Your end-of-semester assignment is as follows: (a) (i) read the two Economist articles entitled ?Debt is Good for You? (dated 01/25/2001) and ?Debtors? Prison? (dated 02/09/2009), which discuss the reasons for corporations? increased use of debt financing, and subsequent concerns about excess borrowing. (ii) Summarize and synthesize, in not more than two (2) pages, the contents of the articles, and conclude with an opinion on how the information you have read would affect your capital structure decisions as a financial manager (i.e would you use less or more or less debt than suggested by the MM and Trade-off (static) models of capital structure), and why. (b) Read the Economist article entitled ?The Gods Strike Back? (dated 02/13/2010, pages 1 to 4 only. The other articles can be read at your leisure) and in (not more than) one page, summarize an additional information contained in this article that you would consider relevant in updating your capital structure decisions. So, your assignment will be a 3-page one. PLEASE NOTE 1) Single spaced.

Debt is good for you Jan 25th 2001 From The Economist print edition Or so the theorists say EVER since Franco Modigliani and Merton Miller published their famous papers on the relative merits of debt and equity financing, the central question in corporate finance has been about the optimal balance between the two. Remember that Messrs Modigliani and Miller argued that, given certain assumptions, the proportions of debt and equity capital were irrelevant to the value of a firm; the only difference they made was to the distribution of the spoils between creditors and shareholders. This was because the more debt a firm issued for a given level of equity, the riskier that firm became. Leverage increases the expected return to shareholders, but it also increases their risks. In an efficient stockmarket, the two should cancel each other out. But a later, modified version of the ModiglianiMiller theory said something rather different. It allowed for the fact that the original assumptions, particularly on taxation, might not apply. In America, dividends are paid out of companies' netoftax income, and are then taxed again in the hands of the recipients. Interest payments on debt, on the other hand, are taxdeductible. This means that a firm's overall value should increase as it substitutes debt for equity, and suggests that many firms in the 1950s and 1960s had too much equity and not enough debt. However, it is clear that over the past couple of decades they have been trying to rectify that. But not, perhaps, as vigorously as might be expected. As Mr Miller cheerfully conceded, his and his colleague's proposition implied that firms should be financed almost entirely with debt. Yet many big companies still think that their weighted average cost of capitalthe total mix of debt and equitywould be cheaper in the long term if they maintained a solid credit rating. Clearly, piling up more debt benefits shareholders only up to a point. That point, roughly speaking, is reached when bondholders are so worried about the company defaulting that the cost of its debt rises to unsustainable levels. To go on borrowing beyond that point may even lead to bankruptcythough note that bankruptcy in America is rather less onerous to shareholders than it is in many other big economies. Moreover, inflation, both in America and elsewhere, is much less of a problem than it was in the 1970s and early 1980s, so interest rates are lower and companies can afford to borrow more. Some commentators, notably Stern Stewart, a consultancy that does a lot of work in this area, maintain that many firms still have too little debt. Mature, profitable firms, with the least need to borrow, probably benefit most from doing so. Bond markets are a harsh taskmaster: that interest has to be paid. A matter of degree Two other theories try to explain why firms are still reluctant to incur debt, or at least do not borrow as much as implied by the ModiglianiMiller theory. The first, called the tradeoff theory, says that the amount of debt a firm is willing to take on depends, among other things, on the business it is in. Profitable companies with stable cashflows and safe, tangible assets can afford more debt; unprofitable, risky ones with intangible assets, rather less. So dot.com companies, to take a formerly fashionable sector, would be illadvised to shoulder any debt at all. Firms in highly cyclical industries, such as car making, should probably be wary of taking on too much. By contrast, utilities, whose business tends to be more predictable, can afford much greater leverage. Managers prefer this kind of theory to the ModiglianiMiller one because it does not imply categorically that they are doing the wrong thing. But does it give them much guidance on what, in fact, they should be doing? Some would argue that in a way it does; that firms \"target\" a credit rating they are happy with according to the business they are inand stick to it. Rick Escherich, an analyst at J.P. Morgan, has looked at a sample of 50 companies taken from Fortune magazine's list of \"most admired companies\DEBTORS' PRISON (From The Economist) Feb 19th 2009 Companies made a fashionable mistake CHIEF executives get no credit in good times if their companies have good credit. Back in 1980 more than 60 American non-financial companies qualified for the ultra-chic AAA rating from Standard & Poor's (S&P). Now there are just six. That change is not just a reflection of the financial crisis or the recession. The decline in credit ratings has been remorseless over the past couple of decades. In 1987 just 38.1% of issuers in the American bond market were rated as speculative, or "junk". In 2007 junk-bond issuers made up most of the market for the first time. The number of lowly-rated CCC issuers has almost tripled over the past 21 years. The intellectual fashion has been for companies to have "efficient" balance-sheets. If cash is not immediately needed to reinvest in the business, it should be handed back to shareholders, who can use it more profitably elsewhere. Hoarding cash for a rainy day was seen as a failure of executive imagination. Corporate-finance theory may state that the value of a company should not be affected by its decision to finance itself with equity or debt. But, in practice, interest payments are generally tax-deductible; dividends are not. That gives companies a big push in the direction of debt. So has the state of the financial markets in recent years. Measures of stockmarket valuation, such as price-earnings ratios, never recovered to the peak levels of 2000, even when share prices were rising during 2003-07. In contrast, corporate-bond investors quickly forgave issuers for the failures of Enron and WorldCom in 2002; spreads fell to historic lows. It was easier to issue debt than equity. In addition, debt was credited with operational benefits. The need to meet regular payments imposes a discipline on corporate executives, ensuring they keep a lid on costs. This is one of the arguments used to extol the merits of private equity, which relies heavily on debt finance. But these strategic reasons for taking on debt may have played second fiddle to a more basic motive: managers' self-interest. Using cash to buy back equity boosted earnings per share, making it easier for companies to meet quarterly profits targets. Meanwhile, executives are motivated by share options. Favouring debt over equity made the share price more volatile, and the more volatile the shares, the more valuable an option becomes. Debt was also often used to finance acquisitions. Again, deals may be in the executive's self-interest; bigger companies mean bigger salaries and it is much better for the executive if his company is perceived to be predator, not prey. Moreover, outside advisers, such as investment banks, have an incentive to recommend debt issuance and acquisitions, both of which generate fees. Activist shareholders such as hedge funds pushed companies to pay out surplus cash. It is only in recessions that this enthusiasm for debt reveals its dangers. The default rate is now rising rapidly and S&P is forecasting that nearly 14% of bond issuers will fail to meet their obligations this year. It is difficult to roll over new debt, given the credit crunch. Meanwhile, suppliers demand instant payment from companies with weak balance-sheets and equity investors downgrade the shares. Were there no voices for caution? To be fair, it was households rather than business that piled up the bulk of the debt in recent years. Strong profits allowed many companies to rely on internal funds for their investment needs. However, in a few industries, carmaking, for example, debt has been pushed very high. And many public companies that were taken private in recent years are now struggling to cope with their debts. Companies will naturally now seek to issue shares to repair their balance-sheets. Sometimes this will mean selling equity, a galling experience for those who spent a fortune on share buy-back programmes just a year or two ago. That ought to cast doubt on the financial acumen of the executives concerned. A bigger problem is that the best time to issue shares is when stockmarkets are soaring, not languishing. Figures from Absolute Strategy Research, a consultancy, show that the peak period for European issuance was in 1998-2000, in monetary terms, or in 1986-88, as a proportion of market value. In recessions, rights issues can seem like chucking good money after bad. And as the banks have already discovered, the more a rights issue appears to be imminent, the bigger the fall in the share price and the harder it is to get the issue away. The "efficient" balance-sheet can be a disorderly death sentence. The gods strike back A special report on financial risk l February 13th 2010 The Economist February 13th 2010 A special report on nancial risk 1 The gods strike back Also in this section Number-crunchers crunched The uses and abuses of mathematical models. Page 3 Cinderella's moment Risk managers to the fore. Page 6 A matter of principle Why some banks did much better than others. Page 7 When the river runs dry The perils of a sudden evaporation of liquidity.Page 8 Fingers in the dike What regulators should do now. Page 10 Blocking out the sirens' song Moneymen need saving from themselves. Page 13 Financial risk got ahead of the world's ability to manage it. Matthew Valencia asks if it can be tamed again T Acknowledgments In addition to those mentioned in the text, the author would like to thank the following for their help in preparing this report: Madelyn Antoncic, Scott Baret, Richard Bookstaber, Kevin Buehler, Jan Brockmeijer, Stephen Cecchetti, Mark Chauvin, John Cochrane, Jos Corral, Wilson Ervin, Dan Fields, Chris Finger, Bennett Golub, John Hogan, Henry Hu, Simon Johnson, Robert Kaplan, Steven Kaplan, Anil Kashyap, James Lam, Brian Leach, Robert Le Blanc, Mark Levonian, Tim Long, Blythe Masters, Michael Mendelson, Robert Merton, Jorge Mina, Mary Frances Monroe, Lubos Pastor, Henry Ristuccia, Brian Robertson, Daniel Sigrist, Pietro Veronesi, Jim Wiener, Paul Wright and Luigi Zingales. A list of sources is at Economist.com/specialreports An audio interview with the author is at Economist.com/audiovideo HE revolutionary idea that de nes the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature. So wrote Peter Bernstein in his seminal history of risk, Against the Gods , published in 1996. And so it seemed, to all but a few Cassandras, for much of the decade that followed. Finance enjoyed a golden period, with low interest rates, low volatility and high returns. Risk seemed to have been reduced to a permanently lower level. This purported new paradigm hinged, in large part, on three closely linked developments: the huge growth of derivatives; the decomposition and distribution of credit risk through securitisation; and the formidable combination of mathematics and computing power in risk management that had its roots in academic work of the mid-20th century. It blossomed in the 1990s at rms such as Bankers Trust and JPMorgan, which developed value-atrisk (VAR), a way for banks to calculate how much they could expect to lose when things got really rough. Suddenly it seemed possible for any nancial risk to be measured to ve decimal places, and for expected returns to be adjusted accordingly. Banks hired hordes of PhD-wielding quants to ne-tune ever more complex risk models. The belief took hold that, even as pro ts were being boost- ed by larger balance sheets and greater leverage (borrowing), risk was being capped by a technological shift. There was something self-serving about this. The more that risk could be calibrated, the greater the opportunity to turn debt into securities that could be sold or held in trading books, with lower capital charges than regular loans. Regulators accepted this, arguing that the great moderation had subdued macroeconomic dangers and that securitisation had chopped up individual rms' risks into manageable lumps. This faith in the new, technologydriven order was re ected in the Basel 2 bank-capital rules, which relied heavily on the banks' internal models. There were bumps along the way, such as the near-collapse of Long-Term Capital Management (LTCM), a hedge fund, and the dotcom bust, but each time markets recovered relatively quickly. Banks grew cocky. But that sense of security was destroyed by the meltdown of 2007-09, which as much as anything was a crisis of modern metrics-based risk management. The idea that markets can be left to police themselves turned out to be the world's most expensive mistake, requiring $15 trillion in capital injections and other forms of support. It has cost a lot to learn how little we really knew, says a senior central banker. Another lesson was that managing risk is as much about judgment as about numbers. Trying ever harder to capture 1 2 A special report on nancial risk 2 risk in mathematical formulae can be counterproductive if such a degree of accuracy is intrinsically unattainable. For now, the hubris of spurious precision has given way to humility. It turns out that in nancial markets black swans , or extreme events, occur much more often than the usual probability models suggest. Worse, nance is becoming more fragile: these days blow-ups are twice as frequent as they were before the rst world war, according to Barry Eichengreen of the University of California at Berkeley and Michael Bordo of Rutgers University. Benoit Mandelbrot, the father of fractal theory and a pioneer in the study of market swings, argues that nance is prone to a wild randomness not usually seen in nature. In markets, rare big changes can be more signi cant than the sum of many small changes, he says. If nancial markets followed the normal bell-shaped distribution curve, in which meltdowns are very rare, the stockmarket crash of 1987, the interest-rate turmoil of 1992 and the 2008 crash would each be expected only once in the lifetime of the universe. This is changing the way many nancial rms think about risk, says Greg Case, chief executive of Aon, an insurance broker. Before the crisis they were looking at things like pandemics, cyber-security and terrorism as possible causes of black swans. Now they are turning to risks from within the system, and how they can become ampli ed in combination. Cheap as chips, and just as bad for you It would, though, be simplistic to blame the crisis solely, or even mainly, on sloppy risk managers or wild-eyed quants. Cheap money led to the wholesale underpricing of risk; America ran negative real interest rates in 2002-05, even though consumerprice in ation was quiescent. Plenty of economists disagree with the recent assertion by Ben Bernanke, chairman of the Federal Reserve, that the crisis had more to do with lax regulation of mortgage products than loose monetary policy. Equally damaging were policies to promote home ownership in America using Fannie Mae and Freddie Mac, the country's two mortgage giants. They led the duo to binge on securities backed by shoddily underwritten loans. In the absence of strict limits, higher leverage followed naturally from low interest rates. The debt of America's nancial rms ballooned relative to the overall economy (see chart 1). At the peak of the madness, the median large bank had bor- The Economist February 13th 2010 rowings of 37 times its equity, meaning it could be wiped out by a loss of just 2-3% of its assets. Borrowed money allowed investors to fake alpha , or above-market returns, says Benn Steil of the Council on Foreign Relations. The agony was compounded by the proliferation of short-term debt to support illiquid long-term assets, much of it issued beneath the regulatory radar in highly leveraged shadow banks, such as structured investment vehicles. When markets froze, sponsoring entities, usually banks, felt morally obliged to absorb their losses. Reputation risk was shown to have a very real nancial price, says Doug Roeder of the O ce of the Comptroller of the Currency, an American regulator. Everywhere you looked, moreover, incentives were misaligned. Firms deemed too big to fail nestled under implicit guarantees. Sensitivity to risk was dulled by the Greenspan put , a belief that America's Federal Reserve would ride to the rescue with lower rates and liquidity support if needed. Scrutiny of borrowers was delegated to rating agencies, who were paid by the debt-issuers. Some products were so complex, and the chains from borrower to end-investor so long, that thorough due diligence was impossible. A proper understanding of a typical collateralised debt obligation (CDO), a structured bundle of debt securities, would have required reading 30,000 pages of documentation. Fees for securitisers were paid largely upfront, increasing the temptation to originate, og and forget. The problems with bankers' pay went much wider, meaning that it was much better to be an employee than a shareholder (or, eventually, a taxpayer picking up the bail-out tab). The role of top executives' pay has been overblown. Top brass at Lehman Brothers and American International Group (AIG) suf1 Borrowed time US financial-industry debt as % of GDP 120 100 80 60 40 20 0 1978 1988 Source: Federal Reserve 1998 2008 fered massive losses when share prices tumbled. A recent study found that banks where chief executives had more of their wealth tied up in the rm performed worse, not better, than those with apparently less strong incentives. One explanation is that they took risks they thought were in shareholders' best interests, but were proved wrong. Motives lower down the chain were more suspect. It was too easy for traders to cash in on short-term gains and skirt responsibility for any timebombs they had set ticking. Asymmetries wreaked havoc in the vast over-the-counter derivatives market, too, where even large dealing rms lacked the information to determine the consequences of others failing. Losses on contracts linked to Lehman turned out to be modest, but nobody knew that when it collapsed in September 2008, causing panic. Likewise, it was hard to gauge the exposures to tail risks built up by sellers of swaps on CDOs such as AIG and bond insurers. These were essentially put options, with limited upside and a low but real probability of catastrophic losses. Another factor in the build-up of excessive risk was what Andy Haldane, head of nancial stability at the Bank of England, has described as disaster myopia . Like drivers who slow down after seeing a crash but soon speed up again, investors exercise greater caution after a disaster, but these days it takes less than a decade to make them reckless again. Not having seen a debt-market crash since 1998, investors piled into ever riskier securities in 2003-07 to maintain yield at a time of low interest rates. Risk-management models reinforced this myopia by relying too heavily on recent data samples with a narrow distribution of outcomes, especially in subprime mortgages. A further hazard was summed up by the assertion in 2007 by Chuck Prince, then Citigroup's boss, that as long as the music is playing, you've got to get up and dance. Performance is usually judged relative to rivals or to an industry benchmark, encouraging banks to mimic each other's risk-taking, even if in the long run it benets no one. In mortgages, bad lenders drove out good ones, keeping up with aggressive competitors for fear of losing market share. A few held back, but it was not easy: when JPMorgan sacri ced ve percentage points of return on equity in the short run, it was lambasted by shareholders who wanted it to catch up with zippier-looking rivals. An overarching worry is that the com- 1 The Economist February 13th 2010 A special report on nancial risk 3 2 plexity of today's global nancial network makes occasional catastrophic failure inevitable. For example, the market for credit derivatives galloped far ahead of its supporting infrastructure. Only now are serious moves being made to push these contracts through central clearing-houses which ensure that trades are properly collateralised and guarantee their completion if one party defaults. Network overload The push to allocate capital ever more e ciently over the past 20 years created what Till Guldimann, the father of VAR and vice-chairman of SunGard, a technology rm, calls capitalism on steroids . Banks got to depend on the modelling of prices in esoteric markets to gauge risks and became adept at gaming the rules. As a result, capital was not being spread around as e ciently as everyone believed. Big banks had also grown increasingly interdependent through the boom in derivatives, computer-driven equities trading and so on. Another bond was crossownership: at the start of the crisis, nancial rms held big dollops of each other's common and hybrid equity. Such tight coupling of components increases the danger of non-linear outcomes, where a small change has a big impact. Financial markets are not only vulnerable to black swans but have become the perfect breeding ground for them, says Mr Guldimann. In such a network a rm's troubles can have an exaggerated e ect on the perceived riskiness of its trading partners. When Lehman's credit-default spreads 2 In lockstep Weighted average cumulative total returns, % 200 Large complex financial institutions Banks Insurers Hedge funds 150 100 50 + 0 - 50 2000 01 02 03 04 05 06 07 08 09 Source: \"Banking on the State\" by Andrew Haldane and Piergiorgio Alessandri; Bank for International Settlements rose to distressed levels, AIG's jumped by twice what would have been expected on its own, according to the International Monetary Fund. Mr Haldane has suggested that these knife-edge dynamics were caused not only by complexity but also paradoxically by homogeneity. Banks, insurers, hedge funds and others bought smorgasbords of debt securities to try to reduce risk through diversi cation, but the ingredients were similar: leveraged loans, American mortgages and the like. From the individual rm's perspective this looked sensible. But for the system as a whole it put everyone's eggs in the same few baskets, as re ected in their returns (see chart 2). E orts are now under way to deal with these risks. The Financial Stability Board, an international group of regulators, is trying to co-ordinate global reforms in areas such as capital, liquidity and mechanisms for rescuing or dismantling troubled banks. Its biggest challenge will be to make the system more resilient to the failure of giants. There are deep divisions over how to set about this, with some favouring tougher capital requirements, others break-ups, still others including America a combination of remedies. In January President Barack Obama shocked big banks by proposing a tax on their liabilities and a plan to cap their size, ban proprietary trading and limit their involvement in hedge funds and private equity. The proposals still need congressional approval. They were seen as energising the debate about how to tackle dangerously large rms, though the reaction in Europe was mixed. Regulators are also inching towards a more systemic approach to risk. The old supervisory framework assumed that if the 100 largest banks were individually safe, then the system was too. But the crisis showed that even well-managed rms, acting prudently in a downturn, can undermine the strength of all. The banks themselves will have to nd a middle ground in risk management, somewhere between gut feeling and number fetishism. Much of the progress made in quantitative nance was real enough, but a rm that does not understand the aws in its models is destined for trouble. This special report will argue that rules will have to be both tightened and better enforced to avoid future crises but that all the reforms in the world will never guarantee total safety. 7 Number-crunchers crunched The uses and abuses of mathematical models I T PUT noses out of joint, but it changed markets for good. In the mid-1970s a few progressive occupants of Chicago's options pits started trading with the aid of sheets of theoretical prices derived from a model and sold by an economist called Fisher Black. Rivals, used to relying on their wits, were unimpressed. One modelbased trader complained of having his papers snatched away and being told to trade like a man . But the strings of numbers caught on, and soon derivatives exchanges hailed the Black-Scholes model, which used share and bond prices to calcu- late the value of derivatives, for helping to legitimise a market that had been derided as a gambling den. Thanks to Black-Scholes, options pricing no longer had to rely on educated guesses. Derivatives trading got a huge boost and quants poured into the industry. By 2005 they accounted for 5% of all nance jobs, against 1.2% in 1980, says Thomas Philippon of New York University and probably a much higher proportion of pay. By 2007 nance was attracting a quarter of all graduates from the California Institute of Technology. These eggheads are now in the dock, along with their probabilistic models. In America a congressional panel is investigating the models' role in the crash. Wired, a publication that can hardly be accused of technophobia, has described default-probability models as the formula that killed Wall Street . Long-standing critics of riskmodelling, such as Nassim Nicholas Taleb, author of The Black Swan , and Paul Wilmott, a mathematician turned nancial educator, are now hailed as seers. Models increased risk exposure instead of limiting it , says Mr Taleb. They can be worse 1 4 A special report on nancial risk 2 than nothing, the equivalent of a danger- ous operation on a patient who would stand a better chance if left untreated. Not all models were useless. Those for interest rates and foreign exchange performed roughly as they were meant to. However, in debt markets they failed abjectly to take account of low-probability but high-impact events such as the gutwrenching fall in house prices. The models went particularly awry when clusters of mortgage-backed securities were further packaged into collateralised debt obligations (CDOs). In traditional products such as corporate debt, rating agencies employ basic credit analysis and judgment. CDOs were so complex that they had to be assessed using specially designed models, which had various faults. Each CDO is a unique mix of assets, but the assumptions about future defaults and mortgage rates were not closely tailored to that mix, nor did they factor in the tendency of assets to move together in a crisis. The problem was exacerbated by the credit raters' incentive to accommodate the issuers who paid them. Most nancial rms happily relied on the models, even though the expected return on AAA-rated tranches was suspiciously high for such apparently safe securities. At some banks, risk managers who questioned the rating agencies' models were given short shrift. Moody's and Standard & Poor's were assumed to know best. For people paid according to that year's revenue, this was understandable. A lifetime of wealth was only one model away, sneers an American regulator. Moreover, heavy use of models may have changed the markets they were supposed to map, thus undermining the validity of their own predictions, says Donald MacKenzie, an economic sociologist at the University of Edinburgh. This feedback process is known as counter-performativity and had been noted before, for instance with Black-Scholes. With CDOs the models' popularity boosted demand, which lowered the quality of the asset-backed securities that formed the pools' raw material and widened the gap between expected and actual defaults (see chart 3). A related problem was the similarity of risk models. Banks thought they were diversi ed, only to nd that many others held comparable positions, based on similar models that had been built to comply with the Basel 2 standards, and everyone was trying to unwind the same positions at the same time. The breakdown of the models, which had been the only basis for pricing The Economist February 13th 2010 the more exotic types of security, turned risk into full-blown uncertainty (and thus extreme volatility). For some, the crisis has shattered faith in the precision of models and their inputs. They failed Keynes's test that it is better to be roughly right than exactly wrong. One number coming under renewed scrutiny is value-at-risk (VAR), used by banks to measure the risk of loss in a portfolio of nancial assets, and by regulators to calculate banks' capital bu ers. Invented by eggheads at JPMorgan in the late 1980s, VAR has grown steadily in popularity. It is the subject of more than 200 books. What makes it so appealing is that its complex formulae distil the range of potential daily pro ts or losses into a single dollar gure. Only so far with VAR Frustratingly, banks introduce their own quirks into VAR calculations, making comparison di cult. For example, Morgan Stanley's VAR for the rst quarter of 2009 by its own reckoning was $115m, but using Goldman Sachs's method it would have been $158m. The bigger problem, though, is that VAR works only for liquid securities over short periods in normal markets, and it does not cover catastrophic outcomes. If you have $30m of two-week 1% VAR, for instance, that means there is a 99% chance that you will not lose more than that amount over the next fortnight. But there may be a huge and unacknowledged threat lurking in that 1% tail. So chief executives would be foolish to rely solely, or even primarily, on VAR to manage risk. Yet many managers and boards continue to pay close attention to it without fully understanding the caveats 3 Never mind the quality CDOs of subprime-mortgage-backed securities Issued in 2005-07, % Estimated 3-year default rate Actual default rate AAA 0.001 0.10 AA+ 0.01 1.68 AA 0.04 8.16 AA- 0.05 12.03 A+ 0.06 20.96 A 0.09 29.21 A- 0.12 36.65 BBB+ 0.34 48.73 BBB 0.49 56.10 BBB- 0.88 66.67 Source: Donald MacKenzie, University of Edinburgh the equivalent of someone who cannot swim feeling con dent of crossing a river having been told that it is, on average, four feet deep, says Jaidev Iyer of the Global Association of Risk Professionals. Regulators are encouraging banks to look beyond VAR. One way is to use CoVAR (Conditional VAR), a measure that aims to capture spillover e ects in troubled markets, such as losses due to the distress of others. This greatly increases some banks' value at risk. Banks are developing their own enhancements. Morgan Stanley, for instance, uses stress VAR, which factors in very tight liquidity constraints. Like its peers, Morgan Stanley is also reviewing its stress testing, which is used to consider extreme situations. The worst scenario envisaged by the rm turned out to be less than half as bad as what actually happened in the markets. JPMorgan Chase's debt-market stress tests foresaw a 40% increase in corporate spreads, but high-yield spreads in 2007-09 increased many times over. Others fell similarly short. Most banks' tests were based on historical crises, but this assumes that the future will be similar to the past. A repeat of any speci c market event, such as 1987 or 1998, is unlikely to be the way that a future crisis will unfold, says Ken deRegt, Morgan Stanley's chief risk o cer. Faced with either random (and therefore not very believable) scenarios or simplistic models that neglect fat-tail risks, many nd themselves in a no-man'sland between the two, says Andrew Freeman of Deloitte (and formerly a journalist at The Economist). Nevertheless, he views scenario planning as a useful tool. A rm that had thought about, say, the mutation of default risk into liquidity risk would have had a head start over its competitors in 2008, even if it had not predicted precisely how this would happen. To some, stress testing will always seem maddeningly fuzzy. It has so far been seen as the acupuncture-and-herbal-remedies corner of risk management, though perceptions are changing, says Riccardo Rebonato of Royal Bank of Scotland, who is writing a book on the subject. It is not meant to be a predictive tool but a means of considering possible outcomes to allow rms to react more nimbly to unexpected developments, he argues. Hedge funds are better at this than banks. Some had thought about the possibility of a large broker-dealer going bust. At least one, AQR, had asked its lawyers to grill the fund's prime brokers about the fate of its 1 assets in the event of their demise. The Economist February 13th 2010 2 A special report on nancial risk 5 Some of the blame lies with bank regulators, who were just as blind to the dangers ahead as the rms they oversaw. Sometimes even more so: after the rescue of Bear Stearns in March 2008 but before Lehman's collapse, Morgan Stanley was reportedly told by supervisors at the Federal Reserve that its doomsday scenario was too bearish. The regulators have since become tougher. In America, for instance, banks have been told to run stress tests with scenarios that include a huge leap in interest rates. A supervisors' report last October ngered some banks for window-dressing their tests. O cials are now asking for reverse stress testing, in which a rm imagines it has failed and works backwards to determine which vulnerabilities caused the hypothetical collapse. Britain has made this mandatory. Bankers are divided over its usefulness. Slicing the Emmental These changes point towards greater use of judgment and less reliance on numbers in future. But it would be unfair to tar all models with the same brush. The CDO asco was an egregious and relatively rare case of an instrument getting way ahead of the ability to map it mathematically. Models were an accessory to the crime, not the perpetrator , says Michael Mauboussin of Legg Mason, a money manager. As for VAR, it may be hopeless at signalling rare severe losses, but the process by which it is produced adds enormously to the understanding of everyday risk, which can be just as deadly as tail risk, says Aaron Brown, a risk manager at AQR. Craig Broderick, chief risk o cer at Goldman Sachs, sees it as one of several measures which, although of limited use individually, together can provide a helpful picture. Like a slice of Swiss cheese, each number has holes, but put several of them together and you get something solid. Modelling is not going away; indeed, number-crunchers who are devising new ways to protect investors from outlying fattail risks are gaining in uence. Pimco, for instance, o ers fat-tail hedging programmes for mutual-fund clients, using cocktails of options and other instruments. These are built on speci c risk factors rather than on the broader and increasingly uid division of assets between equities, currencies, commodities and so on. The relationships between asset classes have become less stable , says Mohamed El-Erian, Pimco's chief executive. Asset-class diversi cation remains desir- able but is not su cient. Not surprisingly, more investors are now willing to give up some upside for the promise of protection against catastrophic losses. Pimco's clients are paying up to 1% of the value of managed assets for the hedging even though, as the recent crisis showed, there is a risk that insurers will not be able to pay out. Lisa Goldberg of MSCI Barra reports keen interest in the analytics rm's extreme-risk model from hedge funds, investment banks and pension plans. In some areas the need may be for more computing power, not less. Financial rms already spend more than any other industry on information technology (IT): some $500 billion in 2009, according to Gartner, a consultancy. Yet the quality of information ltering through to senior managers is often inadequate. A report by bank supervisors last October pointed to poor risk aggregation : many large banks simply do not have the systems to present an up-to-date picture of their rm-wide links to borrowers and trading partners. Two-thirds of the banks surveyed said they were only partially able (in other words, unable) to aggregate their credit risks. The Federal Reserve, leading stress tests on American banks last spring, was shocked to nd that some of them needed days to calculate their expo- sure to derivatives counterparties. To be fair, totting up counterparty risk is not easy. For each trading partner the calculations can involve many di erent types of contract and hundreds of legal entities. But banks will have to learn fast: under new international proposals, they will for the rst time face capital charges on the creditworthiness of swap counterparties. The banks with the most dysfunctional systems are generally those, such as Citigroup, that have been through multiple marriages and ended up with dozens of legacy systems that cannot easily communicate with each other. That may explain why some Citi units continued to pile into subprime mortgages even as others pulled back. In the depths of the crisis some banks were unaware that di erent business units were marking the same assets at di erent prices. The industry is working to sort this out. Banks are coming under pressure to appoint chief data o cers who can police the integrity of the numbers, separate from chief information o cers who concentrate on system design and output. Some worry that the good work will be cast aside. As markets recover, the biggest temptation will be to abandon or scale back IT projects, allowing product development to get ahead of the supporting technology infrastructure, just as it did in the last boom. The way forward is not to reject hightech nance but to be honest about its limitations, says Emanuel Derman, a professor at New York's Columbia University and a former quant at Goldman Sachs. Models should be seen as metaphors that can enlighten but do not describe the world perfectly. Messrs Derman and Wilmott have drawn up a modeller's Hippocratic oath which pledges, among other things: I will remember that I didn't make the world, and it doesn't satisfy my equations, and I will never sacri ce reality for elegance without explaining why I have done so. Often the problem is not complex nance but the people who practise it, says Mr Wilmott. Because of their love of puzzles, quants lean towards technically brilliant rather than sensible solutions and tend to over-engineer: You may need a plumber but you get a professor of uid dynamics. One way to deal with that problem is to self-insure. JPMorgan Chase holds $3 billion of model-uncertainty reserves to cover mishaps caused by quants who have been too clever by half. If you can make provisions for bad loans, why not bad maths too? 7 6 A special report on nancial risk The Economist February 13th 2010 Cinderella's moment Risk managers to the fore I N A speech delivered to a banking-industry conference in Geneva in December 2006, Madelyn Antoncic issued a warning and then o ered some reassurance. With volatility low, corporate credit spreads growing ever tighter and markets all but ignoring bad news, there was, she said, a seemingly overwhelming sense of complacency . Nevertheless, she insisted that the rm she served as chief risk o cer, Lehman Brothers, was well placed to ride out any turbulence, thanks to a keen awareness of emerging threats and a rocksolid analytical framework. Behind the scenes, all was not well. Ms Antoncic, a respected risk manager with an economics PhD, had expressed unease at the rm's heavy exposure to commercial property and was being sidelined, bit by bit, by the rm's autocratic boss, Dick Fuld. Less than two months after her speech she was pushed aside. Lehman's story ended particularly badly, but this sort of lapse in risk governance was alarmingly common during the boom. So much for the notion, generally accepted back then, that the quality of banks' risk regimes had, like car components, converged around a high standard. The variance turned out to be shocking, says Jamie Dimon, chief executive of JPMorgan Chase. The banks that fared better, including his own, relied largely on giving their riskmanaging roundheads equal status with the risk-taking cavaliers. That was not easy. In happy times, when risk seems low, power shifts from risk managers to traders. Sales-driven cultures are the natural order of things on Wall Street and in the City. Discouraging transactions was frowned upon, especially at rms trying to push their way up capital-markets league tables. Risk managers who said no put themselves on a collision course with the business head and often the chief executive too. At some large banks that subsequently su ered big losses, such as HBOS and Royal Bank of Scotland (RBS), credit committees, which vetted requests for big loans, could be formed on an ad hoc basis from a pool of eligible members. If the committee's chairman, typically a business-line head, encountered resistance from a risk manager or other sceptic, he could adjourn the meeting, then reconstitute the committee a week or two later with a more pliable membership that would approve the loan. Another common trick was for a business line to keep quiet about a proposal on which it had been working for weeks until a couple of hours before the meeting to approve it, so the risk team had no time to lodge convincing objections. Exasperated roundheads would occasionally resort to pleading with regulators for help. In the years before the crash the Basel Committee of bank supervisors reportedly received several requests from risk managers to scrutinise excessive risk-taking at their institutions that they felt powerless to stop. Many banks' failings exposed the triumph of form over substance. In recent years it had become popular to appoint a chief risk o cer to signal that the issue was receiving attention. But according to Leo Grepin of McKinsey, it was sometimes a case of management telling him, 'you tick the boxes on risk, and we'll worry about generating revenue'. Since 2007 banks have been scram- bling to convince markets and regulators that they will continue to take risk seriously once memories of the crisis fade. Some are involving risk o cers in talks about new products and strategic moves. At HSBC, for instance, they have had a bigger role in vetting acquisitions since the bank's American retail-banking subsidiary, bought in 2003, su ered heavy subprimemortgage losses. Everyone should now see that the risk team needs to be just as involved on the returns side as on the risk side, says Maureen Miskovic, chief risk ofcer at State Street, an American bank. Glamming up Ms Miskovic is one of an emerging breed of more powerful risk o cers. They are seen as being on a par with the chief nancial o cer, get a say in decisions on pay and have the ear of the board, whose agreement is increasingly needed to remove them. Some report directly to a board committee as well as or occasionally instead of to the chief executive. For many, the biggest task is to dismantle cumbersome silos , says Ken Chalk of 1 The Economist February 13th 2010 A special report on nancial risk 7 A matter of principle Why some banks did much better than others 2 America's Risk Management Association. Risks were often stu ed into convenient but misleading pigeonholes. Banks were slow to re ne their approach, even as growing market complexity led some of the risks to become interchangeable. Take the growth of traded credit products, such as asset-backed securities and CDOs made up of them. Credit-risk departments thought of them as market risk, because they sat in the trading book. Market-risk teams saw them as credit instruments, since the underlying assets were loans. This buck-passing proved particularly costly at UBS, which lost SFr36 billion ($34 billion) on CDOs. Many banks are now combining their market- and creditrisk groups, as HSBC did last year. For all the new-found authority of risk managers, it can still be hard to attract talent to their ranks. The job is said to have the risk pro le of a short option position with unlimited downside and limited upside something every good risk manager should avoid. Moreover, it lacks glamour. Persuading a trader to move to risk can be like asking a trapeze artist to retrain as an accountant , says Barrie Wilkinson of Oliver Wyman, a consultancy. A question of culture Besides, there is more to establishing a solid risk culture than empowering risk o cers. Culture is a slippery concept, but it matters. Whatever causes the next crisis, it will be di erent, so you need something that can deal with the unexpected. That's culture, says Colm Kelleher of Morgan Stanley. One necessary ingredient is a tradition of asking and repeating questions until a clear answer emerges, suggests Clayton Rose, a banker who now teaches at Harvard Business School. The tone is set at the top, for better or worse. At the best-run banks senior gures spend as much time fretting over risks as they do salivating at opportunities (see box). By contrast, Lehman's Mr Fuld talked of protecting mother but was drawn to the glister of leveraged deals. Stan O'Neal, who presided over giant losses at Merrill Lynch, was more empire-builder than risk manager. But imperial bosses and sound risk cultures sometimes go together, as at JPMorgan and Banco Santander. A soft-touch boss can be more dangerous than a domineering one. Under Chuck Prince, who famously learned only in September 2007 that Citigroup was sitting on $43 billion of toxic assets, the lunatics were able to take over the asylum. Astonishingly, the head of risk reported not to Mr J fore subprime defaults began to explode. More willing than rivals to take risks, Goldman is also quicker to hedge them. In late 2006 it spent up to $150m oneeighth of that quarter's operating pro t hedging exposure to AIG. The rm promotes senior traders to risk positions, making clear that such moves are a potential stepping stone to the top. Traders are encouraged to nurture the risk manager in them: Gary Cohn, the rm's president, rose to the top largely because of his skill at hedging tail risks. Crucially, Goldman generally does not re its risk managers after a crisis, allowing them to learn from the experience. Yet despite everything, it still needed government help to survive. By contrast, UBS's risk culture was awful. Its investment bank was free to bet with subsidised funds, since transfers from the private bank were deeply underpriced. It confused itself by presenting risk in a net and forget format. Trading desks would estimate the maximum possible loss on risky assets, hedge it and then record the net risk as minimal, inadvertently concealing huge tail risks in the gross exposure. And it moved its best traders to a hedge fund, leaving the B-team to manage the bank's positions. Publicly humbled by a frank report on its failings, the bank has made a raft of changes. Risk controllers have been handed more power. Oswald Grbel, the chief executive, has said that if his newish risk chief, Philip Lofts, rejects a transaction he will never overrule him. If the two disagree, Mr Lofts must inform the board, which no longer delegates risk issues to a trio of long-time UBS employees. A new, independent risk committee is bristling with risk experts. Whether all this amounts to a new paradigm , as Mr Lofts claims, remains to be seen. Prince or the board, but to a newly hired executive with a background in corporate-governance law, not cutting-edge nance. Another lesson is that boards matter too. Directors' lack of engagement or expertise played a big part in some of the worst slip-ups, including Citi's. The sociology of big banks' boards also had something to do with it, says Ingo Walter of New York's Stern School of Business: as the members bonded, dissidents felt pressure to toe the line. Too few boards de ned the parameters of risk oversight. In a survey last year De- loitte found that only seven of 30 large banks had done so in any detail. Everyone agrees that boards have a critical role to play in determining risk appetite, but a recent report by a group of global regulators found that many were reluctant to do this. Boards could also make a better job of policing how (or even whether) banks adjust for risk in allocating capital internally. Before the crisis some boards barely thought about this, naively assuming that procedures for it were well honed. A former Lehman board member professes himself astonished , in retrospect, at how 1 PMORGAN CHASE managed to avoid big losses largely thanks to the tone set by its boss, Jamie Dimon. A voracious reader of internal reports, he understands nancial arcana and subjects sta to detailed questioning. PowerPoint presentations are discouraged, informal discussions of what is wrong, or could go wrong, encouraged. These soft principles are supplemented by a hard-headed approach to the allocation of capital. Though the bank su ered painful losses in leveraged loans, it was not tripped up by CDOs or structured investment vehicles (SIVs), even though it had been instrumental in developing both products. Nor was it heavily exposed to AIG, an insurance giant that got into trouble. This was not because it saw disaster coming, says Bill Winters, former co-head of the rm's investment bank, but because it stuck by two basic principles: don't hold too much of anything, and only keep what you are sure will generate a decent risk-adjusted return. The bank jettisoned an SIV and $60 billion of CDOrelated risks because it saw them as too dicey, at a time when others were still keen to snap them up. It also closed 60 credit lines for other SIVs and corporate clients when it realised that these could be simultaneously drawn down if the bank's credit rating were cut. And it took a conservative view of risk-mitigation. Hedging through bond insurers, whose nances grew shaky as the crisis spread, was calculated twice: once assuming the hedge would hold, and again assuming it was worthless. Goldman Sachs's risk management stood out too unlike the public-relations skills it subsequently displayed. Steered by its chief nancial o cer, David Viniar, the rm's traders began reducing their exposure to mortgage securities months be- 8 A special report on nancial risk 2 some of the risks in the company's proper- ty investments were brushed aside when assessing expected returns. The survivors are still struggling to create the sort of joined-up approach to risk adjustment that is common at large hedge funds, admits one Wall Street executive. Board games Robert Pozen, head of MFS Investment Management, an American asset manager, thinks bank boards would be more e ective with fewer but more committed members. Cutting their size to 4-8, rather than the 10-18 typical now, would foster more personal responsibility. More nancialservices expertise would help too. After the passage of the Sarbanes-Oxley act in 2002 banks hired more independent directors, many of whom lacked relevant experience. The former spymaster on Citi's board and the theatrical impresario on Lehman's may have been happy to ask questions, but were they the right ones? Under regulatory pressure, banks such as Citi and Bank of America have hired more directors with strong nancial-ser- The Economist February 13th 2010 vices backgrounds. Mr Pozen suggests assembling a small cadre of nancially uent super-directors who would meet more often say, two or three days a month rather than an average of six days a year, as now and may serve on only one other board to ensure they take the job seriously. That sounds sensible, but the case for another suggested reform creating independent risk committees at board level is less clear. At some banks risk issues are handled perfectly well by the audit committee or the full board. Nor is there a clear link between the frequency of risk-related meetings and a bank's performance. At Spain's Santander the relevant committee met 102 times in 2008. Those of other banks that emerged relatively unscathed, such as JPMorgan and Credit Suisse, convened much less often. Moreover, some of the most important risk-related decisions of the next few years will come from another corner: the compensation committee. It is not just investment bankers and top executives whose pay structures need to be rethought. In the past, risk managers' pay was commonly determined or heavily in uenced by the managers of the trading desks they oversaw, or their bonus linked to the desks' performance, says Richard Apostolik, who heads the Global Association of Risk Professionals (GARP). Boards need to eliminate such con icts of interest. Meanwhile risk teams are being beefed up. Morgan Stanley, for instance, is increasing its complement to 450, nearly double the number it had in 2008. The GARP saw a 70% increase in risk-manager certi cations last year. Risk is the busiest area for nancial recruiters, says Tim Holt of Heidrick & Struggles, a rm of headhunters. When boards are looking for a new chief executive, they increasingly want someone who has been head of risk as well as chief nancial o cer, which used to be the standard requirement, reckons Mike Woodrow of Risk Talent Associates, another headhunting rm. The big question is whether this interest in controlling risk will zzle out as economies recover. Experience suggests that it will. Bankers say this time is di erent but they always do. 7 When the river runs dry The perils of a sudden evaporation of liquidity S TAMPEDING crowds can generate pressures of up to 4,500 Newtons per square metre, enough to bend steel barriers. Rushes for the exit in nancial markets can be just as damaging. Investors crowd into trades to get the highest risk-adjusted return in the same way that everyone wants tickets for the best concert. When someone shouts re , their ight creates an endogenous risk of being trampled by falling prices, margin calls and vanishing capital a negative externality that adds to overall risk, says Lasse Heje Pedersen of New York University. This played out dramatically in 2008. Liquidity instantly drained from securities rms as clients abandoned anything with a whi of risk. In three days in March Bear Stearns saw its pool of cash and liquid assets shrink by nearly 90%. After the collapse of Lehman Brothers, Morgan Stanley had $43 billion of withdrawals in a single day, mostly from hedge funds. Bob McDowall of Tower Group, a consultancy, explains that liquidity poses the most emotional of risks . Its loss can prove just as fatal as insolvency. Many of those clobbered in the crisis including Bear Stearns, Northern Rock and AIG were struck down by a sudden lack of cash or funding sources, not because they ran out of capital. Yet liquidity risk has been neglected. Over the past decade international regulators have paid more attention to capital. Banks ran liquidity stress tests and drew up contingency funding plans, but often half-heartedly. With markets awash with cash and hedge funds, private-equity rms and sovereign-wealth funds all keen to invest in assets, there seemed little prospect of a liquidity crisis. Academics such as Mr Pedersen, Lubos Pastor at Chicago's Booth School of Business and others were doing solid work on liquidity shocks, but practitioners barely noticed. What makes liquidity so important is its binary quality: one moment it is there in abundance, the next it is gone. This time its evaporation was particularly abrupt because markets had become so joined up. The panic to get out of levered mortgage in- vestments spilled quickly into interbank loan markets, commercial paper, prime brokerage, securities lending (lending shares to short-sellers) and so on. As con dence ebbed, mortgage-backed securities could no longer be used so easily as collateral in repurchase or repo agreements, in which nancial rms borrow short-term from investors with excess cash, such as money-market funds. This was a big problem because securities rms had become heavily reliant on this market, tripling their repo borrowing in the ve years to 2008. Bear Stearns had $98 billion on its books, compared with $72 billion of long-term debt. Even the most liquid markets were affected. In August 2007 a wave of selling of blue-chip shares, forced by the need to cover losses on debt securities elsewhere, caused sudden drops of up to 30% for some computer-driven strategies popular with hedge funds. Liquidity comes in two closely connected forms: asset liquidity, or the ability to sell holdings easily at a decent price; and 1 The Economist February 13th 2010 A special report on nancial risk 9 2 funding liquidity, or the capacity to raise - nance and roll over old debts when needed, without facing punitive haircuts on collateral posted to back this borrowing. The years of excess saw a vast increase in the funding of long-term assets with short-term (and thus cheaper) debt. Shortterm borrowing has a good side: the threat of lenders refusing to roll over can be a source of discipline. Once they expect losses, though, a run becomes inevitable: they rush for repayment to beat the crowd, setting o a panic that might hurt them even more. Financial crises are almost always and everywhere about short-term debt, says Douglas Diamond of the Booth School of Business. Banks are founded on this maturity mismatch of long- and short-term debt, but they have deposit insurance which reduces the likelihood of runs. However, this time much of the mismatched borrowing took place in the uninsured shadow banking network of investment banks, structured o -balance-sheet vehicles and the like. It was supported by seemingly ingenious structures. Auction-rate securities, for instance, allowed the funding of stodgy municipal bonds to be rolled over monthly, with the interest rate reset each time. The past two years are littered with stories of schools and hospitals that came a cropper after dramatically shortening the tenure of their funding, assuming that the savings in interest costs, small as they were, far outweighed the risk of market seizure. Securities rms became equally complacent as they watched asset values rise, boosting the value of their holdings as collateral for repos. Commercial banks increased their reliance on wholesale funding and on ckle non-core deposits, such as those bought from brokers. Regulation did nothing to discourage this, treating banks that funded themselves with deposits and those borrowing overnight in wholesale markets exactly the same. Markets viewed the second category as more e cient. Northern Rock, which funded its mortgages largely in capital markets, had a higher stockmarket rating than HSBC, which relied more on conventional deposits. The prevailing view was that risk was inherent in the asset, not the manner in which it was nanced. At the same time nancial rms built up a host of liquidity obligations, not all of which they fully understood. Banks were expected to support o -balance-sheet entities if clients wanted out; Citigroup had to take back $58 billion of short-term securities from structured vehicles it sponsored. AIG did not allow for the risk that the insurer would have to post more collateral against credit-default swaps if these fell in value or its rating was cut. Now that the horse has bolted, nancial rms are rushing to close the door, for instance by adding to liquidity bu ers (see chart 4). British banks' holdings of sterling liquid assets are at their highest for a decade. Capital-markets rms are courting deposits and shunning ighty wholesale funding. Deposits, equity and long-term debt now make up almost two-thirds of Morgan Stanley's balance-sheet liabilities, compared with around 40% at the end of 2007. Spending on liquidity-management systems is rising sharply, with specialists almost able to name their price , says one banker. Collateral management has become a buzzword. Message from Basel Regulators, too, are trying to make up for lost time. In a rst attempt to put numbers on a nebulous concept, in December the Basel Committee of central banks and supervisors from 27 countries proposed a 4 Filling the pool US banks' cash assets, $trn 1.25 1.00 0.75 0.50 0.25 0 1973 75 80 85 90 95 2000 05 09 Sources: Federal Reserve; Goldman Sachs global liquidity standard for internationally active banks. Tougher requirements would reverse a decades-long decline in banks' liquidity cushions. The new regime, which could be adopted as early as 2012, has two components: a coverage ratio, designed to ensure that banks have a big enough pool of highquality, liquid assets to weather an acute stress scenario lasting for one month (including such inconveniences as a sharp ratings downgrade and a wave of collateral calls); and a net stable funding ratio, aimed at promoting longer-term nancing of assets and thus limiting maturity mismatches. This will require a certain level of funding to be for a year or more. It remains to be seen how closely national authorities follow the script. Some seem intent on going even further. In Switzerland, UBS and Credit Suisse face a tripling of the amount of cash and equivalents they need to hold, to 45% of deposits. Britain will require all domestic entities to have enough liquidity to stand alone, unsupported by their parent or other parts of the group. Also controversial is the composition of the proposed liquidity cushions. Some countries want to restrict these to government debt, deposits with central banks and the like. The Basel proposals allow high-grade corporate bonds too. Banks have counter-attacked, arguing that trapping liquidity in subsidiaries would reduce their room for manoeuvre in a crisis and that the bu er rules are too restrictive; some, unsurprisingly, have called for bank debt to be eligible. Under the British rules, up to 8% of banks' assets could be tied up in cash and gilts (British government bonds) that they are forced to hold, reckons Simon Hills of the British Bankers Association, which could have a huge impact on business models . That, some ar- 1 10 A special report on nancial risk 2 gue, is precisely the point of reform. Much can be done to reduce market stresses without waiting for these reforms. In repo lending a decades-old practice critical to the smooth functioning of markets the Federal Reserve may soon toughen collateral requirements and force borrowers to draw up contingency plans in case of a sudden freeze. Banks that clear repos will be expected to monitor the size and quality of big borrowers' positions more closely. The banks could live with that, but they worry about proposals to force secured short-term creditors to take an automatic loss if a bank fails. Another concern is prime brokerage, banks' nancing of trading by hedge funds. When the market unravelled, hedge funds were unable to retrieve collateral that their brokers had rehypothecated , or used to fund transactions of their own; billions of such unsegregated money is still trapped in Lehman's estate, reducing dozens of its former clients to the status of unsecured general creditors. Brokers suffered in turn as clients pulled whatever funds they could from those they viewed as vulnerable. Temporary bans on shortselling made things even worse, playing havoc with some hedge funds' strategies and leaving them scrambling for cash. Regulators are moving towards imposing limits on rehypothecation. Early reform could also come to the securities-lending market, in which institu- The Economist February 13th 2010 tional investors lend shares from their portfolios to short-sellers for a fee. Some lenders including, notoriously, AIG found they were unable to repay cash collateral posted by borrowers because they had invested it in instruments that had turned illiquid, such as asset-backed commercial paper. Some have doubled the share of their portfolios that they know they can sell overnight, to as much as 50%. Regulators might consider asking them to go further. Bond markets, unlike stockmarkets, revolve around quotes from dealers. This creates a structural impediment to the free ow of liquidity