Comments on “Three Glass Tragedy Beginning to Rethink (US) Financial Policy” David A Westbrook Andy Haldane Bank of England

The Westbrook Thesis It has been a tragedy – but not a uniquely US one “Portfolio” approach to financial management: –May reduce risk –But increases uncertainty Risk is idiosyncratic; uncertainty is systematic Systematic risk has gone up Uncertainty manifests as: –“Indeterminate” asset prices –“Downward biases” in asset prices

Different regulatory structures, same outcomes

Systematic risk rises…

…and implied losses exaggerated

Roots of Uncertainty Among the primary causes of uncertainty are: –Contract design (eg CDO n ) –Industrial organisation of finance (eg securitisation) –Myopia (eg VAR) –Network topology (eg CDS market)

ABCP Equity SIV HY bonds Mezzanine Leveraged loans Mezzanine tranche Senior AAA Senior ABS/CDO tranches (and bank debt/ capital) CDO mezzanine tranches Senior Mezzanine Equity Capital Notes CDO HY bonds Mezz/second lien debt Corporate assets Leveraged loans Equity LBO’d company CDO 2 Mezzanine (often BBB-) Sub-prime mortgages/ Commercia l mortgages Senior Equity HEL ABS/CMBS Mezzanine BBB- rated HEL ABS/ CMBS or synthetic Senior Equity CDO of ABS CDO equity tranches Principal protected notes CPPI on CDO equity FINANCIAL ECONOMY REAL ECONOMY Financial contract design – ‘Russian Dolls’ MTNs Current episode borne of leveraging developments over the previous few years.

Sub-prime securitisation chain

Pre-crisis VaR

Post-crisis VaR

Post crisis CoVAR

So Where Next? Roll back innovation/liberalisation? – versus Address the identified market failure? –Recognising uncertainty: Network information - “Leontief matrices” for financial claims –Rethinking financial contracts Creative destruction of the CDOs and SIVs –Rethinking financial networks OTC versus centrally traded/cleared Partitioning the public good activities of the financial system –Regulation targeted at systematic risk Countercylical regulation (“common shock”) Systemic regulation (“network shocks”)

Financial Crises – Past and Present