When a shock hits and the correlation breaks down, the hedge breaks down too, with a double whammy to VaR and so, for regulated firms, to regulatory capital requirements: through higher volatility, and a higher measured exposure. To be clear, this is not the fancy of the ivory tower. As discussed in the Bank’s latest Financial Stability Report, it was one of the factors contributing to the recent volatility in the market for US sub-prime mortgage securitisations. Indeed, this hazard may conceivably have increased during a period when markets have not been especially volatile. If investment banking entails warehousing optionality and complex forms of basis risk, it puts a premium on stress testing. Speaking as a policy maker, I would want so-called macro stress tests to be complemented by more fine-grained stress tests in which management explore the exposure to complex risks given their qualitative understanding of their business, and taking into account the possibility of impaired market liquidity. In other words, risk managers need to do “market intelligence”  7  The Bank of England took some steps in this direction as part of the fundamental reforms to its Sterling Monetary Framework market operations in summer 2006. The role of central banks in accommodating sharp (velocity) shocks to the demand for their money was discussed in Tucker P M W (2004), “Managing the central bank’s balance sheet: where monetary policy meets financial stability”, Lecture to mark the fifteenth anniversary of Lombard Street Research, London, June 2004, Bank of England Quarterly Bulletin, Autumn 2004, pp 359-382.
Even country workouts in the early 1980s had that broad shape, albeit with the IMF holding the ring. One might wonder how on earth it would work today, in a world of traded debt, synthetic risk transfer, and vehicular finance. Much thinking remains to be done on this, but a policymaker has to form a preliminary view, just in case the music stops tomorrow. My provisional view is that some investors in credit risk would find themselves without the skill set to participate in a workout. In a “covenant-lite” world, they might also find themselves with fewer protections as conditions deteriorated than they would like ex post. Unless markets seized up, however, they might be able to crystallise their losses by selling out to funds and bank desks who trade in “distressed credit”; and they in turn might be able to sell on to funds and banks with specialist workout skills and risk appetites. By such transfers, the end-game co-ordination problems might be reduced. On the way, some hard bargains would be struck, and some participants would no doubt be surprised by their losses. But this relatively benign scenario is not guaranteed. It depends on markets continuing to function; on the infrastructure holding up through volume surges and stress; on the shadow of the insolvency regimes in various jurisdictions establishing productive incentives; and on lack of uncertainty in the terms and conditions of market contracts. That last point needs underlining.