Novel financial management is needed

Essay published in the 42nd St. Gallen Symposiuim debate (3-2 May 2012)

Prof. Didier Sornette: Novel financial management is needed

We view the world as being in the second stage of a many-acts theatre drama. The indebtedness of developed economies is growing at a completely unsustainable rate and, in addition, prevents adequate fighting of the recession as should be done. Most of the measures taken until now have been misguided or insufficient. Enormous amounts of liquidity are in search of return in a world of quasi-absolute zero interest rates of short-term bonds. This creates fast developing bubbles followed by instabilities.

The world has been shaken by a succession of financial crises, which include
- the subprime debacle starting in 2007,
- the freezing of the US banking system and its bailout in 2008,
- the exceptional Keynesian Quantitative Easing measures in 2009 and 2010
  that are considered by many to have failed,
- the “absolute zero” Fed rate and its expansionary monetary policies,
- the sovereign turmoil of Dubai and Greece in 2009 and 2010,
- the European triplet crises of

(i) pending sovereign defaults of Greece, Ireland, Portugal, and others;
(ii) exposure of European banks to these sovereign debts and to the debts of other East European countries and
(iii)  extraordinary liabilities that the European Central bank has accumulated in bad debts (and which is growing), beyond its initial mandate making de facto the European tax payers the ultimate agents responsible for the salvation of the system at corresponding costs in terms of lost growth and painful belt-tightening, the brutal doubling of the worldwide food price index in 2008 and 2010 that triggered major social unrest in Indonesia, North Africa and Middle East, and growing securitisation of food and commodities leading to improved short-term allocation of resources and possibly medium term bubbles and system-wide instabilities, as well as social unrests, the so-called “great recession” and persistent high rate of unemployment in development countries… and so on.

The view that financial markets are good and performing investment on the long run has been inherited from a glorious past, strongly fuelled by a post-war reconstruction period and growing debts buying the growth. In addition, the central banks, especially the Fed, are dangerously pumping up money to boost stock markets artificially, hoping for a wealth effect and positive feedbacks to the real economy. In this context, we believe that a new kind of investment theory and practice accompanied by revolutionary novel financial management are absolutely needed.

We need

1.      Robust empirical diagnostics of future crises
2.      Financial crisis observatory to predict and use the identification of
         mispricing and unsustainable regimes.
3.      Risk-sensitivity in banking and regulation

1. Robust diagnostic of future crises

We need to stress a major issue that is always forgotten after crises by experts and pundits when they make novel recommendations for better regulations and processes: how to get reliable measures of the elusive economic and financial variables that are in addition often gamed by creative accounting practices as well as special investment manoeuvers. We do not cast a value judgment but only recognise that it is rational for businesses, which strive to maximise shareholder values, growth and returns, to work close to or in the fuzzy zone of the boundaries of regulations. As a consequence, many measures that become available ex post for post mortem analyses are often difficult to obtain or hidden during the ex ante development of a system before it enters a crisis. We need to recognise and never forget this fundamental difficulty when using data to diagnose and forecast. Existing procedures that address this question need to be drastically improve, using a combination of statistical and modelling methods. This is relevant to both developed and major emerging markets in the Americas, Europe and the Asia-Pacific region. This approach requires monitored on all possible dimensions available, with the quest of finding new indicators and combination therefore, in order to foster the development of new ideas, new questions and concepts and new models developed above.

2. Financial crisis observatory (FCO): Feasibility study and development
    of an operational platform for the diagnostics of financial instabilities

New diagnostic tools are needed for detecting and preventing systemic financial crises. This can be foreseen by extending ambitiously the FCO launched by our group at ETH Zurich in August 2008. We call the new concepts and methods, “time-at-risk”, to emphasise the need for dynamical strategic and tactical investment management. The “Time-at-Risk” method is a quantitative dynamical risk management approach to diversification and portfolio allocation, based on the above models. The FCO is based on the main hypothesis that financial bubbles are associated with a maturation phase that evolves by pro-cyclical reinforcement mechanisms towards an instability that is quantified in mathematical terms as a bifurcation. Information on bubbles and regime change must be effectively used to generate trees of scenarios and overlaid models that can be used to develop policies that mitigate their impacts. These models can be applied to pricing, for the allocation of resources, the evaluation of project quality and eventually for advising policy making. The novel directions that we are proposing lead to
-  develop a series of models that allow for a better understanding of the causes
   of financial instabilities
-  formulate diagnostics of the maturing and development of systems towards
   financial instabilities; provide tools towards novel
-  design of markets in the goal of mitigating or removing their occurrence.

3. Bubble options as operational risk management for central banks

We also propose to empower central banks with new tools, such as so-called “bubble options” to enable operational risk management based on our novel diagnostic of impending crisis discussed above. The financial crisis observatory provides warning signals of an upcoming risk to central bankers. While warning makes the authorities responsible, they remain without efficient tools to act. Indeed, central banks have massive balance sheets and the economic production of the country cannot be adapted rapidly in response to the warning. In addition, the decision process is in general very slow. So, if a central bank knows something risky is coming, which makes them in a way responsible, they are however in a very uncomfortable situation of having little control. The political circles will not support such situations and conflicts on the optimal governance of the country and of the central bank will ensue, as can be witnessed with the European crisis. To address such stalemate, we propose to introduce so-called “bubble options” as hedging tools for central banks. The idea is that the FCO not only advises countries and central banks on their risks, but the FCO also gives them tools to manage these risks in the form of specifically constructed hedging instruments. These instruments include out-of-the-money options, constructions on volatility and so on. This is risk management in action compared to risk measurement. It is a fact that 99% of risk management departments are only occupied in risk measurement. Organisationally, central banks can start applying real risk budgeting, and determine how much do they want to spend on hedging extreme risks. This amount can be set aside to use in crisis situations to buy the bubble options. The proposed risk management of crises via bubble options should be very useful to central banks, sovereign wealth funds, and re-insurance companies, pension funds among others. The implementation can be performed by combining the measurement of the risk and the creation of market instruments that make the risk tradable, and in this way diversifiable and manageable.

Didier Sornette (FR) is Professor of Entrepreneurial Risks at ETH, Zurich. He is also Director of the Financial Crisis Observatory, a scientific platform aimed at testing and quantifying the hypothesis that financial markets exhibit a degree of inefficiency and a potential for predictability, especially during regimes when bubbles develop. He graduated from Ecole Normale Supérieure, Paris, with a degree in physical sciences and has been Professor and Visiting Professor at the University of California (UCLA) since 1996.

LINK:http://stgallen-symposium.org/debate?sc_itemid=_DC01B219-568B-49A2-8739-E53404392C83