The missing link of 'risk-taking'

Modern financial markets may have a lot in common with nuclear power stations. Both are capable of working for the good of humanity. Both work particularly well in times of no or little stress. Both can be made more resilient through innovation and technical progress. Both need effective regulation and oversight to make sure that systemic risk remains low. However, both will remain vulnerable to large adverse shocks at all times, even up to the extent to which shocks may activate a core melt accident throwing the world as we know it into ultimate chaos."

This is actually the conclusion of Franz Hahn's small paper*, which gives a review of the latest in research in systemic crises analysis. But, the paper is just a primer on the advances in theory and doesn't go far enough. For a more satisfying foray into where financial and macroeconomic theory should be headed, to avoid the core melt accident, one has to go the Bank for International Settlements again.

Debate over liberalisation, reforms and regulation can be quite futile unless we increase our understanding of the system as it functions today. The BIS, by the way, has been one of those warning about the build up of imbalances, and has usually been put down as being conservative. Now, hopefully, their views will be taken seriously by the academic community as pointers to the gaps in current thinking and policy.

Borio and Zhu** have put together a compelling account of the under-researched areas in finance and monetary economics. This paper essentially deals with the missing link of 'risk-taking' in the transmission mechanism; that is, the link between monetary policy and the perception and pricing of risk by agents has not been given adequate attention, rendering current macro-economic paradigms and models 'ineffective' as guides to monetary policy.

The authors argue that both, changes in the interest rates and the central banks' reaction function, directly and indirectly, impact agents' risk perception and risk tolerance. This affects liquidity, which is defined as the ease with which the perceptions of value are turned into purchasing power. Liquidity and risk feed on each other, adding to the strength of the transmission of monetary policy impulses like a multiplier. Also of relevance in shaping the transmission are accounting practices, since measures of risk and valuation are crucial inputs here.

Higher risk-taking can easily transform into excessive risk-taking, thanks to two factors: Limitations in risk perception and limitations in incentives -- the latter made famous by Chuck Prince's quote of having to dance as long as the music is playing. That music must be ringing in his ears now as Citi tries hard to avoid being a part of the 'We all fall down' syndrome. Current models typically ignore all these issues, they cannot handle cross-sectional and inter-temporal coordination failures.

The authors point out that at the peak, just before the crisis blows, market indicators of risk, such as risk premia are low (when risk is, in retrospect, the highest), and underwriting standards become much looser. Real-time indicators of financial imbalances are actually capable of showing the stress, with good predictive power.

However, often these booms are accompanied by low or moderate inflation regimes that confound matters for monetary policy. For those who doubt whether monetary policy should pay heed to asset bubbles, Borio and Zhu categorically state that despite low near-term inflation, central banks should be concerned about soaring asset values, if they want to avoid disastrous busts.

For central banks to respond meaningfully to the growing fluctuations, therefore, research must have a holistic approach, taking from finance, the measurement and pricing of risk; from monetary economics, the distinction between nominal and real phenomena; from economics of imperfect information, the understanding of contracts, financial constraints and potential coordination failures; from behavioural economics, the limitations in risk perception and incentives; and weaving all together under the macroeconomic general equilibrium framework.

Borio and Zhu admit this is a tall order, but understanding the implications of the risk-taking channel is vital and would go a long way in our efforts to avoid a mushroom cloud of financial debris crippling our globe.

* A Primer on Financial Sector Meltdown: The Economists' View. WIFO Working Papers No 333, December 2008, available at http://www.wifo.ac.at/wwa/servlet/wwa.upload.DownloadServlet/bdoc/WP_2008_333$.PDF

** Capital regulation, risk-taking and monetary policy: a missing link in the transmission mechanism? BIS Working Paper No 268 December 2008, available http://www.bis.org/publ/work268.pdf