Calm Financial Markets Give Regulators Jitters

By Jeff Horwitz
Quiet financial markets should arouse suspicion. That’s the gist of a recent strain of thinking and research on low volatility, some of which has begun to filter into regulatory policy discussions about systemic risk. The concern extends beyond the prospect that tranquility might indicate complacency. Instead, low volatility, tight interest rate spreads, and small haircuts on repurchase agreements facilitate and encourage risk taking behavior. The point is in some ways axiomatic. “You might say that anyone who has spent a week on a trading desk could have told you that,” said Richard Berner, the director of the Office of Financial Research in a speech this month. “But recognition of that dynamic in either academic or policy analysis is only starting to appear.” Framed as the “volatility paradox” in a 2011 post on Richard Bookstaber’s blog, the idea is drawing particular interest at a time when some measures of volatility are approaching the lows of the middle of the last decade while bankers are arguing capital requirements are excessive. At the root of the concern is the concept that low volatility can be self-reinforcing. An argument can be made that low volatility can destabilize markets in other ways, too. Karen Shaw Petrou of Federal Financial Analytics argues that it encourages the reach for yield by diminishing the ability to make money as a financial intermediary. “In a low-volatility market, you can’t make it by being a really sharp trader,” she says. “The market doesn’t afford you the in and the out in which you can buy and sell. You have to do something else.”
http://www.americanbanker.com/issues/178_55/calm-financial-markets-give-regulators-jitters-1057717-1.html