Black swans, perfect storms and financial regulation
by Kathleen Lucia, EAU Vice-President

If there is one thing that is as certain as death and taxes it is governments’ response to financial crises – more regulation. The problem for the world’s regulators is how to avoid strangling economic activity in the process. Is it also about how to legislate for an uncertain future?

There can be no doubting the seriousness of the situation. What began as a crisis in the United States’ mortgage market is tipping the mighty US economy into recession and beginning to have serious global repercussions. At the same time, commodities markets appear to be forming asset class bubbles similar to those so familiar in the financial markets. High prices, particularly of food and fuel are already causing some economic and social disruption and inflation in the newer emerging markets of Asia is beginning to look dangerous.

Some commentators have it that this is the global economy’s “Perfect Storm”, by which they allude to the book, Perfect Storm by Sebastian Junger, which tells the story of an exceptional combination of meteorological events that led to the sinking of a hitherto storm-proof fishing boat off the coast of Newfoundland. It is not difficult to see their point.

To take just the credit crisis in isolation, last year the Organization for Economic Co-operation and Development (OECD) estimated that losses from the crisis would be around $300 billion (US). Now, using a different methodology than one based on now unreliable market prices, the OECD reckons that immediate losses could reach around $422 billion. US banks may be sitting on around $90 billion of this. It could take up to a year for banks to absorb this size of loss and longer still were capital needed for expansion. If credit availability remains scarce over such a long period, the economic consequences could be dire.
Then, there is the extraordinary boom in commodities prices. A straightforward mismatch between supply and demand is generally given as the cause. Global growth and, particularly the growth in the emerging economies of Asia, has massively increased consumption, especially of fuel and grain while, on the supply side, underinvestment in oil and gas exploration and ageing industrial capacity has depressed output. This has been compounded by disruption of the industry in Nigeria, Iraq and Russia as well as political tension in the Middle East. At the same time poor harvests of corn, wheat and soya have resulted from extreme weather conditions and the soaring price of fertilizer which has exacerbated reduced farm output.

But there is another reason: turmoil in the financial markets has been feeding back into commodity markets to fuel the boom. Commodities have a low or negative correlation to equities and bonds, making them a perfect hedge against the volatility of these investments. Commodities have in fact become an alternative asset class to be actively traded, thereby pushing up their price. As the prices have risen, they have attracted more new investors, pushing prices up still further – the classic bubble. According to data from the Bank for International Settlements, in the first quarter of 2008 alone, global turnover in commodity derivatives contracts rose from 420 million to 489 million. Year-on-year, turnover rose by 52%, led by food and fuel. Commodity markets have become much more like financial markets and, in the view of some commentators, are looking suspiciously like a re-run of the dotcom bubble.

Blame the black swan?
So, whence came all these problems, so suddenly, as if out of a clear blue sky? Some would blame the black swan. In his bestselling book The Black Swan: The Impact of the Highly Improbable, Nassim Nicholas Taleb, trader turned philosopher, argues that historical analysis, on which modern finance theory and practice is largely based, is a wholly inadequate way to price risk. The black swan of the title derives from fact that before black swans were discovered in Australia everyone believed that all swans were white. The discovery of black swans exploded that theory. This is used to suggest that what we all we hold to be true about people, the world and the future are open to demolition by “black swans” or unpredictable, unexpected or random events. Our problem, argues Taleb, is that we tend to try to explain these events so that they fit in with what we already know or think we know. Yet these events cannot be predicted or explained in hindsight. They are just chance. All we are doing when we “learn the lessons” of any particular disaster, is prepare for a repetition of that past misfortune when, almost certainly, the next one will be different - and we will therefore be unprepared for it. If we truly foresee and prepare for a disaster, it just does not happen.

All this is, of course, a gross over-simplification of Taleb’s thesis and these general ideas are ones that we are already long familiar with, although we may all have differing views about the extent to which chance governs our lives. Most of us are all too well aware that there are things we know we know; things we don't know we know; things we know we don't know and things we don't know we don't know. The question is whether or not the world’s policymakers, with similar insights, will still be lured by a perceived need to do something into a damaging over-reaction to events, especially when they may be solving yesterday’s problems, not tomorrow’s. The auguries are mixed.

In April, chairman of the OECD Financial Markets Committee and Director General at the Austrian Ministry of Finance, Thomas Wieser, said that the “regulatory framework reflects the “simple” world before globalization; the new division of labor has partially led to global imbalances. We need to ensure a cooperative framework for financial markets that takes account of new realities, and enhances stability, whilst retaining efficiency”. And Adrian Blundell-Wignall, deputy director at the Directorate for Financial and Enterprise Affairs, declared that it was: “no longer possible to assert the view that we have the best of all possible financial systems”. The OECD is calling for a more modern and dynamic approach to financial regulation, promoting a new culture of risk awareness and financial education. The organization argues that the world is now one in which individuals are bearing more and more risks with which they are not necessarily able to cope.

No substitute for effective risk management
Supranational, regional and national regulators are now lining up to back moves for tighter regulation, led by: the G7 finance ministers; the Financial Stability Forum of the International Monetary Fund; the Basel Committee on Banking Supervision at the Bank for International Settlements; the US government and European Union. But they are unlikely to have it all their own way. The world’s financial institutions may be much poorer, and highly embarrassed, but they remain big hitters. They want to be given the space to try to sort out their problems themselves and in truth they know their business better and are more likely to be effective than government officers and politicians. The wiser heads of the policymaking classes are well aware of this. In a speech to a Washington audience recently, Jaime Caruana, head of the IMF’s capital markets directorate said: “Regulation and supervision cannot substitute for effective risk management by private agents and can, if taken too far, exacerbate moral hazard.


Whatever one thinks of black swan theory, the fact is that none of the world’s famous financial upheavals to date were unpredictable or unpredicted. Plenty of observers warned of the encroaching dotcom bubble ahead of its collapse; there were widespread concerns about Enron before its fall and overheating in the housing market both in the US and UK has been anxiously under discussion for years. There has long been concern about the lack of transparency of some new financial instruments and about the role of ratings agencies in guiding the investment decisions of major financial institutions. Nor was the behavior of investors in piling into commodities amid turbulence in the financial markets at all surprising. The problem was not failure of market participants to see trouble coming; it was their apparent inability or unwillingness to do anything about it. One reason for this may well be the vast amounts of money to be made from taking vast risk. Many commentators also blame the obfuscatory nature of modern “creative accounting”, the inability to price risk accurately and the fact there was nothing in any of the rulebooks to hinder these developments, because the regulators had not foreseen them.

We have been here before
There is also a widely held view that existing regulation should have been adequate to head off current problems, because we have been here before and had, we thought, regulated for them. A decade ago, the hedge fund, Long-Term Capital Management (LTCM) held well over a billion dollars in off-balance sheet derivatives, made losses of around $4.6 billion and finally collapsed. In a scenario eerily similar to today’s, it was bailed out by the Federal Reserve Bank of New York amid much hand wringing over the general state of global financial stability and the moral hazards of state intervention to shore up a failing private enterprise. Arguments continue over the root causes of the collapse, but, then as now, the lack of price transparency of the fund’s derivatives was identified as a major trigger. There was, it seemed, urgent need for greater clarity and detail in financial reporting and need for an international approach to regulation.

Since 1998, we have also seen the development and implementation of comprehensive financial reporting transparency initiatives as part of far-reaching regulation, such as:

• International Financial Reporting Standards which, as part of the package, require fair valuation of all financial instruments.
• The European Risk Based Capital Directive (formerly known as Basel II and dealing with banking capital adequacy).
• The Markets in Financial Instruments Directive (MiFID), which contains more than 40 measures (73 articles) on the conduct of financial services business across Europe.
• In the US, the Sarbanes Oxley Act places heavy accounting responsibilities on the senior officers of all companies wishing to list in the country.

It seems, then, there is no shortage of people who make the rules and understand them, or of people who understand the markets and operate in them. The problem is that they are rarely ever the same people and rarely ever share the same visions of the future. And it could be that the world’s regulators are doomed always to regulate for the past.