What lies beneath?

The severity of the global financial crisis took much of the world by surprise. Comprehending the many factors that contributed to this crisis is essential if society is to improve its understanding and ability to reduce future systemic failures, as Andries Terblanche and Brian Chapman explain.

While the impact of the crisis is by no means behind us, it is important to reflect on some of the key learning points this crisis has provided to date. This article seeks to provide an overview of some of the key contributing factors to the crisis and flowing from this, potentially useful information for boards and management to consider with respect to risk management.

In this context, four main factors stand out:

Connectivity
The global economy has become increasingly interconnected. Some of the drivers of this connectivity include the growth in world trade, advances in logistics management and communications technology, and the increased mobility of both people and capital.

Greater interconnectedness has significantly increased the complexity of the financial and economic relationships among nations and between commercial enterprises, including financial institutions. Wider participation in free trade has exponentially increased the level of complexity and opportunities for a country or a business and, as a consequence, exposure to upside and downside risk.

Another (unintended) consequence of the current level of interconnectedness is the near universal adoption of modern economic theory - particularly as it relates to risk quantification and management. As more entities in more countries applied similar risk quantification and mitigation strategies, businesses constructed - at a consolidated, global level - an asymmetrical risk profile. As Chairman of the US Federal Reserve Board, Ben Bernanke, explained, "A single firm may have an acceptable exposure to a particular type of risk that would be unacceptable if replicated across many firms.”¹

While the global risk profile being assembled became increasingly unbalanced, this happened in an environment of growing confidence in the mechanisms to quantify and manage risk exposures at an individual entity level. With benefit of hindsight this confidence, however, was seriously misplaced as an examination of the next factor highlights.

Economic and financial theory
The efficient market hypothesis has gained widespread acceptance over the past third of a century, influencing the development of impressive risk management theories and models. The work of Markowitz on modeling risk², Sharpe on quantifying the worth of assets³ and Merton⁴, Black and Scholes⁵ on the value of risk, changed investment management practices around the world.

These theories were widely adopted by academics and practitioners. They were used to calibrate the price of risk to previously unobserved levels of precision. Such levels of accuracy, in turn, helped to facilitate unprecedented 'certainty' about risk measurement and downside risk exposures - to the point where capital requirements were refined to unusually low levels, in order to optimize capital efficiency and returns.What received comparatively less attention were the principles on which these theories were based, including fields such as the laws of physics. This applied observations from a controlled, statistically 'independent' environment, to a rapidly evolving statistically 'chaotic' environment. This is a critical distinction, as the efficient market theory assumes that:

• people (investors) are alike, and rational 
• investment decisions are made with no price memory 
• investment decisions are made with no sense of anticipation.

In short, the economic theories treated people (investors) broadly similar to molecules in physics: neutral, statistically independent, and rational.

Almost all of the economic theories and risk management models built on this work were applied without context around their limitations and without consideration of their original design and objectives. Used in this way, they overstated the levels of risk management accuracy and precision. For broadly similar reasons, they understated potential catastrophic risks.

Many of the theories being widely used are dependent upon the predicted outcomes being allowed to run their course, without input from the observers. In general, as soon as the investors do make decisions based on the predictions, the basis and the outcome is changed. A single investor taking such action has little effect, however if a large portion of the market makes the same decisions at the same time, then the combined effects could become massive.

As a result there has been resurgence in the use of scenario planning and analysis, as well as stress testing. Indeed, these analyses constitute some of the few risk management tools currently available to complement the mathematical theories and models (including applications such as inter alia Value at Risk or VaR).

The broad application of the efficient market theory and related models which under-quantified risk, contributed to the chronic under pricing of risk. This in turn, fueled an increasingly globally interconnected appetite for risk.

Policy and regulation Following the dotcom crash and the events of September 11 2001, the US Federal Reserve moved to lower the federal funds rate in response to the perceived risk of deflation. Subsequent decisions continued to lower the federal funds rate - decisions that inadvertently fueled two consequences. First, the decision appeared to support the notion that global systemic risk was in decline, which helped to lull more businesses around the world into a false sense of security about the robustness of their risk quantification and measurement. Second, it lowered the cost of debt at a time when more countries and commercial entities were willing and able to participate in international capital markets. One consequence was to drive US house prices ever higher as investors around the world bought US mortgage-backed securities, fueling the now notorious sub-prime crisis. The historic 'dampening mechanism' - regulation - was also being affected by emerging thinking. The Glass-Steagall test was repealed in the 1980s in the US, and in some parts of the world conglomerates could elect which parts of the business should be regulated by different regulators. Furthermore, arbitrage opportunities opened up on the global stage as different countries adopted different regulatory responses to similar economic and accounting issues. Private sector behavior In a world in which risk appeared to have been conquered, there were fewer restraints on increasingly frenetic attempts to increase absolute returns and Return on Equity ratios. In turn, this quest helped to encourage an increased use of leverage to boost returns from businesses and investments. Various forms of 'financial engineering' were deployed in an effort to multiply rates of return. Even returns that by past standards may have been regarded as good, were often greeted with disappointment by many investors, prompting some boards and executives to ignore past caution in the quest for ever-better returns.

Things for you to think about
The extent and depth of the crisis were magnified by the global economy's role in it. Increased risk appetite at global levels in the lead up to the crisis, the cycle being deepened through cheap debt and regulatory arbitrage opportunities also exacerbated it.

In combination, these developments synchronized into an almost unmatched, explosive combination which was allowed to negate historic, hard-learned values and principles see box.

Being clear on these points can help mitigate risks, provide improved transparency and should engender a greater confidence in the organization.

Article authors

Andries Terblanche
Partner
KPMG in Australia +61 2 9335 7570 aterblanche@kpmg.com.au View all articles by this author

Brian Chapman
Director
KPMG in the UK +44 20 7694 2115 Brian Chapman View all articles by this author

1. The Economist, April 25, 2009. p.67.
2. 'Portfolio Selection', The Journal of Finance 7, Markowitz, M.H., March 1952.
3. 'Capital Asset Prices - A Theory of Market Equilibrium Under Conditions of Risk', The Journal of Finance XIX, Sharpe, William F., 1964.
4. Theory of Rational Option Pricing, Merton, 1971.
5. 'The Pricing of Options and Corporate Liabilities', Journal of Political Economy 81(3), Black, F., Scholes, M., 1973.