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Too small a cushion means the company is not just courting default or financial distress but also may be ignoring or deferring growth opportunities in response to smaller-than-expected operating cash flows. Managers can therefore add value by separately and more cheaply hedging some of the risks ordinarily managed by the equity cushion. If risks can be priced and traded, it makes sense for companies to try to lay off the categories of risk in which they have no comparative advantage.
This approach allows them to reserve their expensive equity capital for risks that would cost more to transfer than to manage directly. The work of Merton and other leading academics validated the growing field of risk management and counterbalanced indifference theory. Many important innovations in risk management originated in the banking and securities industries. The reasons are obvious but worth stating. First, financial institutions are in effect risk-intermediation businesses; as the most sophisticated of them came to realize, the ability to describe, price, and manage risk should be among their core competencies.
Second, these industries are rich in data, and thus a natural locus for efforts to quantify risk using new technologies. Third, and perhaps most important, they are typically highly leveraged and are monitored by regulators who, concerned about the potential impact of failures, pushed for improved risk management.
That concern went back at least to , when Herstatt, a German bank, failed and a lot of international banks were badly hurt because of the time lag involved in cross-border settlements. Foreign-exchange transactions executed in Germany had not yet cleared in New York when the bank was declared insolvent, creating enormous exposures. A number of leading financial institutions were in grave danger of going bust; one survived in significant part owing to an enormous investment by a private individual.
Bank of New England, among others, did actually go under. At bottom, poor risk management was to blame. Banks had only a limited understanding of the credit risks in their loan portfolios; their assets and liabilities were typically mismatched; and they retained loss-making exposures on their balance sheets. Even in the early s most commercial banks lacked now commonplace tools such as VaR value at risk , credit risk portfolio models, and RAROC risk-adjusted return on capital. In contrast, securities firms and investment banks had become quite sophisticated in their use of risk-management tools.
They recognized that much of traditional commercial banking could emulate the trading of shares and bonds. Bank loans could be marked to market that is, priced as if they must be sold immediately, even though they might not mature for years to come , turned into securities, and traded. Loan portfolios could be packaged in tranches. Interest-rate risk could be separated from credit risk.
And so on. Because securities firms and investment banks were skilled at packaging and trading risks, and commercial banks were skilled at originating credit, a wave of mergers began; eventually distinctions between the two kinds of organizations blurred and regulatory barriers diminished. Beginning in the mids the financial sector became a gigantic risk clearinghouse, as highly liquid markets for the transfer of all sorts of risk evolved.
Because companies could transfer risk that had previously been cushioned by equity, more equity was available to generate new business where they had a natural competitive advantage. Commercial banks, for example, could lay off interest-rate risk and seek out additional depositors and creditors. More recently they have laid off credit risk as well, further increasing their ability to grow.
As of this writing, of course, liquidity in the securitization and credit-transfer markets has dried up, dramatically diminishing the origination of credit. It remains to be seen how events will unfold; but even if a backlash occurs against some complex structured instruments, financial innovators are extremely unlikely to stop repackaging and trading risks. Despite the recent subprime crisis, financial innovators are extremely unlikely to stop repackaging and trading risks.
The mortgage market perhaps best illustrates how risk instruments can transform the scope and nature of a business and also what the limitations are of relying too heavily on markets for risk management. Traditionally, banks held their mortgages in a single portfolio. In the early s, especially in the United States, they started to securitize these portfolios: They pooled their mortgages, divided the pools into tranches, and sold them to third-party investors—other banks, pension funds, or insurance companies.
In this way the risks of mortgage default were taken off the books of the original banks, which went on to make further mortgage loans and to collect the associated fees , which were also pooled. This growth in business led to unprecedented profitability in the banking sector. But by early it was clear that both the underwriting and the rating of mortgages had become far too lax, so when subprime default rates rose, a major financial crisis ensued.
Its ramifications are still spreading. The higher default rates rapidly depressed the prices of mortgage securitizations, first of the lower-rated tranches and then of the higher-rated ones. Some global banks, though they were not direct U. The resulting credit crunch has changed the policy landscape, creating pressure for interest-rate cuts and giving rise to special lending facilities for liquidity-starved financial institutions. But risk can still be sliced and diced into discrete elements. The lesson here is not that the banks were wrong to take advantage of the markets but that even the largest and most liquid derivatives markets depend on the quality of the underlying assets.
Transferring risk does not mean eliminating risk. Financial innovation has influenced corporate credit as well, triggering a boom in commercial lending. Commercial banks can now refine their portfolios to retain only those risk categories in which they have a comparative advantage—perhaps an information advantage in the middle market, where customers are more idiosyncratic.
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They can also use index derivative products to raise or lower their overall exposure to credit as an asset class if they believe that credit is too cheap or too expensive. Once again, transferring risk in these ways can free up capital for growth, enabling banks to offer more and more credit.
But the liquidity of wholesale credit markets, like that of mortgages, cannot be taken for granted. The mortgage crisis has made investors less willing to participate in the securitization and credit-transfer markets.
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Although companies can separate out and trade individual risks, counterparty credit risk is often created as a result, and this needs to be monitored and managed. If a company has a credit exposure to an institution with which it has laid off some other risk, it still may be indirectly exposed to that underlying risk. The creation and growth of risk-transfer markets enabled fundamental changes in the investment management industry. Professional investors took advantage of their newfound ability to transfer different kinds of risk by creating investment vehicles not subject to some of the regulations on traditional funds typically, those open to the public.
Hedge funds are one such vehicle; they have rapidly evolved to allow investors to be extremely precise about their exposure across different asset classes, time horizons, and so on. In addition, as investors in CDOs and other asset-backed securities, they can help absorb credit risk from the banking system. Hedge funds are controversial: Do they introduce new risks into financial markets by using leverage to boost their returns?