Risk Retention Is Always Required As Risk is Always Here

At the end of the year in 2006, a group of senior bank executives got together to discuss the year. Included in this was the recent year’s performance, their forecast for the future and general chitchat.

The prior years had been blockbusters for them. Large house price gains, a collapse in the cost of financing (in the form of tighter credit spreads) and fantastic momentum in the economy created a feeling of invincibility. This lead to aggressive future growth estimates, assessment that if there was a contraction, a huge amount was required to even make a small dent into them. They thought the boom and bust cycle was gone forever, they had the best risk systems ever developed and economic profits would continue indefinitely.

Those looking for an alternative the new Star Wars film should consider The Big Short as it has a great explanation that whilst the self congratulation was coming out from one group of executives, others were merrily working away at alternative and very contradictory ideas. Harbinger, a hedge fund ran by Philip Falcone, was one firm to take a dramatically different view that catapulted the firm on the world stage.

So where are we now and what can we learn from this?

From an unknown unknown perspective, risk will always be there. It develops and changes over time and does become mis-priced and buffers for some people become insufficient. Right now, the outstanding $2trillion of debt financing resource companies has a strong parallel and CLO (collateralised debt obligations) that survived the financial crises incredibly well might now face a different and new risk if any form of contagion spills into the market.

Funding has changed dramatically and liquidity requirements reduce the risk of an outright credit crunch (liquidity was mis-priced in 2006). But what else could be mis-priced? Revenue could easily be overinflated and margins can erode so quickly across entire sectors. Within Australia, importers may face greater pressure as currency devaluation is used to support exporter (notably the resources sector). If they can’t pass on increased costs to a constrained consumer, margins will erode. If they try to pass on costs, revenues will fall. We will continue to look at the auto market as our leading indicator.

Can we do more to manage risk?

Returning to risk, my personal view on this matter has always been that the seller of investments or debt needs to have an associated through-the-cycle exposure to downside risk. Even short economic cycles of 5 years are enough time for risk to become poorly allocated by investors. A counter-balance is the skin-in-the-game or risk retention rules proposed in recent years. We are finally starting to see the legislation from the GFC form into live regulation.

This by no means suggests current incumbents don’t understand risk. It is a view that all current incumbents should align to the entire system’s through-the-cycle performance. And this includes sales.

So whilst we don’t know what the future will hold, we should continue to look at current incumbents who are creating large economic profit, are able to directly extract this from the financial system and are not directly impacted from cyclical impacts except for a potential decline in revenue. This means others are bearing the risk that should be allocated to them, a risk that people forget to notice.

Some investment banks proposed that staff should receive portions of the investments they create as a bonus rather than cash. This would cover many areas of insufficient capital. There are many more areas where this can apply and we will continue to discuss them in the 2016.

Leave a Reply

Your email address will not be published. Required fields are marked *