THE SUBPRIME crisis has sent many companies back to the drawing board on risk management, Secretary to the Treasury, Ken Henry, said last month.
The fallout from the subprime crisis, he said, proved that even very deep, liquid markets “populated by sophisticated players” can get into positions that are very difficult to understand and explain.
Henry said the subprime crisis had something in common with many of the previous financial meltdowns, including the Asian financial crises, the Russian and Latin American debt crises, and the stock market collapse heralding the end of the dotcom era. “Common to all of these episodes is a mispricing of risk,” he said.
“In the most recent of these crises there is the added dimension of a lack of information concerning counterparty credit risk. That information is gradually being discovered, of course; and as that happens, all sorts of people are re-learning old lessons about risk management.”
He said greater financial integration necessarily led to greater counter-party risk, but there were things, within reason, that could be done to further reduce those risks.
“These lessons we are re-learning about risk management are not of purely financial interest,” he added. “International capital market volatility is not a zero-sum game, with the winning players merely extracting wealth from well-heeled losers.”
Financial volatility affects prices and sometimes – as in the most recent episode – liquidity, he added. “Through both price and liquidity channels, it affects real macroeconomic performance, and the income and employment opportunities of all sorts of people, all over the globe.”
“International capital market volatility matters, therefore, to any government that is properly focused on the living standards of its citizens.”
Henry made the comments in the context of a discussion about making regulation of financial transactions more global through mutual recognition of regulatory regimes.
The greater integration of financial markets globally had led to greater risks, however, and in the wake of financial crises there is always likely to be countries wondering whether there has been too much integration, but he said ultimately the benefits outweigh any occasional pain.
“Despite the occasional serious disruption caused by international financial volatility, the policy advice going from treasuries to their political masters has generally remained stubbornly supportive of liberalisation; and for good reason,” he told the ASIC Summer School.
“Australia’s capital market liberalisation began in earnest at the end of 1983, with the floating of the Australian dollar and the abolition of exchange controls. That was followed by an extensive program of liberalising foreign investment restrictions. And, still in the 1980s, the banking system was opened up to foreign banks. Similar regulatory change occurred at similar times in many other countries.”
Turn to page 9 for Bank of International Settlements assessment of liquidity risk