Tuesday, June 5, 2012

Why Hedging Might Add to Risk of a Market Meltdown

In our modern financial system, bankers worry less about whether the customer is a good credit risk.

Why is that?

Bloomberg: Banks' Hyper-Hedging Adds to Risk of a Market Meltdown

From this Bloomberg article:

They know that if they become uncomfortable with the loans they can always hedge them in the derivatives market.

So hedging can actually be an excuse to relax credit standards.

Hey, if it is someone else's problem why worry, right? Just hedge the risk.

Well, not necessarily. Here's the problem with that thinking according to the article. When a bank hedges it doesn't eliminate the risk:

That only happens when the customer repays the loan or, say, improves its balance sheet.

Hedges don't make risk disappear, they simply transfer the risk to another entity. So while an individual banker feels that there's an "escape hatch":

...hedging doesn't offer an escape for markets as a whole. 

What ends up happening as a result?

...banks take more risks than they otherwise would and thus more risky bets are collectively owned by society. Only now the traders who set the market price are removed from the credit itself.

In the old system, a banker... 

...knew the borrower and evaluated the credit (the original J.P. Morgan Sr. famously testified that an individual's "character" was the basis of credit).

Contrast that with how it often works these days. Loans are issued... 

...with half an eye on their "hedging" potential, that is, on the willingness of traders who may be halfway around the globe to assume the risk. These traders are less well-placed to evaluate the risk. They don't know the customer and, of course, they haven't the faintest concern for character.

The article does a good job of showing how hedging in the derivatives has led to a relaxation of credit standards and makes the system as a whole less robust. The article said it this way:

The plasticity of modern finance -- the ease with which institutions can transfer risk -- is a major cause of the heightened frequency of meltdowns and increased volatility. As with a saloon in which each gunslinger comes armed...markets resemble a shooting gallery in which risk takers, each in the name of self-defense, put the group in peril.

Faith in transferring risk was also a major factor in the housing-related credit bubble and subsequent crisis. If there is not fundamental change this has the potential to be a major factor in the next crisis.

Prior to the modern era (before derivatives of various kinds became widespread) of banking, a lender that wanted to lend money to a potential borrower would think hard about whether the customer was a good credit risk.

Generally, they'd also want to know the borrower well enough to evaluate their credit.

Not so in the current system. Some useful dynamics and incentives seem to have been displaced.

Check out the full article.

Adam

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