Calm Financial Markets Give Regulators Jitters

Article excerpt

Byline: Jeff Horwitz

Quiet financial markets should arouse suspicion.

That's the gist of a recent strain of thinking and research on low volatility, some of which has begun to filter into regulatory policy discussions about systemic risk. The concern extends beyond the prospect that tranquility might indicate complacency.

Instead, low volatility, tight interest rate spreads, and small haircuts on repurchase agreements facilitate and encourage risk taking behavior.

The point is in some ways axiomatic. "You might say that anyone who has spent a week on a trading desk could have told you that," said Richard Berner, the director of the Office of Financial Research in a speech this month. "But recognition of that dynamic in either academic or policy analysis is only starting to appear."

Framed as the "volatility paradox" in a 2011 post on Richard Bookstaber's blog, the idea is drawing particular interest at a time when some measures of volatility are approaching the lows of the middle of the last decade while bankers are arguing capital requirements are excessive.

At the root of the concern is the concept that low volatility can be self-reinforcing.

"If volatility has dropped by a third, why not take one and a half times the leverage?" wrote Bookstaber, a writer, investor, and risk manager who has since gone to work for the Office of Financial Research. As levered entities provide more liquidity to the market, spreads tighten, hedging becomes easier, and volatility drops even further.

Academic research demonstrates how the feedback loop works in practice.

As part of a 2012 paper on the procyclicality of leverage, London School of Economics researchers looked at Barclays' risk-weighted assets between 1992 and 2010 and found that the British bank vastly expanded its portfolio without a corresponding increase of measured risk. In addition to reducing the usefulness of metrics like Value at Risk, low volatility facilitates bets of increasing size.

"The capacity of intermediaries to take on risk exposures depends on the volatility of asset returns," the authors wrote, arguing that volatility must be considered an endogenous trait of markets. In other words, it is produced by the markets, not simply a condition that affects them.

"This isn't something that is too subtle," says Bookstaber, who is looking at how low volatility can set the stage for rapid deleveraging and short-term funding runs. "The very time the waters seem the smoothest is the time that risk is building up."

One regulatory solution to this would be to rely more on "simpleminded leverage ratios" than on sophisticated risk weights to measure banks' capital, Bookstaber says. …