Leverage and executive compensation

FT quotes Andrew Haldane's work that shows how the increased focus on return on equity (as against return on assets) as the metric for measuring executive performance drove executives into over-leveraging and thereby amplifying risk,

For most of the 20th century the long-run return on equity in UK banking moved in line with the underlying growth rate of the UK economy. Then from 1986 to 2006 the return on equity jumped from 2 per cent to an annual average of 16 per cent. Yet the return on assets was largely stagnant over the period. In effect, the managers of banks took to the roulette wheel. They juiced up rotten returns by shrinking their equity capital and taking on more risk. This pattern was repeated across much of the developed world.

Globalization and the dairy farmer

Adam Davidson has a really nice account of the impact of globalization and financial market engineering on the humble dairy farmer. He writes about how milk production went from being a local to an international market by chronicling the travails of one small New Jersey milk farmer Robert Fulper,

For most of the 20th century, dairy farming was a pretty stable business. Cows provide milk throughout the year, so farmers didn’t worry too much about big seasonal swings. Also, at base, dairy-farming economics are simple: when the cost of corn and soybeans (which feed the cows) are low and milk prices are high, dairy farmers can make a comfortable living. And for decades, the U.S. government enforced stable prices for feed and for milk, which meant steady, predictable income, shaken only by disease or bad weather...

But by the early aughts, to accommodate global trade rules and diminishing political support for agricultural subsidies, the government allowed milk prices to follow market demand. People in other parts of the world — notably China and India — also became richer and began demanding more meat and dairy products. Animal feed, especially corn and soybeans, became globally traded commodities with all the impossible-to-predict price swings of oil or copper. Today Robert can predict his profit or loss next month with all the certainty that you or I can predict the stock market or gas prices. During my visit, Robert said that his success this year will be determined by, among other things, China’s unpredictable economic growth, the price of gas (influenced, of course, by events in Iran and Syria) and the weather in New Zealand (a major milk exporter), where a drought can send prices skyrocketing.

Faced with such uncertainty and globalization, financial market innovation could not have been far away,

In the last decade, dairy products and cow feed became globally traded commodities. Consequently, modern farmers have effectively been forced to become fast-paced financial derivatives traders... There are ways to manage, and even profit from, these new risks. The markets offer a stunning range of complex agricultural financial products. Dairy farmers (or, for that matter, anybody) can buy and sell milk and animal-feed futures, which allow them to lock in favorable prices, hedge against bad news in the future and so forth. There’s also a new product that combines feed and milk futures into one financial package, allowing farmers to guarantee a minimum margin no matter what happens to commodity markets down the road.

However, the impact of these innovations, ostensibly aimed at hedging dairy farmers against the risks arising out of globalization, have not been on expected lines,

The Fulpers, like most people, are too busy with their day jobs to truly monitor the markets. But dairy farming has its own 1 percent: that tiny sliver of massive farms, with thousands of cows, that make the biggest profits and are better equipped to pay agriculture-futures experts to help them manage risk. They continue to invest and grow. Unable to keep up with the changes, many smaller farms have gone out of business in the past decade.

This story has parallels across sectors and countries. As countries open up their borders and globalize, occupations and livelihoods become exposed to greater risks. Inflation (for consumers), price volatility (for producers), and job losses (for employees) are some of the commonplace sources of the resultant uncertainty that adversely affect all three categories of people. In order to mitigate them, financial instruments get concocted and peddled. However, irrespective of their real utility, these products, by their inherent nature, are out of bounds for the vast majority of people who are worst affected by the vagaries of globalization.

So, in its balance sheet, globalization has the potential to leave vast numbers at the bottom of the income ladder deeply vulnerable. It therefore becomes important to carefully calibrate the pace and sequence of opening up individual sectors within national economies so that its negative externalities can be minimized. One of the most powerful policy levers to promote such calibrated globalization is to establish a universal social safety net.

In the final analysis, a cushion against the external shocks inflicted by globalization for those affected - both by way of a universal social safety net and some livelihoods training support - is the best insurance policy for globalization itself.

What drives hedge funds which buy Greek debt?

As Greece prepares a legislation to force all private bondholders to take losses on its debts as part of an ECB-EU-IMF rescue package, the hedge funds appear to be playing a game of brinkmanship with Greece.

Hedge funds have been known to use hardball tactics to make money. Now they have come up with a new one: suing Greece in a human rights court to make good on its bond payments. The novel approach would have the funds arguing in the European Court of Human Rights that Greece had violated bondholder rights, though that could be a multiyear project with no guarantee of a payoff.

One of the terms of the 130 billion euro ($165.5 billion) rescue package for Greece, is to cut its debt by 100 billion euros through 2014 by forcing its bankers to accept a 50% loss on new bonds that they receive in a debt exchange. In addition, the Greek government is unwilling to offer the 4% interest rate on new bonds received in exchange for the old bonds. Hedge funds argue that this will effectively increase the relative haircut to between 60-70%.

Though Greece has been negotiating with its bond holders on voluntary haircuts, in the range of 50% of the debt value, these talks have made little headway. The EU-ECB-IMF had made such haircuts and consequent debt restructuring a mandatory requirement for releasing the next instalment of rescue package funds for Greece.

Many of the bondholders - hedge funds, pension funds, banks, etc - have already insured their positions through credit default swaps and find the deal offered by Greece less attractive than a forced default. But a forced haircut would unnerve the markets and potentially destabilize the global financial markets.

Interestingly, over the past year, despite there being ample evidence of Greece being close to default, several hedge funds have continued to buy into Greek debt. All of them were ttracted by the massive potential returns despite the potential for default and a perceived belief that EU and ECB would let Greece default. A Times report nicely captured the incentives,

"Greece may never be able to pay off its huge debts, but its bonds, long scorned by investors, are suddenly being gobbled up by hedge funds... many have turned their attention to the hot yet risky euro zone trade of the moment: buying Greek government bonds that traders say are changing hands for as little as 36 cents for each euro of face value. The investors hope to book a fat profit on the expectation that the European Union and the International Monetary Fund will once again bail out Greece, fearing a global financial disaster if they do not...

Those speculating in Greek bonds are taking on well-documented risks, not the least of which is the possibility that the country will fail to reach a final agreement with the I.M.F. and the European Union and will not get the next portion of money needed to avoid default."

In fact, a major portion of the current bond holders are not the original ones - large European banks - and are speculative investors who have purchased their bonds in recent months. The Times report estimated that as on September 2011, about 30% of the investors bought their bonds after July 21. This share would surely have climbed in the subsequent months.

I have two observations from these events.

1. The hedge fund managers are obviously playing chicken with Greece and Eurozone. Who will be the first to blink? If they are able to scare Greece, EU, ECB, and the IMF away from forced default and/or to get the IMF and EFSF/EU to accept losses, by amplifying fears of a global financial market contagion (driven by bond market vigilantes), then the hedge funds stand to make fantastic gains. Conversely, the governments could call the bond market bluff and proceed with the haircuts and debt restructuring, thereby imposing serious costs on the hedge funds.

2. The action of the hedge funds in buying into Greek debt despite clear knowledge of all the associated risks bears remarkable similarity to the role of real estate agents in India who scout for lands emrboiled in litigation or whose titles are not clear.

Such lands, embrolied in litigation or uncertainty for many years, even decades, cannot be developed without settling the encumberances by clearing the title. Real estate agents with close political connections see them as opportunities. They buy into these lands, including the litigation, at cheaper than the market rates. Then they use their official connections to either weaken government claim (for example, by making the government advocates soft-peddle on court litigation) and eventually get it transferred to private interests or use political muscle power to arm-twist the other private parties into signing away their interests at a bargain rate.

Such agents, who are present in all Indian cities, and have connections with influential people in the establishment - politicians, officials, and judges - are classic risk managers. They spot the opportunity, weigh pros and cons - risks associated with getting the title cleared off encumberances - and make their investments.

The modus operandi is eerily similar to that of the hedge fund managers who have invested in Greek debt despite enough evidence that Greece would default on its sovereign obligations. Like the real estate agents, all these hedge fund managers wield considerable influence in the corridors of power - governments, central banks, financial market regulators, and big financial institutions. Again, like them, the real estate agents try to leverage this influence to benefit them. In fact, they become confident that with an appropriate mixture of brinkmanship and nudging of the powers-that-be who decide on the terms of the Greek default, they would be able succeed with a favorable debt restructuring deal.

These real estate agents operate purely outside the legal boundaries. However, the trades executed by hedge funds, in the face of very obvious and extreme risks, are perfectly legal. Is there a case for atleast some regulation on such trades?

In the instant case, it was plain obvious, as early as early last year, that haircuts on Greek debt was inevitable. In the circumstances, the only logical reason for hedge funds to pile into Greek bond was a belief that they could influence the debt restructuring process. Given the moral hazard and other incentive distortions created by these actions, is there a case to restrict such trades, especially under such conditions?

Supporters of these trades will obviously point to their positive role in risk diversification by helping banks off-load risks to those best able to bear them. But then this diversification becomes a double-edged sword when the buyers do so on the aforementioned assumptions. Systemic risk then gets amplified instead of being diversified.

Post script - As for Greece itself, even with the deal, its debt would be no less than 120% of GDP in 2020 (down from 140% of GDP at $450 bn today) — which seems to be slight progress given the austerity and pain its citizens must endure during this period.

Market failure in the US Banking sector

NYT has an excellent graphic that illustrates the enormity of the huge concentration of market power in the US banking industry. Of the more than 8000 banks in the US, the top 3 have 44% of market share while the top 20 take 92%.



The Times article is spot on its assessment of the US banking sector in the aftermath of the sub-prime mortgage crisis,

Failure is as important to healthy capitalism as success. The nation’s handful of huge banks, however, are spared the indignity of failure... It’s extremely likely that all of the nation’s largest banks would have collapsed over the past three years without enormous help from the Federal Reserve. In any normally functioning market, they would have subsequently had trouble making huge profits. Instead, they’ve gotten bigger and richer.

In this context, more often than not, regulatory expansion will favor the existing entrenched big firms. In fact, even the current credit squeeze, by hurting the smaller firms disproportionately and also subsidizing the bigger firms, will only amplify the market power of the latter. This is a classic market failure, with potentially catastrophic systemic risk consequences (the TBTF moral hazard), crying out for policy intervention. The only way out of this systemic risk gridlock is to break-up the larger firms and disaggregate the concentration of market power and thereby risk.

In light of both the obvious danger of systemic risk caused by a few large firms and the fresh memory of the banking sector trends in the aftermath of the sub-prime crisis, one can only assume that policy makers are being deliberately obtuse if they can't get round to pulling the plug on the banking behemoths.

The influence of Prospect Theory mapped

Mostly Economics points to a fantastic graphic that maps the spectacular growth in "scholarly influence" of Prospect Theory, which examines decision making in conditions of uncertainty and risk, as measured by Journal citations and references in different fields. Daniel Kahneman and Amos Tversky published their landmark paper on Prospect Theory in 1979.



This visualization is also an example of the power of graphically illustrating concepts like growth in influence of ideas and trends.

Lessons from the German Health Insurance Model

Uwe Reinhardt has an excellent summary of the oldest national health insurance system in the world. Germany has a statutory, mandatory, community rated health insurance system which provides a prescribed basic package of benefits to nearly 88% of population through 154 private, non-profit, sickness funds. In addition there are 46 private health insurers operated on commercial principles which provide comprehensive coverage to the remaining 11% of the population (including civil servants) and also top-up supplementary coverage, if demanded, to those on statutory insurance.

Employees and pensioners pay 8.2% of their gross wages/pensions, while employers/pension funds must contribute 7.3%, for a total contribution of 15.5% of gross wages/pensions upto a maximum wage of (or pension) of 44,550 euros. Unemployed people pay premiums in proportion to their unemployment compensation, and for the long-term unemployed the government pays the sickness fund a fixed per-capita payment. The coverage is for the entire family. Insurance is tax-financed for children. Employees/pensioners earning above 49,500 euros (in 2011) are free to opt out of the statutory system and purchase private, commercial coverage, but if they do, they cannot ever return to the statutory system unless they are paupers.



In order to equalize actuarial risk among the competing sickness funds, all premium payments go into a national risk-equalization fund, from where a capitation (that is risk-adjusted for the employee/pensioner and dependents) is paid out to chosen sickness fund of the employee/pensioner. Recent federal legislation has forced private insurers to levy on younger people higher premiums than their actuarial risk can justify to build up an old-age reserve, thus preventing premiums from climbing too rapidly with age.

In countries like India, where health insurance market is in its nascent stages and state and central governments have been experimenting with various models, the German model is instructive. The most important attraction of the German model is its offering of community-rated universal coverage for a basic prescribed package of benefits. This arrangement minimizes actuarial risks and keeps down both premiums for the insured and administration costs for the insurers.

Currently in India a number of states and the Union Government are rolling out independent insurance schemes, each for different categories of citizens within the same geographic area. Such fragmented schemes, by concentrating risks, run contrary to the principles of optimal risk management and increases the costs for all sides. Since most of those covered in such schemes are subsidized, the governments end up paying the higher premiums. Insurers hedge for both the higher risk and the actuarial uncertainties associated with such specific and concentrated risk pools by demanding higher premiums.

An ideal system would be for the Government of India to bring together all state governments on board in a national health insurance scheme which is universal for a basic package of benefits. The scheme should be community rated and opened to all insurers, public and private. An Aadhaar-complaint database can be maintained to administer this scheme and subsidize premiums for certain categories of citizens. All citizens should be mandatorily covered under the scheme, and those requiring additional coverage be permitted to buy supplementary insurance (additional benefits) from the market.

See this excellent comparison of health insurance systems from fourteen countries.

Update 1 (9/3/2012)

Conservatives in the US have for long advocated consumer-driven health plans (CDHPs) which combine high-deductible health plans (HDHPs) with Health Savings Accounts (HSA). The HDHP's have low premiums, out-of-pocket payment caps, no co-payments, but high deductibles. The consumer desposits a fixed amount each year into the HSA, which is tax-deductible and gets carried forward, and which can be used for regular out-patient medical expenses and for payment of deductibles.

It is argued that since consumers make the payments (of deductibles and other regular medical expenditures) directly and are therefore responsible for their health care purchase decisions, they are more likely to optimize on their treatment options. In regular health insurance models, the consumer is completely divorced from the payment decisions, thereby generating several incentive distortions.

Critics see this as part of efforts to introduce more private participation into health insurance and make consumers responsible for their health care plans. They also see this, along with the Republican supported plans to replace Medicare with vouchers that can be used to purchase health insurance plans from private insurers. The rising health care costs, asymmetric information problems in health care, and the lack of expertise in consumers to shop for the best possible insurance alternative, and so on make such consumer-choice plans inefficient and burdensome for consumers. See Paul Krugman's critique here.

See this Youtube video on CDHPs. See this excellent paper comparing helth insurance systems from across the world. See this account of the Swiss health insurance model.

Rating agencies are back in focus

Rating agencies continue to make news, for all the wrong reasons. Over the past few days, there have been three illustrations of how decisions of rating agencies have contributed towards their declining credibility.

Just before the market close on Thursday last week, the Standard & Poor’s (S&P) erroneously sent out an e-mail suggesting that it had lowered the rating on France’s sovereign debt. The mail shook the markets and forced up French bond yields,

"In a statement, S&P attributed the message to "a technical error" and affirmed that the rating was unchanged. But the yield for France’s 10-year benchmark bond jumped more than a quarter point, to 3.48 percent, and the spread between French and German bonds of that duration reached 1.7 percentage points, a euro-era record... The erroneous S.&P. message went out shortly before 4 p.m. Paris time, and the correction was issued almost two hours later, after most European markets had closed."

Simultaneously, in India, Moody's Investors Service revised its outlook for India's banking system to negative from stable. It attributed the downgrade to increasingly challenging operating environment that will adversely affect asset quality, capitalisation, and profitability of Indian banks; high inflation; monetary tightening and rising interest rates; and the crowding out effect of government's massive borrowing program.

Just a day after the Moody's downgrade, S&P went the opposite direction and upgraded the sector from group '6' to group '5', the same as the other similar economies. Its argument

"Dependence on stable bank deposits due to an extensive branch network and limited dependence on external borrowing made India's banking system low-risk on system-wide funding... In our view, banking regulations in India are in line with international standards and the regulator ( RBI) has a moderately successful track record".

So what do we make of these contrasting ratings signals? Do investors and financial market actors go by the fact that since S&P is larger entity, its ratings should be given greater credence? In this context, The Gold Standard has an excellent post where it compares the Moody's decision on India's banking sector with that on China's similarly troubled banking sector. He wrote,

"The price India has paid for its relative transparency on its problems is a negative outlook. The more opaque it is, the higher the rating. That is why these agencies gave AAA ratings to CDOs, CDO-squared and to CDOs on CDOs...

Its giant neighbour to the North has an entirely State dominated banking system and an economy with even greater financial repression. It systematically under-counts and under-reports its bad debts. Those who dare to raise their voice are forced to withdraw their reports.

Banks have large exposure to local governments who are dependent on land banks sales for their revenues. Banks have exposure to developers who want the prices of land banks to decline. Their apartment prices are dropping and transactions are plunging. So, we have no idea of the true health of Chinese banks or, for that matter, the whole economy. We will never have one. Yet, on November 8th, Moody’s reaffirmed its ‘stable’ outlook for Chinese banks."

It is hard not to be baffled by the clear inconsistency in these rating decisions. In fact, during the ongoing European debt crisis, on several occasions ratings downgrade decisions by one or the other of the three big rating agencies have triggered market downslides. There is a strong and credible enough view that the decisions of ratings agencies could contribute towards turning a liquidity crunch into a solvency crisis. It is therefore no surprise that a growing number of opinion makers hold the view that the ratings agencies hold disproportionate power, whose exercise has, as numerous events of the past four years have shown, been questionable.

How we got here and what is the way forward with bank reforms

Andrew Haldane, Executive Director at the Bank of England, is one of the leading and credible voices championing financial regulation reforms so as to prevent a recurrence of events that led to the sub-prime mortgage meltdown. His most recent speech, the Wincott Annual Memorial Lecture, is an excellent chronicle of banking industry and summarizes his reform proposals.

He describes the source of a governance fault-line in banking sector,

"Ownership and control rights are exercised by shareholders. But for banks, equity is a vanishingly small fraction of their balance sheet. Worse still, equity-holders often have risk-taking incentives out of line with the interests of other bank stakeholders, much less society. This fault-line lies at the heart of the imbalance between privatised returns and socialised risks. Only in banking do control rights and incentive wrongs combine so uncomfortably."

He traces the evolution of the banking sector since the nineteenth century - unlimited liability moved to extended liability and finally to limited liability. Given limited liability, bank managements realized the benefits of excessive risk taking - the downside losses were capped, while the upside gains were all theirs. This meant that volatility with high upside gains increased the returns on equity. Similarly, higher leverage too enabled equity holders to amplify their returns on equity.

With equity holders having increasingly limited skin in the game, the other possible restraint on excessive risk taking, arising from debt holders (who could either have demanded higher returns on their investments or even denied their funds), too started breaking down. The disciplining role that debt holders had exercised on banks started failing for various reasons, the most prominent being the realization that governments will step in and bail out failing banks.

A measure of the too-big-to-fail (TBTF) subsidy of UK and global banks, based on different models, rose dramatically in the build-up to the sub-prime crisis. For the global banks, the TBTF subsidy is worth at least hundreds of billions of dollars per year. This subsidy is also a measure of the risk mispricing by bank debtors, and by implication also the extent of dilution in debtor discipline.



Finally, there is the executive compensation system that rewards short-term equity market gains over more sustainable value addition. Return on equity (ROE), with quarterly periodicity, has become the guiding post on evaluating manager performance and shareholder returns. Haldane describes how the shorter-term investors in bank equities gained from volatility,

"Institutional investors in equities are typically structurally long. They gain and lose symmetrically as returns rise and fall. Many shorter-term investors face no such restrictions. If their timing is right, they can win on both the upswings (when long) and the downswings (when short). For them, the road to riches is a bumpy one – and the bigger the bumps the better. As in Merton’s model, all volatility is good volatility. Perhaps reflecting that, there is evidence of the balance of shareholding having become increasingly short-term over recent years... Average holding periods for US and UK banks fell from around 3 years in 1998 to around 3 months by 2008. Banking became, quite literally, quarterly capitalism. Today, the average bank is owned by an investor with a time-horizon considerably less than a year...

What we have, then, is a set of mutually-reinforcing risk incentives. Investors shorten their horizons. They set ROE targets for management to boost their short-term stake. These targets in turn encourage short-term risk-taking behaviour. That benefits the short-term investor at the expense of the long-term, generating incentives to shorten further horizons. And so the myopia loop continues."

Increased volatility, high leverage, and distorted basis for calculating management compensation and return on shareholder investments favors the short-term investor and the management over all others. All this coupled with the basic "governance fault-line" meant that incentives became badly mis-aligned all round.

He captures the results of all this in a few stunning figures. In the 1880s, total UK bank assets were equal to 5% of GDP. At the bubble peak they were 500%. The assets of the UK’s three biggest banks at the start of the 20th century were 7% of GDP. By the end of it they were 75%, and by 2007 it was 200%. Leverage climbed from 3-4 times in the 19th century to 30 times in the bubble. And return on equity went from modest single figures to 30% at the peak. As to executive compensation among the CEOs of the seven largest US banks, in 1989 it averaged $2.8 million, or almost 100 times the median household income. By 2007, it had risen ten-fold to $26 m, over 500 times the median US household income. Most astonishingly, temporary support for the global banking system during the crisis peaked at around a quarter of global GDP.

Haldane suggests four financial market regulation proposals

1. Higher equity capital. He writes about its benefits

"It would put more skin in the game for equity-holders, thereby reducing their incentives to extract option value. It would reduce leverage directly, thereby reducing banks’ capacity to risk-up. And it would increase banks’ capacity to absorb loss, thereby reducing the probability of official intervention."

He favors much higher capital reserve ratios than that being considered under the Basel III norms. More radically, he favors equalizing the scaales between equity and debt, thereby forcing debt holders to have much greater skin in the game and encourage them to play their traditional disciplining role.

2. Equity-like liabilities

He favors the use of financial instruments which explicitly combine the incentive features of debt and equity, the so-called contingent convertible securities or CoCos. They are debt in good times, but convert to equity in bad, and combines the benefits of unlimited liability without its practical drawbacks.

However, such instruments should be time-consistent (they should kick-in without discretion and expectations of its kicking in should not distort market incentives).
He suggests that the bank management should have no discretion on when and how conversion takes place. Further, conversion needs to take place well ahead of bankruptcy, thereby avoiding the deadweight costs of default which, for too-big-to-fail institutions, are likely to be too large to be tolerable by the authorities.

As a trigger for the conversion, Haldane prefers market-based measures of capital adequacy, like even equity prices. This would be better that regulatory ratios which can be tweaked to suit requirements. Such triggers would expedite pre-emptive recapitalisation of failing institutions and contain the spread of risks.

3. Control rights

Haldane prefers a ownership and control rights model that is a right mixture of the two extremes of a public limited company (rights vested in a small minority and voting rights assigned according to portfolio weights – an equity dictatorship) and the mutually-owned co-operative (rights spread over a wide set of liability-holders, with voting rights unrelated to portfolio weights – a liability democracy). Voting rights could be extended across a wider set of liability stakeholders, with rights allocated on the basis of their deposits, thereby ensuring that governance and control are distributed across the balance sheet - a wealth-weighted democracy.

4. Performance and compensation

he advocates moving over from a system of evaluating performance based on ROE to one based on return on assets (ROA). This covers the whole balance sheet and, because it is not flattered by leverage, does a better job of adjusting for risk. He writes that if the CEOs of the seven largest US banks had in 1989 agreed to index their salaries not to ROE, but to ROA, by 2007, their compensation would not have grown tenfold but would have risen from $2.8 million to $3.4 million. Rather than rising to 500 times median US household income, it would have fallen to around 68 times.

Global economy's external debt tangle

Excellent graphic in Times that captures the web of debt exposures among all major global economies. As the graphic shows, the consequences of a cascade of adverse events - defaults, contagion, credit contraction, and collapse of economic activity - can be potentially catastrophic.



(Click on the graphic to enlarge)

See also this interactive graphic.

Update 1 (24/12/2011)

An analysis of the age of debt.

Commodity bonds to hedge price volatility

Commodity exporters have always been vulnerable to the vagaries of global commodity price volatility. Jeffrey Frankel suggests the use of commodity bonds by both commodity exporters and their buyers to hedge against price risks.

Exporters of a particular commodity would issue debt denominated in terms of the price of that commodity (say Aluminium bonds by Jamaica), rather than dollar or any other currency. The interest rate paid on this debt will increase or decrease depending on whether the commodity prices are rising or falling respectively. This will ensure that the cost of debt service adjusts automatically (and debt-to-export ratio does not rise) in case of a decline in the price of the underlying commodity. The purchasers of this debt could include the major buyers of these commodities, whose (price increase) risk can be mitigated by the increased returns from higher commodity prices. He writes,

Instead of denominating a loan to Nigeria in terms of dollars, the Bank would denominate it in terms of the price of oil and lay off its exposure to the world oil price by issuing that same quantity of bonds denominated in oil. If the Bank lends to multiple oil-exporting countries, the market for oil bonds that it creates would be that much larger and more liquid. This pooling function would be particularly important in cases where there are different grades or varieties of the product (as with oil or coffee), and where prices can diverge enough to make an important difference to the exporters.

Too Big To Fail fact of the day

Zero Hedge quotes the latest report from the US Office of the Currency Comptroller and writes about the extreme concentration of derivatives risk in the US financial markets,

"Of the $250 trillion in gross notional amount of derivative contracts outstanding (consisting of Interest Rate, FX, Equity Contracts, Commodity and CDS) among the Top 25 commercial banks (a number that swells to $333 trillion when looking at the Top 25 Bank Holding Companies), a mere 5 banks (and really 4) account for 95.9% of all derivative exposure... The top 4 banks: JPM with $78.1 trillion in exposure, Citi with $56 trillion, Bank of America with $53 trillion and Goldman with $48 trillion, account for 94.4% of total exposure."

And more worryingly, the TBTF problem keeps getting worse, posing even greater systemic risks,

"The biggest banks are not only getting bigger, but their risk exposure is now at a new all time high and up $5.3 trillion from Q1 as they have to risk ever more in the derivatives market to generate that incremental penny of return."

No lessons learnt - The UBS ETF scam

The $2 bn loss incurred by the rogue UBS trader Kweku Adoboli is surely another big blow to the confidence of the embattled European banking sector. It is also a reiteration of the fact that financial market regulators and governments have learnt little from the bitter lessons of the sub-prime mortgage meltdown.

Adoboli headed the Exchange Traded Funds (ETF) trading desk, which packaged ETF-based derivatives and transacted its trades for clients, and which are typically hedged to minimize risks. But Adoboli did not always hedge them, thereby exposing the bank to huge swings.

ETFs track financial indices and its value arises from either directly from an underlying index fund or a derivative with the index fund as the counterparty. It is the later which makes ETF's risky. If the counterparty suffers a huge loss, leaving it without the funds to service the derivative contract, then the ETF owner suffers huge losses.

Further, depending on the complexity of the packaging of the underlying index funds, the risk is dispersed far and widely across, making it difficult to accurately locate and price risk. In recent years, as ETFs have gained popularity, investment banks have even been packaging ETF derivatives to create "synthetic" ETFs (the counterparty is another set of derivatives). In this regard, it is similar to the complex and highly opaque Collateralized Debt Obligations (CDOs) and synthetic CDOs constructed by splicing and dicing and then packaging pools of mortgage loans.

The risks from activities of traders like Adoboli go beyond these. His 'Delta One' trading desk effectively conducted both client and proprietary trading. Investor clients were promised certain benchmark returns, with the excess returns going to the bank (and those in the trading desk), an incentive for the traders to take extra risk, often leveraging their employer's (bank's) balance sheet. Sometimes, even as banks sell ETF's to their clients, they themselves form the derivative counterparty (positions often taken with their proprietary capital), thereby creating the potential for deeply undesirable conflicts of interests.

Adoboli is only the latest in the long history of such rogue traders - Tomonori Tsurumaki of Sumitome, Nick Leeson of Barings, and Jérôme Kerviel of Société Générale - who caused huge losses to their employers and clients. Incidents such as these lend further weight to the argument that even the best monitoring cannot firewall a determined trader who tries to systematically mislead his employer, even over long periods of time. This naturally revives calls about separating commercial and investment banking operations in big financial institutions. An editorial in FT succinctly sums up the need of the hour,

"The narrow lesson is that derivatives can conceal risk as well as manage it. The broad lesson is that inherently risky investment banking must not be allowed to contaminate utility banking or the wider economy. It is a call to speed up efforts to increase investment banks’ capital buffers and the ease with which they can be resolved if the buffers are worn through. If this is done, the risks investment banks take on and the gains and losses that ensue are largely a matter between banks and their shareholders – provided that shareholders are not defrauded or misled."

The final report of the Independent Commission on Banking, appointed by the British Government to improve stability and competition in the British banking system, and headed by John Vickers, which was released a few days before, has much the same to say. It calls for ring-fencing investment and deposit taking retail banking and alos higher capital buffers for investment banks to limit systemic risks.

Ring-fencing will limit the taxpayer guarantees to individual and business depositers and will not cover the risks taken by traders within the investment bank. Today, the deposit insurance guarantee within the large universal banks (that combines all activities, not spearated from each other), acts as an effective public subsidy for their private investment banking activity. As Martin Wolf has argued, ring-fencing, and not outright separation (as was the case during the Glass-Steagall era in the US, which was replaced with the Gramm-Leach-Bliley Act in 1998), will retain the benefits of a single management - like an investment bank bailing out its failing retail banking division.

In this context, Matt Taibi raises an important point about inherently risk-taking investment banking traders and the apparent incompatibility of their activities with the need to protect the interests of retail depositers and tax payers. He argues that there is little distinction between rogue traders and most investment bankers, in so far as both have the freedom to take excessive risks with their client's money and bear limited direct and immediate responsibility to their clients' interests. He writes scathingly about the adverse consequences of the legal end to separation of retail and investment banking and the inherent risk-taking nature of investment bankers,

"the brains of investment bankers by nature are not wired for "client-based" thinking... it just defies common sense to have professional gamblers in charge of stewarding commercial bank accounts... Investment bankers do not see it as their jobs to tend to the dreary business of making sure Ma and Pa Main Street get their $8.03 in savings account interest every month... investment bankers by nature have huge appetites for risk...

The influx of i-banking types into the once-boring worlds of commercial bank accounts, home mortgages, and consumer credit has helped turn every part of the financial universe into a casino... They’re not "rogue" for the simple reason that making insanely irresponsible decisions with other peoples’ money is exactly the job description of a lot of people on Wall Street... they don’t call these guys "rogue traders" when they make a billion dollars gambling.

The only thing that differentiates a "rogue" trader like Barings villain Nick Leeson from a Lloyd Blankfein, Dick Fuld, John Thain, or someone like AIG’s Joe Cassano, is that those other guys are more senior and their lunatic, catastrophic decisions were authorized... if you're a well-groomed 60 year-old CEO who uses his authority to ignore quality control and internal audits in order to make disastrous trades that could sink the company, you get a bailout, a bonus, and heroic treatment in an Andrew Ross Sorkin book... rogue companies are protected at every level of the regulatory structure and continually empowered by dergulatory legislation giving them access to our bank accounts."

Felix Salmon's makes this excellent case for separating or atleast ring-fencing retail/commercial and investment banking activities,

"When you’re hiring people for the UBS trading floor, you’re hiring men who love to win, congenital risk-takers. And then you surround them with risk-management protocols designed to keep them under some semblance of control. There’s a natural tension there. And if you take the hundreds of thousands of risk-takers working on trading floors in London and Hong Kong and New York and Paris, it’s a statistical inevitability that one or two of them will go rogue every year or so.

Risk-managment protocols are important, but they can never be foolproof, because they’re run by humans. So we really shouldn’t let investment bankers — by which I mean risk-hungry traders with access to billions of dollars of balance sheet — anywhere near the systemically-important balance sheets of our largest commercial banks. Losses like the $2 billion at UBS are manageable. But they’re small beer compared to the entirely legitimate losses made by the likes of Morgan Stanley’s Howie Hubler during the financial crisis. He managed to lose $9 billion, and get paid millions for doing so."

The rising risk correlations

"The correlation between the biggest 250 stocks in the S&P 500 over the past month has reached its highest since 1987 this week, at 81 per cent, according to JPMorgan figures. This means those stocks move in the same direction 81 per cent of the time. The historical average is 30 per cent. The measure peaked at 88 per cent during the October 1987 US crash, when the Dow Jones Industrial Average fell 22 per cent in one session. Other spikes in correlation, including the collapse of Lehman and the Japanese earthquake, peaked at about 70 per cent but quickly fell away."

The FT article is a strong pointer to a repeat of the 1987 crash. The high correlations provide a circular ring to volatility. Higher volatility puts pressure on VaR limits, forcing traders to pare back their positions, which in turn drives the correlations further up. In these conditions, a small trigger can set off a cascade, bringing down the markets.

The other barometers of market uncertainty too are on the rise. The CBOE Volatility Index, VIX, which measures the prices of S&P 500 index options 30 days ahead, is at nearly three times its historical average and has remained there for more than a month now.

Moral hazard, systemic risk, and financial markets

It is increasingly evident that the regulators and policymakers have learnt little from the bitter lessons of the sub-prime mortgages meltdown induced global financial market crisis.

As Simon Johnson points out in an excellent post, the numbers of too-big-to-fail banks looks set to grow as more mergers are in the pipeline, despite growing signs of risk build-up. He points to the recent decision of beleaguered Bank of America (BofA) to court and accept $5 bn from America's most credible investor, Warren Buffet, as sure sign of serious troubles at the bank.

The bank is the largest bank-holding company in the United States, with assets at the end of June of more than $2.26 trillion. It services one in five home loans, and with 5,700 branches assembled through decades of mergers, it counts 58 million customers. Investors are worried at BofA's long-term health, despite the roughly $20 billion set aside to atone for its mortgage misdeeds at the height of the housing bubble, in light of the $ 9bn in losses suffered by the bank over the past 18 months.

He also points to an interesting NBER working paper by Bryan T. Kelly, Hanno Lustig and Stijn Van Nieuwerburgh who highlight the distortions in the price of put options for the financial sector stock index relative to put options on individual banks' stocks. Put options, which are effectively an insurance against price collapses, are cheaper if investors percieve less risk of such eventualities. They write,

"Investors in option markets price in a substantial collective government bailout guarantee in the financial sector, which puts a floor on the equity value of the financial sector as a whole, but not on the value of the individual firms. The guarantee makes put options on the financial sector index cheap relative to put options on its member banks... The government’s collective guarantee partially absorbs financial sector-wide tail risk, which lowers index put prices but not individual put prices, and hence can explain the basket-index spread. A structural model with financial disasters quantitatively matches these facts and attributes as much as half of the value of the financial sector to the bailout guarantee during the crisis."

The authors find that index puts were a lot cheaper than the appropriately weighted sum of put options on individual bank stocks, especially during the recent financial crisis. They argue that because "investors price in substantial government bailout guarantees for the financial sector as a whole", they find little need to insure privately against overall collapse. This disproportionately benefits the TBTF institutions (over smaller institutions), since any problems individually affecting each of them will translate into a risk for the financial sector as a whole.

In simple terms, the moral hazard created by the sub-prime bailouts and the the resultant market expectations have had the effect of lowering the price of risk for the TBTF institutions. The cause of this risk reduction being the effective bailout guarantee for TBTF institutions that governments provide. The handful of TBTF institutions are so large that they have become proxies for the financial market itself. As Simon Johnson writes, "No other sector in the United States economy gets anything like this kind of insurance". I would call it subsidy.

The construction risk transfer through takeout financing

I had blogged earlier about how infrastructure financing can be made more attractive for investors by a two-step financing pattern. This would involve separating the construction activity and its attendant risks from the project life-cycle costs and financing the two separately.



This approach assumes importance in view of the considerable construction risks associated with many infrastructure projects in India, which in turn increases the financing cost and therefore raises doubts about its financial viability. The broad strategy would therefore be to finance the construction with short-term loans, preferably raised by the government (since government is best able to bear the common site-clearance related construction risks) and then swap the loan with long-term bonds once the construction is completed and construction risk has been off-loaded.



In this context, the recent announcement on liberalised takeout financing conditions by the state-owned India Infrastructure Finance Company Ltd (IIFCL) assumes significance. The IIFCL plans to take over projects immediately after their commercial operation date (COD) from the original financiers (mainly banks) and pass on interest rate concessions to project developers. As part of this, a lender financing the infrastructure project can enter into an arrangement with IIFCL for transferring to the latter the outstanding in respect of such financing in its books on a pre-determined basis.



Takeout financing is attractive to banks as it addresses sectoral/group exposure issues and asset-liability mismatch concerns (banks give most of their loans as short-term ones, 3-5 years). Interest rates on the loan taken out by IIFCL is likely to be an estimated 75-200 basis points lower than the original project loan. The project developer would benefit from this reduction in cost of capital. The IIFCL has so far inked takeout financing agreements aggregating about Rs 3,100 crore with a host of banks, including Union Bank of India (Rs 1,020 crore), Central Bank of India (Rs 1,000 crore); Punjab National Bank (Rs 180 crore), and Punjab National Bank (Rs 600 crore).



This intermediation role by the IIFCL will align the incentives of all project parties to commission the project within time and access the take-out loan swap at the much lower cost of capital.

The institutional cash pools and the demand for safe assets

Gillian Tett points to a possible explanation for the massive investor flight to US Treasuries despite its ratings downgrade by S&P last week. She has an interesting interpretation of an excellent working paper by an IMF economist Zoltan Pozsar that traces the rise of the shadow banking sector over the past two decades to an explosive growth in institutional cash pools during the same time and their preference for safety and counter-party risk diversification.



The paper highlights the spectacular growth in volumes of institutional cash pools in recent years, on the back of the rise of the asset management sector and centralized treasury operations by companies. From just $100 bn two decades back, institutional cash managers now control between $2,000bn and $4,000bn globally. The share of cash held by individual companies has exploded from just over $100 mn across the world to an estimated $75bn with individual securities lenders, $20bn with asset managers, and $15bn with large US companies.











The practice was to invest this liquid cash pool in bank accounts. However, once the US FDIC limited deposit insurance to only upto the first $100,000 of any account from 1990, investors started searching for alternative short-term, liquid, and risk-free investment opportunities. Repurchase deals (backed by collateral), money market funds (often implicitly backed by banks), and highly rated short term securities (such as triple A rated asset backed commercial paper or mortgage bonds) were natural options.



Zoltan Pozsar also finds that institutional cash pools prefer not being intermediated through the traditional banking system, as they prioritize principal safety and portfolio diversification over yield and are hesitant (in many cases due to fiduciary reasons) to take on too much direct, unsecured exposures to banks through even insured deposits. The author writes,

"Between 2003 and 2008, institutional cash pools’ cumulative demand for short-term government guaranteed instruments (as alternatives to insured deposits) exceeded the supply of such instruments by at least $1.5 trillion. The “shadow” banking system rose to fill this vacuum, through the creation of safe, short-term and liquid instruments. Thus, from this perspective the "shadow" banking system was just as much about networks of banks, investment banks and asset managers working together to respond to institutional cash pools’s preference to invest cash at a distance from banks as it was about banks’ funding preferences and off-balance sheet banking. From this perspective, the rise of "shadow" banking has an under-appreciated demand-side dimension to it...



In other words, what looks like undesirable regulatory arbitrage from the perspective of regulated institutions, was desired portfolio diversification from the perspective of institutional cash pools. This is to say that if regulatory arbitrage inspired the pejoratively-sounding term shadow banking, cash portfolio diversification could imply renaming it to market-based banking."

Consequently, it should come as no surprise that in 2007, just 16-20% of these funds were invested in bank deposits, while the rest went into Treasuries, commercial papers, and securities traded in the shadow banking sector, whose emergence coincided with and was maybe even caused by the rapid growth in the institutional cash pools. Once the shadow banking system froze in the aftermath of the sub-prime meltdown, these cash pools have been left with Treasuries as the only remaining investment avenue with the required depth.



The US-EU debt crisis has exacerbated the market uncertainty and accelerated the flight to the safety of US Treasuries. In simple terms, even with all the downside risks associated with the US economy, its government securities appear the least risky among all available alternatives required to accommodate this huge cash pool.

Debt Contagion Fears - Is Italy next?

Here is a grapical representation of European national debts, with countries sized in proportion to their respective sovereign debts.



Notice that, excluding Greece, Eurozone's third largest economy, Italy, has the highest debt-to-GDP ration among these economies. And as expected, exacerbated by domestic political uncertainty, markets appear to be forming expectations about Italy following Greece, Ireland, Portugal and Spain into the troubled periphery of Eurozone, thereby completing the complement of PIIGS.

Admittedly, Italy's banks never speculated in a property bubble and are sound, its budget deficit at 4.6% of GDP looks low when compared to the sinners, and unlike other PIIGS Italian own more than half the country's debt. But as interest rates rise and with economy not likely to get back into high growth path anytime soon, it does not require much for the markets to tip the balance against Italy. And the indications look ominious.

As this Bloomberg ticker shows, the cost of insuring Italian sovereign debt against default have zoomed to its highest ever.



Italy is the largest issuer of government bonds among Eurozone economies and its 10-year Bond yields shot up alarmingly, again to its highest in recent history. And if rates exceed 6%, Italy will start experiencing the same repayment and new debt raising problems as others.



A contagion spread to Italy would make Greece and Portugal look like boy-scouts. As the Timess reports, European banks have total claims and potential exposures of 998.7 billion euros to Italy, more than six times the 162.4 billion euro exposure they have to Greece. European banks have 774 billion euros of exposure to Spain and 534 billion euros of exposure to Ireland. American banks are also more exposed to Italy than to any other euro zone country, to the tune of 269 billion euros. American banks’ next biggest exposure is to Spain, with total claims estimated at 179 billion euros.

Update 1 (28/9/2011)

List of "Who Gets Smashed If Italy Goes Bust".

Early warning indicators missed in Europe

Arguably the most important lesson from the sub-prime mortgage meltdown and the consequent Great Recession is that regulators and policy makers across the board either failed to spot or, if they did, ignored early warning signals of impending problems. Post-facto analysis has revealed ample and clear distress signals across many markets on which regulators and policy makers should have acted on.

As Floyd Norris writes by pointing to the examples of Spain and Ireland, more critical and objective analysis of national macroeconomic data could have given out clear indicators of the crisis ahead. Just five years back, both these countries were the star performers among all Euro zone economies with the highest GDP growth rates and lowest fiscal deficits and debt-to-GDP ratios.

However, as the graphic below shows, this rosy picture masked concerns about the unsustainable debts the private sector in these (and Greece and Portugal) were piling up. These borrowings were fueling rapid economic growth that, in turn, produced rising tax collections, allowing national governments to run budget surpluses. The big problem was that instead of going to productive capital investments, this money was finding its way into the property market, fuelling an unproductive property bubble across these countries.



When the crash came private excesses got nationalized and got converted to public sector debt. The massive bailouts of beleaguered financial institutions, fiscal stimulus spending to prop up the recessionary economy, and the slump in all tax revenues ended up devastating the government fiscal balances.

The financial market regulators clearly failed in their responsibility of broad management of the process of capital allocation. The end-use patterns of these external private capital inflows would have been very clear for anybody who cared to observe. But regulators turned the other way.

Bubbles make a mockery of the rational economic man hypothesis among all stakeholders, even regulators. Regulators living through a bubble have always given the impression of being carried away by its "irrational exuberance" and the feeling that the party will go on forever. Then there is the issue of nobody wanting to "take the punch bowl away when the party is on". How do we know that we are not nipping a new growth cycle in the bud?

But all these instincts flies in the face of all standard macroeconomic and financial market theories. There is ample historical evidence, supporting theories, to show how such distress signals could be forebodings of crisis ahead, if not appropriately addressed. It is a constant theme from history that if private sector deficits reached the levels of Spain, Protugal and Ireland, and they were going into fuelling a bubble, then a debt crisis is not far away. Why did regulators think that "this time is different"?

Does this mean that we need to have exclusive arms within the regulatory and policy making appratus whose main job is to exclusively look for the danger signs and act as devil's advocates? Risk managers in private financial institutions are mandated to do precisely this job for their firms, but failed spectacularly. Can we expect anything different from such managers within government regulatory and policy making machinery?

In any case, spotting early warning signals, dissseminating them widely in a cognitively salient manner, and triggering off actions to mitigate these indicators of distress are arguably the most important areas of work for academics, risk managers, regulators, and policy makers.

Mapping and disseminating the risk topography

It is now widely acknowledged that arguably the biggest contributor to the sub-prime financial market crisis was a failure to anticipate and act on the build-up of risks across the sector. This constitutes failures at two levels - having access to information on the evolution of various cross-sectional risks with time and then acting appropriately to mitigate these emerging risks.

Robert Shiller points to a 2010 paper by Donald L. Kohn, Matthew J. Eichner and Michael G. Palumbo, who argue that the underlying themes were similar to previous crises,

"Although the instruments and transactions most closely associated with the financial crisis of 2008 and 2009 were novel, the underlying themes that played out in the crisis were familiar from previous episodes: Competitive dynamics resulted in excessive leverage and risktaking by large, interconnected firms, in heavy reliance on short-term sources of funding to finance long-term and ultimately terribly illiquid positions, and in common exposures being shared by many major financial institutions."

Taking cue from this, they point to the need for policy makers to have "better and earlier indications regarding these critical, and apparently recurring, core vulnerabilities in the financial system". In particular with the sub-prime crisis, they point to two information failures. One was the failure to anticipate "the underlying credit risk associated with the rapid growth of home mortgages and a consequent increase in the vulnerability of borrowers to a downturn in home prices or incomes". The other was the inability to assess the growth of financial vulnerability outside the traditional banking sector because of "a greater reliance on short-term funding for longer-term financial instruments". They emphasise the need to fill up these data gaps and have real-time information on them to have a comprehensive early warning system in place.

The authors also argue that merely collecting data, even analyzing them, would not serve much purpose. It is critical that the analysis focus on the relevant areas - specific instruments and their transactions - and then it should be rendered in the most effective manner to evoke the desired response among all the relevant stakeholders. In this context, as a large number of researchers have argued, the presence of automatic stabilizing mechanisms (like say, dynamic capital buffers and reserve requirements) can eliminate the risk of stakeholders not acting (for whatever reasons) even when faced with information on emerging risks. They write,

"More fundamental, in our view, is the need to use data in a different way — in a way that integrates the ongoing analysis of macro data to identify areas of interest with the development of highly specialized information to illuminate those areas, including the relevant instruments and transactional forms... We can easily imagine specifying ex ante a program of data collection that would look for vulnerabilities in the wrong place, particularly if the actual act of looking by macro- or microprudential supervisors causes the locus of activity to shift into a new shadow somewhere else."

In this context, in a recent working paper, Markus K. Brunnermeier, Gary Gorton, and Arvind Krishnamurthy have sought to identify the kinds of risk measurements of leverage and liquidity that should be collected and how it should be interpreted in terms of modern financial theory to provide real-time decision support for financial market participants. They conceptualize and design a risk topography that outlines a data acquisition and dissemination process that informs policymakers, researchers and market participants about systemic risk. They write,

"Our approach emphasizes that systemic risk (i) cannot be detected based on measuring cash instruments, e.g., balance sheet items and income statement items; (ii) typically builds up in the background before materializing in a crisis; and (iii), is determined by market participants’ response to various shocks. We propose that regulators elicit from market participants their (partial equilibrium) risk as well as liquidity sensitivities with respect to major risk factors and liquidity scenarios. General equilibrium responses and economy-wide system effects can be calibrated using this panel data set."

This is one such excellent data reresentation technique that maps the build-up of co-related risks. HSBC researchers use heat maps to identify the changes in correlations between different categories of asset classes.

Re-coupled global financial markets

Even as the emerging and developed economies appear to be de-coupling from each other, there is growing evidence that their financial markets are getting more closely synchronized. Have the global financial markets become too-interconnected to fail? Are financial markets no longer useful in risk diversification?

An recent study by HSBC draws attention to the growing correlation between different markets and asset classes - equities, bonds, forex instruments, commodities etc - since the onset of the sub-prime crisis. They argue that the financial markets have become entrapped into a binary state of "risk on-risk off" strategy - all the financial market segments have been swinging in unison, believing that either the future is bright ("risk on") or that it is bad ("risk off"). Risky assets move up or down together. They characterize the present market conditions thus,

"1. Risk on – risk off must be the foremost consideration in any trading activity today.
2. Financial markets, and in particular portfolios, are not as diversified as they once were. Risk takers may be holding more risk in their portfolios than they realise.
3. In current market conditions, there is little point trying to understand the nuances between different asset classes, or the relative value within asset classes. Commodities behave like bonds, which behave like equities. They are no longer easily identifiable, uncorrelated trades, which should be borne in mind when developing new trading strategies."

While synchronization of disparate markets and "risk on-risk off" strategy is a feature of financial markets in the immediate aftermath of a major financial crisis, it persistence for an extended period now is causing concern among market participants. It is argued that the depth of blow suffered to the economic confidence has been so massive that the markets are taking much longer to recover its normal features.

The HSBC researchers use heat maps to identify the changes in correlations between different categories of asset classes. The dark red indicates strong positive correlation while dark blue is strong negative correlation, while green and yellow represents weak (or uncorrelated) negative and positive correlations respectively. The heat map below represents the normal and generally uncorrelated markets in 2005-06. At this time, correlations were strong only between same types of assets and the large share of assets were uncorrelated.



However, with time, the correlations have strengthened and we now have a strongly correlated market landscape. Observe the more widely dispersed streaks of red - indicating much increased correlations across disparate asset categories.



These correlations are far from static and are evolving over time in response to various triggers that move the markets. The changes in the market can be tracked by observing the changes in this heat map. The HSBC report argues that when normalcy returns, relative valuations between aseet classes will make a comeback and asset allocation and diversification will return.