidly taking place
in financial markets. This was perceived by most observers as a positive development, on
balance, because it enabled a better and wider distribution of risk. In fact, the diversification
of risk appeared to be beneficial not just for the financial sector's stability, but also for the real
economy, since companies were able to more efficiently spread the risks they were bearing.
This perception is likely to have encouraged risk-taking not only inside but also outside the
financial sector. However, as the turmoil has since shown, there was a generalised tendency
to overestimate the true degree of risk spreading and diversification, especially in credit
markets.
Warnings by the authorities about the possibility of an abrupt correction in financial markets
date back to 2006. Many warnings were made about the risks associated with what was
essentially a "pricing for perfection" - which, put simply, meant that risk premia were not, or
hardly pricing in the possibility of anything going wrong. Given such pricing, even a small
change in conditions had the capacity to severely disrupt financial markets. At the same time,
a number of financial stability reports - including from the ECB, the Bank for International
Settlements (BIS), the Financial Stability Forum (FSF) and other organisations - analysed
vulnerabilities of the financial sector and warned of emerging weaknesses.1 In particular,
these reports often emphasised that the rapid pace of innovation in financial markets and
products coupled with the low level of risk premia called for investors to take greater care in
understanding and managing the risks they were exposed to. However, while it was
perceived that a storm was brewing, it was not known exactly what would trigger it, but that it
would be appropriate that the financial sector agents should prepare for it so that the
correction would be as orderly as possible. Both the underpricing of the "unit of risk" and,
even more importantly in my view, the underestimation of the "quantity of risk" turned out to
be at the core of the crisis. Let me explain further how I see these two concepts.
Underpricing of the unit of risk
The underpricing of the unit of risk related mainly to inadequate assumptions made about the
distribution of returns to highly complex, new financial securities. Let me mention a few
examples. First, take the fact that, in calculating the probability of default of mortgages in a
large economy, the possibility of a drop in real estate prices or the ongoing deterioration in
lending standards, were not properly factored in, or even totally disregarded. A second
example relates to the reliance on recent data to estimate parameters of probability
distributions. Statistical models, generally using data based on the recent past, tended to
produce over-optimistic estimates due to the apparently very favourable operating
environment that preceded the eruption of the turmoil that I just described. The generalised
"hunt-for-yield" in global financial markets was also likely to have contributed a great deal to
the distortion of the price of the unit of risk. The compression of spreads and risk premia
coupled with the search for higher returns tended to lead to a higher level of investors'
appetite for risk. This, in turn, further inflated valuations based on very favourable
expectations of future returns. Contributing to the underpricing of a unit of risk was also the
opacity and complexity of structured financial products. Not even sophisticated investors
were able to assess the risks embedded in these products properly.
Underestimation of the quantity of risk
But in my view, an even more astounding aspect was the generalised under-appreciation of
the quantity of risk borne by market participants. In fact, as the turmoil unfolded, some large
financial institutions revealed a massive concentration of risk, suggesting that risk
management systems had failed to identify the quantity of risk that financial institutions were
accumulating. A good example relates to the credit default swap (CDS) market. This market
hardly existed in 2002 and grew at an incredible pace to reach a size of $58 billion in notional
amounts in 2007. By buying protection on a particular bond, market participants believed
themselves to be largely insulated against the risk of default of the issuer. However, this
protection turned out to be defective when the first signs of financial market distress
emerged. In fact, during its steady growth in the pre-turmoil phase, the performance of the
CDS market under stress had not been tested before. This market also brought home the
importance of counterparty risk - a crucial notion in risk assessment - which, it seems, was
not always fully understood and accounted for in market participants' management of risks
before the turmoil erupted.
Another example refers to the failure of the same risk management systems to assess the
systemic consequences arising from the turmoil. Take, for example, the risks involved in
relying excessively on short-term debt to finance long-term assets, both by financial
intermediaries and the corporate sector. These risks were barely accounted for. In fact, the
probability of a sudden closure of specific markets was assumed to be very close to, if not,
zero. To put it in more general terms, cross-correlations across and between defaults on the
one hand and the rest of the economy on the other hand were generally not properly factored
in when calculating probabilities of default. The limited importance given to risks of a
systemic nature was thus responsible, to a large extent, for the massive underestimation of
the quantity of risks borne by market players, as shown by the unfolding of the crisis.
In general, the evaluation methodology of the quantity of risk and the price of a unit of risk
has turned out highly inadequate in the light of the current experience. The dominant models
rely on simplified hypotheses, consisting of laws of probabilities about future events. The
periods of crisis bring to light the major shortcomings of the underlying mathematical models.
In these periods the behaviour of markets and prices does not appear to follow any
probabilistic model ex ante but rather reflects a more fundamental Knightian uncertainty in
which even probabilities are unknown.
III. Three main factors to be addressed
After reflecting on the origins of the crisis and the initial lessons learnt over the past 18
months since the turmoil erupted, let me now turn to the future and the avenues for reform to
be addressed in our response to the crisis. I would like to highlight three areas where, in my
view, change is particularly needed.
First, there is the need to address short-termism, i.e. the excessive focus on short-term
returns in the financial sector, part of what is often called the "bank-bonus culture".
Shorttermism may encourage excessive risk-taking, since less attention is paid to low-probability
outcomes which might only crystallise over longer periods of time. More worrying is the fact
that it can exacerbate the impact of conflicts of interest and perverse incentives at all levels
within a financial institution.
Considerable thought is being devoted to compensation-related issues both by the official
sector (e.g. the Financial Stability Forum) and market participants themselves. Sound and
reasonable principles for compensation schemes at large financial institutions, including
incentives for prudent long-term behaviour, and a real adjustment to risk are some important
ways for reform.
A second factor to be addressed in our response to the crisis relates to the enhancement of
transparency in financial markets. As the turmoil has shown, the availability of aggregate
information regarding the main risks to the financial system is of the essence. Information on
institutions, instruments and markets that are currently unregulated, but whose risks raise
financial stability concerns on account of their potential systemic impact, proved to be crucial
for effective financial stability monitoring and accurate risk assessment. One clear example
of some first steps taken in the right direction relate to the initiative to establish a central
counterparty clearing house for the CDS market, a move that I strongly welcome. This would
be a first important contribution to increasing transparency in over-the-counter (OTC)
derivatives markets. Increasing the number of standardised securities exchanged on
regulated markets would also make it easier to price these financial instruments, based on
relevant public information and on traded prices.
Finally, a third factor that, in my view, needs to be addressed is the excessive pro-cyclicality
of the financial system in its entirety, i.e., the tendency of the financial system to accumulate
too much risk and leverage in good times, and to shed risks hastily in a downturn. We should
endeavour to systematically eliminate wherever possible the elements that reinforce or
amplify the spontaneous cyclicality of the financial economy. In particular, but not exclusively,
we have to reassess from this point of view capital requirements, valuation and leverage,
provisioning regimes as well as banks' compensation schemes. In this field, I also welcome
the work being carried out under the auspices of the Financial Stability Forum.
IV. First lessons drawn from the current situation
We are going through an exceptional period marked by a recent intensification of the
financial turmoil since last September and by a major slowdown in the global economy.
Virtually all economies - both industrialised as well as emerging - have been moving in the
same direction since the end of 2008, which has contributed to the magnitude of the overall
current downswing.
In conclusion, I would like to draw your attention to three points, which I consider as
important:
First of all, the full-scale test to which the global financial system is subject reveals an
excessive fragility that the prevailing mathematical models had not anticipated. This fragility
is unacceptable. The global market economy, in all its elements, including and especially in
its financial component, must considerably strengthen its resistance to shocks, i.e. its
resilience. This calls for a set of ambitious reforms aiming to introduce, re-introduce and
reinforce if need be counter-cyclical mechanisms and the shock-absorbers in the financial
system. Financial and economic fluctuations are inevitable and necessary in a market
economy. It is up to us to ensure that we don't amplify those shocks by our own making and
our own rules, as is the case at the moment. Shocks, sometimes abrupt, are inevitable: they
may come from technology and innovation, from structural transformations that characterise
globalisation, from geostrategic risks and many other angles.
It is up to us to deal with them as smoothly as possible, not only at the level of the economies
concerned but also at global level. The corresponding reforms must be systematic without
giving the least privilege to any entity and without focusing attention either on a few
scapegoats. As a matter of fact, everything can and must be substantially improved.
In second place, we should note the rapid reaction of the public authorities, central banks
and governments in particular, in these exceptional circumstances. Of course, I am not
referring to the decisions taken since the start of the turbulence on 9 August 2007: you may
remember that the ECB's Executive Board decided to lend overnight at our refinancing rate
€95 billion to the commercial banks in the euro area. What I want to talk about are the
decisions of the European Central Bank and the other central banks after the crisis worsened
in September concerning the organisation of what I would call a line of defence against a
systemic threat of illiquidity: those decisions have led us to expand the collateral framework
and to commit to ourselves to refinancing without limit a fixed interest rate, at one week, one
month, three months and six months. The governments themselves have set up a second
line of defence against the systemic solvency threat. They have done so by organising,
whenever necessary, support to ailing institutions and by systematically supporting the
banking sector by means of guarantees and recapitalisation. The difficulties are still there,
and in these circumstances there is no room for whatever form of complacency. We have to
remain permanently ready to act.
My third point concerns confidence. Confidence is the most precious ingredient today. It is
also the ingredient that is lacking most in the real and financial sphere of the economy at
present. Having underestimated considerably the true underlying risks that were lying ahead
in 2008 and 2009, it would be an error of equal magnitude for the actors of the private sector
to now overestimate the risks that are lying ahead over the medium term, for 2010 and
beyond. The year 2009 will be very difficult, as I mentioned last Thursday. The ECB's
Governing Council considers that economic growth in the global economy and in Europe will
be substantially lower than projected in early December. However, I see at least four reasons
to have confidence in a recovery of the global economy and the industrialised economies
over the medium term, after the trying year of 2009:
•
The responsiveness of public authorities, central banks and governments, in a
difficult situation makes out of the current episode a unique period in economic and
financial history. I do not consider that the scope of the actions by public authorities
has been sufficiently taken into account by the private actors.
• The growth potential of the large and emerging economies is considerable: the
deceleration of their growth patterns currently observed will be temporary; for
several of them the potential growth of domestic demand, which today is
suppressed, is enormous.
•
Technological progress is remarkable and even accelerating in the current period: it
will be the source of an important part of tomorrow's economic growth.
•
An important factor in the current slowdown has been the spike in oil and commodity
prices. This spike was both inflationary and contractionary. The current sharp
decline is, by consequence, both dis-inflationary and expansionary.
For all these reasons, which are not exhaustive, after an exceptionally difficult 2009, it seems
to be a good working hypothesis to me to see 2010 as the year of rebound. The European
Central Bank and the Eurosystem will for their part continue to provide a solid anchor of
stability and confidence over the medium and long term, in the service of our 329 million
citizens.