WHY BANKERS MUST BEAR THE RISK OF "TOO SAFE TO FAIL" ASSETS / THE FINANCIAL TIMES ( HIGHLY RECOMMENDED READING )

Why bankers must bear the risk of ‘too safe to fail’ assets

By Viral Acharya and Arvind Krishnamurthy

Published: March 17 2010 17:30

The financial crisis of 2007-09 featured large-scale losses to financial institutions from assets such as AAA rated tranches of mortgage-backed securities. Simultaneously, markets for collateralised borrowing (“repos” or repurchase agreements) froze or experienced severe stress. Investors lending in repo transactions started charging large “haircuts”. In other words, repos could be rolled over only with successively high levels of over-collateralisation, which disrupted the financing model of broker-dealers and in fact caused Bear Stearns to fail in March 2008.

AAA rated tranches and repo financing were never supposed to experience such stress in the bankers’ view of the world. Bank risk management had considered stress scenarios in which unsecured financing through interbank markets would freeze, but secured overnight funding through repos was deemed to be essentially risk-free.

Of course, we have learned in the past two years, that these “too safe to fail” transactions do fail. Most importantly, they failed in a systemic event.

Why was the financial sector so exposed to their systemic risk? The answer lies in understanding the incentives of the financial sector to disregard, in fact to take on, systemic risk. Let us elaborate.

The only states of the world in which AAA rated tranches of a diversified pool of mortgages fail are when there is a secular decline in house prices that causes homeowners to default across the entire economy. Similarly, the only time rolling over repos becomes untenable is when the financial sector is experiencing systemic stress so that repo lenders become concerned about counterparty risk and forced selling of collateral in crowded and illiquid markets. In other words, though AAA rated tranches and repo financing are relatively safe, their entire risk is systemic in nature.

This is unlike, say, a much junior tranche or unsecured borrowing. These can experience problems even when there is a regional house price decline or an ordinary recession. While riskier in an absolute sense, much of the risk in junior tranches and unsecured borrowing is not systemic in nature.

Now, when financial firms experience problems in isolation, they run the risk of losing market share and employees, and even being taken over by others. In contrast, when they experience problems together, it is more likely they will be bailed out, interest rates lowered, and central bank liquidity facilities opened up.

Thus, there are strong private incentives to manage the risks of losses on junior tranches and unsecured financing, for instance, by holding prudential capital buffers. In contrast, the financial sector has all incentives to create huge quantities of undercapitalised systemic risk exposures – load up on AAA rated tranches funded primarily through repos. Although the risk of failure on this trade is tiny, when there is a failure, the world is in a catastrophic state, affecting a large part of financial sector’s balance-sheet. The result is significant difficulty in rolling over short-term debt, severe deleveraging of balance sheets, and bad asset overhang, of the type seen in 2007-09.

What should regulation do about this paradox of too safe to fail? Regulation charged with the macro-prudential objective of containing systemic risk should be more concerned about seemingly fail-safe assets and secured financing, rather than worrying much about riskier assets and unsecured financing.

It is striking this the opposite of how Basel capital requirement works. It gives a big capital advantage to AAA rated tranches of mortgage backed securities compared to lower-rated tranches and corporate bonds. And it ignores the risk of liabilities altogether.

This is unsurprising since most current regulation is focused on the micro-prudential objective of stabilising each financial firm. This makes holding of too safe to fail assets and liabilities look attractive. But stabilising each firm in this manner in fact increases systemic risk, endangering financial stability.

The moral of the story is that regulators need to impose tighter constraints, such as higher capital requirements, on activities such as holdings of AAA rated tranches and repo financing of risky assets where there is a conflict of interest between the privately optimal and socially optimal choices. Bankers will fight such a proposal. But it should be well understood that they have all incentives to ignore the attendant systemic risk.

If a financial activity is viable only if its systemic risk must be borne by the society while its profits in good times remain privatised in the financial sector, then it is time to revisit the desirability of the activity in the first place.

Viral V. Acharya teaches at the Stern School of Business at the University of New York and is co-editor of forthcoming book “Regulating Wall Street”. This article was co-written by Arvind Krishnamurthy, Professor of Finance at the Kellogg School of Management at Northwestern University

Copyright The Financial Times Limited 2010.