T&R: Why is this recession different?
Guldimann: This one was triggered by banking, on top of consumption excess. The global meltdown reveals two fundamental flaws in the evolution of our financial system: One is a short-term focus with an over-reliance on mark-to-market and modeling, while neglecting liquidity; the other, a regulatory framework and reporting practice that have not kept up with globalization and off-balance-sheet activities. Regulatory changes coming soon will be significant for financial institutions and have lasting effects on treasurers.
T&R: Why did bank stocks drop before other sectors when it's typically the opposite?
Guldimann: Big banks lost 30% to 90% in market value in 2008, where in previous recessions, the economy tanked before the financials. The back story lies in the financial innovations introduced in the last 25 years and the presumptions we made. We believed these innovations helped to dramatically improve the efficiency of allocating capital to those financial entities that delivered the highest risk-adjusted returns. We started by accepting market values as the best estimate for true value and monitored changes in value (i.e., profits) over ever shorter intervals. We then divided these returns by an estimate of the risks incurred and so computed risk-adjusted performance. Then we provided incentive to the decision-makers and allocated capital to optimize total risk-adjusted returns. We believed the very high compensation to individuals was justified, since it was just a fraction of their economic contributions.
In retrospect, the flaws we missed were:
o Increased dependence on ever more esoteric secondary markets.
o Reliance on an array of modeling that assumed stable relationships and extrapolated related values.
o Gaming of incentive systems by managers taking highly asymmetric positions that resulted in models underestimating the risks.
o Ever larger bonuses and stock options created a misalignment of interest (you win, I take my bonus; you lose, it's all yours).
So, perhaps the resulting allocation of capital was not as efficient as we believed.
T&R: Why the sudden global meltdown?
Guldimann: This was a result of growing instability. The global financial markets have evolved into a massive network of specialists, characterized by increased interdependence of players, asymmetries in incentives and increased opacity. Global interdependence was the natural consequence of globalization, bringing more cross-border transactions, more cross-border trading at increasing speeds and dramatic growth in derivatives and counterparty exposures. Asymmetries were created by the broadening use of Value at Risk (VaR), which understates tail risk, by return-on-risk-based incentive systems, and by gaming, or taking tail risks. Meanwhile, opacity prevailed as no single regulator had global oversight, more and more transactions moved across borders and off balance sheets, and we depended on liquid markets to operate without fail.
According to network theory, the more tightly coupled the components of a system and the more nonlinear the relationships, the less stable the system is. First, we dramatically increased interdependencies, then there probably was a very large, unnoticed buildup of leveraged asymmetric positions, which created the second factor for systems instability. A systems engineer could argue a systemic meltdown was preprogrammed. So when the markets got jittery, institutions started to question the strength of their counterparties and increased haircuts on or, worse, refused to roll over repos. Thus funding between institutions dried up.
T&R: Why did the financial meltdown immediately threaten the real economy?
Guldimann: Credit stopped flowing to even the highest quality borrowers. Therefore governments needed to intervene immediately in every major financial market on an unprecedented scale. The global rescue effort to resuscitate the financial industry has probably surpassed $10 trillion, all in an effort to re-establish trust in the financial system. This was job one. Job two has started more recently: Restart the battered real economies. The effort involved may end up being even larger.
T&R: Where should we look for inspiration in monitoring financial markets?
Guldimann: There are plenty of other disciplines with knowledge about system stability. Engineers have learned to contain cascading failures in electric power networks and aircraft. We know about feedback loops creating wild oscillations. Experts in disease control have studied pandemics, learned about the value of diversity and are looking into cell stability in cancer research. Network specialists fight traffic gridlocks and have designed the Internet so it is extremely resilient. Anti-terror specialists are concerned about exposures to small attacks with catastrophic effects. In all these fields there are experts who may have novel ideas that could trigger new thinking about how to safeguard global financial stability. They may be a good source for out-of-the-box ideas.
T&R: What's next?
Guldimann: We are still in the midst of crisis, and it is not clear yet whether and how all the stimuli will prevent a prolonged recession--and if successful, how the liquidity can be withdrawn before it creates massive inflation. But we can make a few predictions and draw implications for banks and treasury professionals.
The (temporary) quasi-nationalization of the largest institutions will have network effects. Downward pressure on compensation will drive talent to smaller institutions, so that's where the innovation will come from. Government controlled institutions will likely retreat into their home markets so politicians can get more support from voters, so treasurers will likely have to deal with more banks. That implies a shift from one-to-one connections to connectivity platforms.
Government intervention will also mean regulatory capital requirements will remain high and will be computed based on a broader set of risks (credit, market, operational). Credit will stay expensive, leading to more transactions on listed markets and better collateral management. Listed derivatives will be used more. Companies will need to further improve their cash management and limit counterparty exposures.
Treasurers will focus even more on optimizing the use of capital and limiting debt on their balance sheets while emphasizing services and operational efficiencies. They will seek more financing flexibility on debt and try to securitize more assets (e.g., receivables), but with less complexity and more focus on serving long-term investors. They will push for faster inventory turnover and tighter deliveries and better financing from suppliers. They will monitor counterparty exposures and credit risks.
The world continues to change ever more rapidly. More than ever, companies need to ask what they need to do differently, how they can improve agility and stay ahead of the pack.
Technology pioneer and visionary Till Guldimann developed J.P. Morgan's market risk management systems and led its risk metrics initiative that made Value at Risk (VaR) a financial industry standard. He is now vice chairman of SunGard Data Systems.