The pattern of risks differed somewhat from earlier periods with problems. Instead of the familiar difficulties with the banks’ loan portfolios, in large measure it was a matter of risks that certain highly leveraged players would generate problems through large positions in the repo market, for example. A drastic example—LTCM  5  BIS Review 23/1999  The problems in the U.S. hedge fund Long Term Capital Management can be seen as a drastic example of how systemic risks can arise if the banks’ counterparty risks and concentration risks become unduly large. A single player, seemingly far removed from the payment system, threatened to generate a systemic crisis in the U.S. financial system, with the risks of contagion that this might involve. LTCM, which had been operating since 1994, based its strategy on the use of statistical and mathematical models to identify temporary price differentials between similar financial market assets. This involved speculating, for example, in narrowing interest rate spreads in the U.S. bond market. In simple terms, a limited capital input was used to combine forward purchases of U.S. corporate bonds with forward sales of U.S. federal bonds. The combination of countervailing positions meant that the outcome would not be affected by the general development of interest rates. It was only the relative paths of the two asset categories that mattered—a narrowing interest rate spread would result in a profit. Similarly, the fund took large countervailing positions between different asset markets as well as between markets in different geographical regions.

With such a regime, the central bank seemingly absorbs exchange risks, which gives private investors an incentive to utilise the interest rate differential with the rest of the world that characterises a situation where domestic inflation expectations are higher than in other countries. Loans were therefore obtained in foreign currency for investment in domestic assets. The maturities of the financing instruments often differed from those of the investments—the funds were borrowed short and invested long. When the exchange rate ceased to be perceived as sustainable and the risk of an adjustment grew, the earlier capital inflows turned into massive outflows. This accentuated the pressure on the exchange rate and created an acute currency crisis. If the capital inflow had been channelled through the banking system, the lack of confidence during the acute phase of the crisis often led to severe repercussions on the financial system. The course of events of this type is essentially dependent on the supply of credit. The problem has lain in widespread lending losses and it seems that the banks have repeatedly made much the same mistakes. This applies to their generosity in financing asset investment by private players as well as to the willingness of international banks to supply foreign currency to domestic counterparties. Situations of this type often involve a high concentration of credits and the credit risk assessments appear to have been rather superficial. What are the reasons for this? One is probably the difficulty, for banks as well as supervisors, in assessing the risks in loan portfolios.