What happened to risk dispersion?

The turbulence in credit and funding markets in the second half of 2007 is disturbing evidence that risk dispersion in financial markets has been less effective than expected. Investors appear to have acquired risks that they did not understand. Much more worrisome, however, is the evidence that major financial firms did not succeed in shedding risks so much as in transferring them among their own business lines, resulting in an unintended concentration of risks on their own balance sheets. In order to restore confidence in the near term, and to put credit creation on a more sustainable path in the future, supervisory authorities, central banks and governments will first need to understand why the much-vaunted dispersion of risk fell so far short of expectations. The “reluctance to lend” which underlies these strains in money markets was widely attributed to concerns about the financial condition of borrowers, as a consequence of uncertainty about the value of assets on the borrowers’ balance sheets, and also to insuffi cient attention to liquidity management by financial firms. But the focus on uncertainty about borrowers ignores the awkward fact that the major financial intermediaries are both lenders and borrowers themselves and their reluctance to lend significantly reflects a defensive reaction to their own uncertainties about their own balance sheets. Better stress testing for liquidity as well as solvency would certainly be beneficial. Yet a major cause of the strains in credit and funding markets has been the apparent inability of many firms to anticipate the interaction of their various on- and off-balance sheet exposures and, particularly, to understand the velocity of their off-balance sheet activities and how these affected their overall exposures. In considering potential remedies to the credit market’s turbulence and to the apparent failure of risk dispersion, the authorities should first reflect on their own role in the trend of pushing risks off of bank balance sheets.