It’s said that investors learn more from their mistakes than their successes. If so, most of us are a lot wiser today compared with a year ago. If so, much of the progress in controlling cognitive bias relates to understanding risk. Such insight doesn’t come easy, nor does it insure success in the future although we’re confident that ignorance of risk eventually leads to failure.
With that in mind, consider a recently published essay by Malcolm Knight, general manager of the Bank for International Settlements. In a speech late last month, given at the Ninth Annual Risk Management Convention and Exhibition of the Global Association of Risk Professionals, he discussed what he sees as the major surprises and non-surprises that have defined much of market activity since roughly mid-2007. Perspective is no short cut to profits, but a healthy dose of historical context may save us from grief later on.
An excerpt from Malcom Knight’s Feb. 26, 2008 lecture on risk:
Some of these problems could have been foreseen, and indeed some observers had expressed strong warnings well before the turmoil. Which developments should not have come as a surprise? And what has been genuinely surprising? Let me highlight three non-surprises and three surprises.
The first non-surprise was the sharp repricing of risk that began in the middle of last year. The signs of an underpricing of risk had not been hard to discern beforehand. A month before the turmoil, we issued our BIS Annual Report for 2007 and repeated our grave concerns about the build-up of financial imbalances and their potential disorderly unwinding. Admittedly, it was impossible to predict the timing of the repricing. But the likelihood that it would occur was not. Indeed, in one respect the fact that it did occur is actually welcome: had the underpricing continued, the eventual adjustment would have been worse.

The second non-surprise should have been the simultaneous evaporation of market liquidity and funding liquidity. Reflecting the increasing marketisation of finance, the system had become critically dependent on liquidity – the oil that greases the wheels of the financial machine, but is the first to disappear when confidence is shaken. Rising uncertainties in the valuations of complex products, and in the location of risks in the system, exacerbated this process.
The third non-surprise should have been that banks did not prove immune to the turmoil in credit markets. A key feature of the new financial landscape is precisely the tighter association between banks and other financial market participants. Markets now rely on both “traditional” financial firms and “new” types of financial firms for the supply of securities, market-making services and backup liquidity lines. Financial firms increasingly rely on markets for generating new activities and profits and, above all, for managing their own risks. The shift from the originate-and-hold banking model to the originate-and-distribute financial business model that has accelerated in recent years is just one of the most conspicuous aspects of this growing interaction.
What about the genuine surprises? The first major surprise was the sheer intensity and speed with which the turmoil hit the banks. Not even during the banking problems of the early 1990s or those in the 1980s associated with the Mexican crisis were the dislocations in the interbank market so severe. It seems that everyone – market participants and policymakers alike – had seriously underestimated the impact of potential tensions in financial markets on the involuntary reintermediation pressures that would affect banks. The geographical reach of these pressures, well beyond the US markets where the subprime crisis originated, had also been underestimated.
The second surprise was the major role played by special purpose vehicles – what some observers have aptly characterised as the “shadow banking system”. Conduits and SIVs had grown very rapidly in recent years, but were hardly on the radar screen of authorities and observers. And yet, this sector was thinly capitalised and carried out covert liquidity transformation on a large scale. As a result all of us, I think, greatly underestimated the potential liquidity demands that could fall back on the banks, or the degree of leverage embedded in the global financial system.
The third surprise was the apparent inadequacy of financial institutions’ capital cushions. The reported high degree of capitalisation of the banking system before the turmoil was a source of pride and comfort to market participants and policymakers alike. And yet, the major efforts that are now being made by banks to strengthen their capital bases suggest that capital cushions are considered too small in the face of currently perceived risks. This is just the latest reminder of how easy it is to overestimate the size of buffers in booming, exuberant times. And it is precisely the non-linearities inherent in the financial system, such as in the case of the option-like payoff patterns I mentioned earlier, that underlie this all too familiar error of judgment. Examples are not hard to find: debt contracts increasingly vulnerable to frothy housing prices; CDOs with strong in-built leverage; high leverage in conduits and SIVs involved in liquidity transformation; monoline insurers sailing too close to the wind. All of these strategies yield steady earning streams in good times, but possibly at the expense of raising tail risks. The widespread use of securitisation seems to have facilitated this process further, by appearing to disperse risks across the system and hence encouraging risk-taking.