Stephen Cecchetti sums it up as follows: “Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare. But, when it is used imprudently and in excess, the result can be disaster” (cf. slide 27). 27 I myself have compared lending not with a double-edged sword, but with food. A balanced diet is essential for survival. Excessive and unhealthy eating, however, can become a problem. Judicious borrowing and lending is an essential foundation of a flourishing economy. Excesses on the credit market, by contrast, can lead to crises and, as a result, cause extensive damage to the economy as a whole. It is therefore important that banks, households and companies always exercise sufficient caution and restraint at the ‘credit buffet’. Equally, it is just as important that the SNB carefully analyses developments on the credit market and makes optimal use of the tools at its disposal in order to mitigate any risks to financial stability as far as possible. 26  The overall subdued economic growth in Switzerland over the last two years and lower net immigration are also explanations for the recent restrained momentum on the credit and real estate markets. 27 Cecchetti et al. (2011). The International Monetary Fund (IMF) came to a similar conclusion regarding household debt in its latest financial stability report: Household borrowing promotes growth in the short term. In the medium term, however, too high a level of household debt reduces economic growth (IMF, 2017).
For some years before the turmoil erupted, we have been puzzled by how low risk was priced in most credit markets. Again, with slight exaggeration, the case can be made that mispricing of risk occurred because extreme events – i.e. tail risks – were systematically ignored. At a general level, complexity and opacity in the originate and distribute model made it difficult to understand the "true " nature of risk i.e. the probability distribution attached to specific instruments. More subtly, I wonder whether the slicing and tranching process – which gave rise to structured products – has, intentionally or not, both created additional tail risk and contributed to conceal it. Most managers, for instance, have been caught by surprise by the fast downgrading of AAA CDO tranches, which triggered massive write downs. With hindsight, we know that those tranches had lower average probability of default than the underlying loans – which provided the rationale for the AAA rating – but also possessed a much higher exposure to tail risk. That latest characteristic was not apparent from the rating. As a consequence, tail risk was clearly not priced in, which made those securities both very attractive and absolutely lethal. Tail risk was not only deeply concealed in the complex structure of the instrument. It was also, to some extent, "created" by the instrument itself. As a result of the tranching process, an underlying portfolio with normal risk distribution was transformed into a different set of instruments. Some (equity tranches) had a with very high average default probability.