Bernanke, B.S, 2008, Risk Management and Financial Institutions, Speech delivered at the Federal Reserve Bank of Chicago’s Annual Conference on Bank Structure and Competition, Chicago, Illinois, May 15.
Financial Services Board South Africa, 2007: Report to CISNA on Developments within the South African Control Markets, FSB, May.
Kashyap, A.K, R.G. Rajan, and J.C. Stein, 2008: Rethinking Capital Regulation, Federal Reserve Bank of Kansas City Symposium on “Maintaining Stability in a Changing Financial System”, Jackson Hole, Wyoming, August 21–23, 2008.
Liyina, A., 2004, “The Role of Financial Derivatives in Emerging Markets,” in D.J. Mathieson, J.E. Roldos, R. Ramaswamy, and A. Ilyina eds. Emerging Local Securities and Derivatives Markets, Washington, IMF.
Rajan, R.G (2005): Has Financial development Made the World Riskier? NBER Working Papers 11728, National Bureau of Economic Research, Inc
Tsetsekos, G, P. Varangis, 1997: The Structure of Derivatives Exchanges: Lessons from Developed and Emerging Markets, The World Bank, (Washington), Dec.
The notional amounts in 2008 are from January to October.
The financial market turmoil that erupted in August 2007 has caused heavy damage to markets and institutions at the core of the financial system. The turmoil was initiated by high defaults on sub-prime mortgages in the U.S, and the consequent blowout in spreads on securities backed by such mortgages, including collateralized debt obligations structured to attract high credit rating. The fallout has resulted in depletion of capital, an unprecedented disruption in interbank funds, a sharp contraction in credit supply, and in the repricing of risk across a broad range of instruments, with adverse consequences for the larger economy. Economies around the world have been seriously affected and emerging economies have not been spared with the damage being inflicted through both financial and trade channels (See Bank for International Settlements (2008, chapter 6, Bernanke (2008), Kashyap et al, (2008), IMF WEO, April, (2008 and 2009)). The crisis has underscored the need for effective regulation and transparency of financial derivatives activities.
Emerging markets, including SSA countries are the recipients of “hot money” flows by investment managers from developed countries. The investment managers are fickle and they evaporate when interest rates rise. Emerging markets are most likely to be damaged by a ‘sudden stop’ imposed by a movement of investment managers toward lower risk as developed country rates rise.
Self-regulation might be better than public regulation and supervision because norms can be set by those with experience in the derivatives market, and can be monitored by those who know how the norms can be evaded. They also have the incentive to keep bureaucratic costs down.
Tail risks are risks that are concealed most easily from investors. Given the requirement for periodic reporting, they are risks that generate severe adverse consequences, but with a small probability of occurring. In return, they offer fat compensation the rest of the time, and it will make the manager look as if he is outperforming his peers given the risk he takes (Rajan, 2005).
Herding with other investment managers on investment choices provides a guarantee that the manager will not underperform his peers if boom turns to bust. Herding can move asset prices away from fundamentals. This can result in an upward spiral, creating a condition for a sharp and messy realignment (Rajan, 2005).
Investment managers can always produce returns by taking on more risk. The young and unproven investment mangers are likely to take more tail risks and the established ones have the tendency to herd more. The two distortions are a volatile combination. If herd behavior moves assets prices away from fundamentals, the likelihood of large realignments that trigger tail losses increases (Rajan, 2005).
Capital insurance is an additional element of the capital-regulation toolkit designed with the intention of mitigating the underlying frictions that make equity expensive, namely the governance and internal agency problems that are pervasive in the derivatives market. The added flexibility associated with the insurance option may help to reduce the externalities associated with distress, while at the same time minimizing the potential costs of public bailouts during crises, as well as on the drag on intermediation in normal times (Kashyap, et al, 2008).
Caveat emptor means, “let the buyer beware.”