Financial globalization and international integration, which are key components of the recipe for global prosperity, acted during the crisis as a channel for the transmission of shocks to the global economy. Systemic risks arose due to the interconnectedness of the financial systems and the impossibility to isolate the problems within the sectors and institutions that were hit first. The global financial architecture showed deficiencies that need to be addressed in order to strengthen the foundations of our economic systems. The role of risk management in the crisis In general, most of the causes of the crisis that I have just described relate to some extent to a clear deviation from well-established principles in the management of risk by financial institutions and investors. Common sense risk management practices such as “know your counterparties”, “invest only in products you understand”, “do not outsource credit risk management by relying exclusively on external credit assessments”, “do not rely exclusively on quantitative models, no matter how sophisticated they are” were abandoned. Overconfidence in: (1) the ability of portfolio managers to generate returns, (2) the advantages of financial innovation to spread in an efficient way risks and returns, (3) the adequacy of models and data used to estimate risks, (4) the efficiency of markets, and (5) the ability and willingness of monetary authorities to mitigate the effect of downturns in asset prices, did not allow the capital markets to adequately reflect upon and price-in the considerable risks that were being built. Quite obviously, the crisis has taught us some lessons.
They matter because banks, dealers and funds rely on them in order to provide services to the rest of the economy, and also because they can increase fragilities in the system. They are perhaps represented best by what have become known as the “financing markets”: repo, securities lending, certificates of deposit etc – the markets that financial firms use to access short-term wholesale funding. The authorities’ engagement with them is, frankly, patchy. At one end of the spectrum, central bankers in particular have a good track record of ensuring the professionalism of core government-bond repo markets. That was not without good cause. When the US Treasury repo markets started in the mid-to-late 1970s, there was a string of scandals4. When the UK authorities opened up the way to a gilt repo market in the early-90s, therefore, we worked with the industry on the supporting hard and soft infrastructure, including a Code drawn up by the Stock Lending and Repo Committee, to avoid a repetition in London of Wall Street’s experience. It would be hard for the authorities to claim the same foresight concerning the wider securities lending or repo markets in recent years. The employment by securities lenders of cash collateral became a core but hugely opaque financing market in the run up to the latest crisis5. The run on repo, documented by Gary Gorton6, was how the US securities dealers unravelled. The authorities need to develop policies for monitoring and, where necessary, controlling these markets for providing leverage and maturity transformation.