Risk Exposures Cannot Be Measured Fully

jck at Alea pointed to this deceptively important Reuters story, “Ability to track risk has shrunk ‘forever’ -Moody’s,” which says that financial innovation has created information asymmetries that make it impossible for participants to understand their exposures fully.

That position may cynically be seen as a defense of the rating agencies’ poor performance, but the implications are much greater than that. The biggest implication is for intermediaries. Moody’s is saying that intermediaries cannot know their risk exposures with a high degree of confidence, due to complexity of financial instruments, opacity, and leverage.

Although the rating agency does not spell it out, it’s not hard to connect the dots. Investment banks and commercial banks have put more faith in their risk models than is warranted. Moody’s makes a recommendation consistent with the fact that risks are not fully understood: counterparties will need to hold more capital.

From Reuters:

The complexity of the global financial system and the imbalance of information available to market participants means the ability to track risk has declined “probably forever”, Moody’s Investors Service said on Monday. “It is extremely unlikely that in today’s markets we will ever know on a timely basis where every risk lies,” analysts at the ratings agency, led by chief international economist Pierre Cailleteau, wrote in a report.

The warning touches on a hot topic in the credit crisis that engulfed markets in 2007.

The problems faced by markets, sparked by losses on securities linked to U.S. subprime mortgages, were exacerbated as institutions became increasingly uncertain about which market participants were exposed and how big the losses might be.

A number of investment banks were forced rapidly to revise write-offs running into billions of dollars higher and higher as the risk of new losses came to light.

All of that contributed to a stand-off in interbank lending markets, with rates surging higher as banks sought to hoard cash, leading to a coordinated effort by the world’s biggest central banks in December to ensure liquidity was available.

One of the key reasons for the lack of information on the extent of risk and its location has been financial innovation, leading to greater complexity, Moody’s said.

“The combination of financial innovation, opacity and leverage is generally explosive,” the ratings agency said. “Financial innovation often leads to an uneven distribution of the information available to the different parties at risk.

“The problem in the case of extreme complexity of inter-connecting financial systems is that it is hard to see how the level of information could reach levels adequate to enable reasonable risk management standards,” the agency said.

Ratings agencies have been viewed as one of the means for increasing information available in the market, but Moody’s said this had proved “somewhat unrealistic when the incentive structure of (subprime) loan originators, subprime loan borrowers and market intermediaries also shifted in favour of less information”.

The agency said overall, the financial system suffered from flawed incentives that encouraged excessive risk-taking.

But it said regulators and policymakers tolerated this as it was the way to maximise growth, even though it would inevitably lead to regular crises, saying this was the “Faustian pact” they had implicitly agreed to with the financial industry.

Moody’s said, however, that as a result of the lost ability to track risk, counterparties and regulators would likely need or require more capital to be held against risk.