A few weeks ago, we argued that systemic risk isn’t just the result of evil-doing bankers, as the ongoing reform effort largely has it. They played their part, to be sure, but the anti-bailout fervor forgets about the acts of others – God included – that can confront the global financial system with near-death experiences. One of these is under way right now in the Middle East, where revolution is rattling the foundations of the global energy market. We’re old enough to remember the “petrodollar” scare of the 1970s and 1980s. It created a sizeable systemic crisis, so we’re looking now over the transom to see if another is in the offing.
What scares us the most isn’t the systemic risk stirring in the Sahara, substantial though it could prove to be. Instead, it is how wholly unprepared global banking is for what could befall it if political turmoil turns to energy uncertainty that drives a panicky flight to “quality” across the global banking system.
One of the grim legacies of the financial crisis is a crop of unpronounceable buzzwords. Among these is “macroprudential” – that is a word supposed to identify factors that drive financial markets from sound to shaky. As the “prudential” part of the word suggests, regulators are focusing on things they know – capital, liquidity, and the like. Reflecting the hard lesson of the crisis, these are the factors that bankers can control and regulators can dictate, with many of them rightly targeted as probable causes of this global melt-down.
But, what about macro factors far afield from prudential regulation? The systemic potential of the Middle-Eastern and North-African revolutions is what we’ll call a macro-political event. And, as the petrodollar crisis makes clear, it isn’t the first. In fact, macropolitical events have had profound financial-market consequences since at least the Battle of Waterloo and, indeed, well earlier than that.
The only good way to address macropolitical risk is to spot it coming. Spurred in part by the petrodollar crisis, many global banks invested in political-risk assessment in the years after they learned some costly lessons from countries that changed their minds about repaying sovereign obligations. We know this for a fact because doing political-risk analysis was our first job at Bank of America back in the way back.
But, as losses faded from memory, political-risk analysis got fewer resources at most global banks and less and less attention from their regulators. Attention turned from due diligence about country risk to uncritical reliance on the credit rating agencies. Here, as in the MBS arena, anything with a AAA appended to it was bullet proof even if the rating agencies had, if anything, even less expertise judging political risk than asset-backed securities. For recent evidence on this front, look at the rating-agency decision to downgrade Libya and Bahrain the day after crowds took to the street.
Of course, this failure to spot sovereign risk follows one just last summer, when the agencies failed to see the EU debt crisis. And, in the Saharan one as in the EU, regulators not only counted on rating agencies, but also on complex risk mitigating instruments never tested under this kind of stress. The thinking seemed to be: there’s not much sovereign risk since the rating agencies are happy and banks are hedged. Oops.
This is evidence – clear, we think – that political risk can and should be subject to the same type of due diligence and independent judgments belatedly demanded of banks in other arenas where rating agencies once held unquestioned sway. It isn’t, though, to suggest that banks can and should be regulated so that any macropolitical event can be withstood. A critical difference between macroprudential risk –largely of a bank’s own making – and macropolitical risk is that the latter is wholly external to a bank. To regulate to the worst-case macropolitical event is equivalent to engineering to withstand 1,000-year natural disasters. It can be done, at least in theory, but it costs so much as to threaten the viability of a private concern.
Now, supervisors are looking in the rear-view mirror on this bout with systemic risk. In the future, we hope they’ll add this to the lessons being learned the hard way and work with banks to build better early-warning systems to anticipate events of this magnitude Still for a change, another tome of complex, costly rules isn’t the answer to macropolitical risk, but effective, independent and forward-looking risk management sure is.