5/1/2008: Avinash Persaud on mark to market accounting

Excerpts from The Inappropriateness of Financial Regulation
By Avinash Persaud

My own view of banking regulation would be considered quaint next to today’s practice. I consider the primary objective of intervening in the banking market to be mitigating the substantial systemic consequences of market failure in banking. It is therefore puzzling to me that market prices are now placed at the heart of modern financial regulation, whether in the form of mark-to-market accounting or the market price of risk in risk models. It is not clear to me how we can rely on market prices to protect us from a failure of market prices.
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Almost every economic model will tell you that if all the players have the same tastes (reduce capital adequacy requirements) and have the same information (public ratings, approved risk-models using market prices) that the system will sooner or later send the herd off the cliff edge ... And no degree of greater sophistication in the modelling of the price of risk will get around this fact. In this world, where falling prices generate more sell-orders from price-sensitive risk models, markets will not be self-stabilising but destabilising and the only way to short-circuit the systemic collapse is for a non-market actor, like some agent of the tax payer, to come in and buy up assets to put a floor under their prices.

Excerpts from Why bank risk models failed
By Avinash Persaud

When a market participant's risk model detects a rise in risk in his portfolio, perhaps because of some random rise in volatility, and he or she tries to reduce his exposure, many others are trying to do the same thing at the same time with the same assets. A vicious cycle ensues as vertical price falls, prompting further selling. Liquidity vanishes down a black hole. The degree to which this occurs has less to do with the precise financial instruments and more with the depth of diversity of investor behaviour. Paradoxically, the observation of areas of safety in risk models creates risks, and the observation of risk creates safety. Quantum physicists will note a parallel with Heisenberg's uncertainty principle.
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This brings us to the philosophical problem of the reliance of supervisors on bank risk models. The reason we regulate markets over and above normal corporate law is that from time to time markets fail and these failings have devastating consequences. If the purpose of regulation is to avoid market failures, we cannot use, as the instruments of financial regulation, risk-models that rely on market prices, or any other instrument derived from market prices such as mark-to-market accounting. Market prices cannot save us from market failures. Yet, this is the thrust of modern financial regulation, which calls for more transparency on prices, more price-sensitive risk models and more price-sensitive prudential controls. These tools are like seat belts that stop working whenever you press hard on the accelerator.

The reliance on risk models to protect us from crisis was always foolhardy. In terms of solutions, there is only space to observe that if we rely on market prices in our risk models and in value accounting, we must do so on the understanding that in rowdy times central banks will have to become buyers of last resort of distressed assets to avoid systemic collapse.

Excerpts from Sending the herd off the cliff edge: the disturbing interaction between herding and market-sensitive risk management practices
By Avinash Persaud

While many believe that market sensitive risk management, prudential standards and transparency are probably not enough to avoid future crises, they believe these measures will probably help to provide the right discipline for governments and can surely do no harm. These measures are likely to be a positive force in the long run when markets are better at discerning between the good and bad. But in the short-run, there is growing evidence that market participants find it hard to discern between the good and the unsustainable, they often herd and contagion from one crisis to another is common. The problem is that in a world of “herding”, tighter market-sensitive risk management regulations and improved transparency can, perversely, turn events from bad to worse, creating volatility, reducing diversification and triggering contagion. How can this happen?
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The growing fashion in risk management, supported by the Basel Committee on Banking Supervision, is a move away from discretionary judgements about risk and a move to more quantitative and market sensitive approaches ... This is well illustrated by how banks now tend to manage market risks by setting a DEAR limit - daily earnings at risk. DEAR answers the question: how much can I lose with, say, a 1% probability over the next day. It is calculated by taking the bank’s portfolio of positions and estimating the future distribution of daily returns based on past measures of market correlation and volatility. Both rising volatility and rising correlation will increase the potential loss of the portfolio, increasing DEAR. Falling volatility and correlation will do the opposite. Banks set a DEAR limit: the maximum dollar amount they are prepared to put at risk of losing with a 1% probability. When DEAR exceeds the limit, the bank reduces exposure, often by switching into less volatile and less correlated assets such as US dollar cash.
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Imagine that over time a herd of banks have acquired stocks in two risky assets that have few fundamental connections, say, Korean property and UK technology stocks. Imagine too that some bad news causes volatility in UK technology stocks and the banks most heavily invested there find that their DEAR limits are hit. As these banks try and reduce their DEAR by selling the same stocks (Korean property and UK technology) at the very same time, there are dramatic declines in prices, rises in volatility in both markets and in the correlation between Korean and UK markets. Rising volatility and correlation triggers the DEAR limits of banks less heavily invested in these markets but invested in other markets. As they join the selling milieu, volatility, correlation and contagion rises.