A crisis in an interconnected world
Over the past 18 months, a crisis that began in a small segment of the US housing market evolved into a global credit crisis of systemic proportions. After the demise of Lehman Brothers and the near-collapse of AIG in September 2008, credit markets became dysfunctional and capital flows that had already slowed ground to a halt. As global banks continued to reduce leverage, the impact of the crisis began to engulf households and businesses around the world. By the end of 2008, most advanced economies were simultaneously in recession for the first time since World War II, reducing growth prospects in emerging markets due to lower demand for export goods. As a consequence, global growth is expected to remain below potential in 2009 and 2010.
The speed at which these events unfolded was unprecedented. In Global Risks 2008, "panic" was identified as an element of the anatomy of a systemic financial crisis that in this case exacerbated pressure on asset prices and induced contagion effects to the rest of the financial system and around the globe. In this sense, 2008 served as a reminder of how the world and its risks are highly interconnected. Contagion not only arises through linkages in trade and finance, but also through the often complex interaction of risks that increases uncertainty and renders decisions more difficult (see Figure 2, page 8).
Increased short-term economic risks and focus on the long term
As discussed in the last two global risks reports, the collapse of asset prices marked only the beginning of a complex chain of events that exposed numerous systemic vulnerabilities and triggered other risks and potentially adverse developments. The salient risks likely to affect the global economy through 2009 include:
| ||Deteriorating fiscal positions. The US, United Kingdom, France, Italy, Spain and Australia are all already running high deficits. Massive government spending in support of financial institutions and growth are threatening to worsen fiscal positions that are already precarious in many countries. The convergence of this decline with rising health and pension costs in industrialized economies due to demographic trends will place further fiscal pressure on governments1.|
| ||A further significant reduction in China's growth. The decline in export demand has led to a substantial reduction in China's overall economic growth, increasing considerably the risk of a hard landing that would stress the financial system and could generate social tensions within China and beyond as other economies face similar declines. Over recent years, China built up nearly US$ 2,000 billion in foreign reserves to prevent the renminbi appreciating. Although starting mid-2007 China began to allow a moderate appreciation, the trend reversed towards the end of 2008 with the rapid rise of the US dollar relative to most other currencies.|
| ||Continued depreciation of asset prices. Although global equity markets have declined on average by more than 50% in a very short time, the vicious circle between falling asset values, write-downs and attendant pressure on the capital position of financial institutions and continued deleveraging appears to be unbroken. This vicious circle is now affecting manufacturing, services and households around the world and the credit crunch has generated a substantial weakening of economic activity and growing credit losses.|
| ||Deflation replaces inflation as a key concern. In Global Risks 2008, the impact of high energy and food prices in combination with rapid credit growth were strongly linked to concerns about inflation. A year later, uncertainty in the financial sector, falling asset prices, poor credit conditions, weak demand and rising unemployment could create a deflationary spiral. However, the short-term risk of deflation must be seen in the context of a long-term inflation risk caused by the large monetary stimulus in pursuit of financial and economic stability and the risk posed by the growing public debt. Economic history is littered with periods during which governments reduced their debt burden through inflation.|
|Country Exposure to Asset Bubbles and Economic Risks|
Before the current global downturn, it was often claimed that emerging markets had decoupled from advanced economies. It is clear, however, that with respect to cyclical changes, emerging and advanced economies continue to be closely correlated; a fact that may have been masked by years without sharp recessions.
Developing and emerging market countries are tightly clustered with respect to economic and asset bubble risks but to different degrees. African countries, for example, have relatively fewer financial and real assets, and thus lower exposure to asset bubbles. Even their overall exposure to economic risks is small, reflecting in part their lagging integration into global markets.
In contrast, East Asia shows high exposures to economic and asset bubble risks; in fact, their overall exposure is very similar to Japan and the US. Most Asian economies are heavily exposed to a hard landing in China. Asia is also subject to risks related to the price of oil, dollar fluctuations and a retrenchment from globalization, with the latter being especially acute for the small and open economies of Hong Kong SAR and Singapore.
Beware of unintended consequences
The risks associated with a decline in China's growth, deteriorating fiscal positions and deflation illustrate the need for forward-looking policies. While it is essential for leaders to respond forcefully to the current financial market instability and the risk of a global recession, they must also be mindful of the implications that today's decisions have in the long term. Risks related to underinvestment in infrastructure, for example, or the degradation of natural resources and climate change, may be low in the short term, but these risks and associated losses increase in a longer time horizon.
Policy-makers must also consider the unintended consequences arising from regulation and government interventions. Market participants always react to incentives and one can argue that the growth of unregulated and highly leveraged investment vehicles was in some part due to market participants' activities designed to avoid regulation that they perceived as onerous. Indeed, this regulatory arbitrage added to the opacity that made it difficult to spot the extent of the weaknesses in the system. Hence, future financial market regulation must strike a fine balance between fostering an environment conducive to innovation and reducing the risk of systemic failure. This calls inter alia for regulatory measures that reduce pro-cyclicality and assign accountability to reduce incentives for excessive risk taking that can have disastrous results.
Government interventions in support of the financial and manufacturing sectors carry the risk of rewarding failure or propping up inefficient corporations and industries. There is also an inherent risk of creating uneven playing fields for companies excluded from access to government funds. This tends to impede competition among locally and globally active corporations, which will ultimately hurt consumers. If interventions are necessary, then governments should develop exit strategies by setting firm milestones for their duration and clear conditions for the industries concerned.
Improving risk management
The credit crisis has revealed glaring gaps in risk management. Banks, for example, learned at their peril that the underestimation of liquidity had created severe systemic risk. Moreover, there was a significant lack of clarity about the extent of risk exposure in each part of the system and financial organizations were not proactive enough in seeking out that information.
However, identifying and understanding individual risks is not enough. Risk management must also account for interlinkages and remote possibilities. Low-probability, high-severity events, such as the terrorist attacks of 9/ 11, the Asia tsunami of 2004 and the current global credit crisis do happen. All of these events were considered outside the normal distribution of experience and all imposed high human and economic costs, which affect people, regions and industries that are often quite far removed from the epicentre of the catastrophe.
But this should be no reason for paralysis. Risk management that considers extreme events, employs stress testing and calibrates quantitative approaches with informed qualitative judgments can make a difference. Today's arsenal of tools is impressive. But models have their limits and decision-makers need to be mindful of the assumptions, sensitivities and limitations of the models used in the analysis and anticipation of risk, and of their own inherent biases.
|The Implications of Risk Myopia and Misperception|
Human risk perception and behaviour have been scrutinized by economists, psychologists and neuroscientists in recent years. As a more recent interdisciplinary subject, behavioural economics is still developing and its policy implications are only beginning to be understood. However, basic elements are coming more clearly into focus. Risk perception is one such element. When faced with risks, humans often respond in ways that are deeply rooted in their physiological and neurological make-up. Fear, doubt, fight or flight are all emotions and responses that limit our capacity for rational decision-making. Fear of loss is an example of one type of risk behaviour. In many different experiments, research has found that people exhibit loss aversion by avoiding short-term expenditures, even though they could actually result in significant long-term gains. More specifically, people often miss an opportunity to mitigate risks by not acting with a long-term perspective and by not taking interdependencies into account.
An example from disaster mitigation
Disaster preparedness and response planning is a good example of how people fail to take sufficient action even though they know they are exposed to a serious risk. Property owners, lenders, investors and government agencies often ignore worst-case scenarios and do not invest adequately in infrastructure or enforce regulations designed to reduce the risk of catastrophes and accidents.
How can one explain this behaviour? Part of the response is that people rarely look at probability estimates in choosing between alternatives and tend to ignore risks with perceived likelihoods falling below some threshold of concern. For instance, despite the first terrorist attack against the World Trade Center in 1993 which cost insurers several hundred million dollars, terrorism risk continued to be included as an unnamed peril in most US commercial insurance policies. When the 9/ 11 attacks occurred, insurers and reinsurers from all over the world had to pay US$ 35 billion of insured losses.
There is another reason why many people do not act until after a crisis has occurred. Individuals and corporations have short time horizons when planning for the future so they may not fully weigh the long-term benefits of investing today in loss reduction measures that could benefit them in the future. The upfront costs of mitigation loom disproportionately large relative to the delayed expected benefits over time. Applied to businesses, short-term horizons can translate into a NIMTOF perspective (Not in My Term of Office). In other words, if a major crisis occurs everyone hopes it is not on their watch.
Overcoming myopia: thinking ahead
One way to overcome the behavioural biases caused by myopia and misperception of risk is to change the decision time frame in which risk information is presented. For example, recent research2 shows the importance of reframing the probability dimension so that people pay attention to the consequences of an event. Rather than specifying that the chance of a disaster occurring next year is greater than 1 in 100, experts could indicate that the chances of a disaster occurring in the next 25 years exceeds 1 in 5. These two probabilities are identical except that the time horizon has been stretched to obtain the latter figure. Empirical studies have shown that people are much more likely to overcome their risk misperception and to consider undertaking protective measures when they focus on a probability of greater than 1 in 5 over 25 years rather than 1 in 100 next year because the loger time horizon is above their threshold level of concern.
So how might this concept be applied to encourage long-term thinking? One proposal in the context of catastrophe risk financing is to move from the usual oneyear contracts towards the development of longer term contracts. Similar strategies may also be appropriate to encourage longer term thinking in other areas. For example, the standard annual bonus system implemented by many organizations could be modified so that a more significant portion of managers' remuneration packages are contingent on multi-year performance rather than on just the past 12 months. This might induce managers to consider more systematically the potential consequences of their immediate actions in the long run and to pay more attention to worst-case scenarios rather than hoping that they will not occur by the end of the current year.
Furthermore, given the interconnectedness of the world today, actions taken in one part of the world can have ripple effects thousands of miles away and months and years after these decisions have been made. Innovative strategies will be crucial to help businesses and individuals focus on the long term and to move beyond "it cannot happen to us" to "what if it occurs" – a mentality better suited to the current climate of interdependent global risks.
|Hedging Commodities Risk: Lessons Learned|
2008 saw commodity prices fall sharply from historic highs. The price of crude oil (WTI) declined from a peak of US$ 147 a barrel in mid-July 2008 to below US$ 50 in December 2008. Other commodities experienced similar declines. Between March 2008 and August 2008, steel fell by 68%, wheat by 67% and ethylene by 50%. This boom and bust further highlighted just how exposed many economies and industries are to the impact of commodity prices. Producing nations have seen their growth prospects deteriorate, increasing their vulnerability to other risks. From a corporate perspective, it underlined the need for new approaches to managing both price levels and volatility patterns.
Heavy commodity users are now facing a new paradigm where reduced prices but higher volatility is not necessarily giving the expected economic benefit. A new phenomenon has emerged whereby reduced price levels should support increased industrial activity; however, the higher price volatility adds more uncertainty and, therefore, potentially reduces economic activity. While, until recently, commodity/ raw material users had to manage margin compression as a consequence of increasing commodity prices, the pressure has now shifted to the supply side. Producers are now suffering from both a drop in commodity prices and reduced demand. Both market situations impose particular management challenges beyond pure financial hedging for both the demand and supply side. Throughout the high price period, businesses found it difficult to secure supply, achieve price certainty and, ultimately, pass the increased costs on to customers. The prospect for 2009 means that heavy commodity users are seeking to adapt to a new context and to reflect the lower price/ higher volatility situation in their commodity risk management approach.
Corporate commodity risk management clearly needs to be more responsive to changing price levels and higher than expected volatility. For most commodity users this means a fundamental reassessment of their hedging objectives over a longer period of time; the incorporation of uncertainty in price and volatility forecasts; a better understanding of exposures; and finding a more sophisticated way of assessing the range of hedging tools and approaches available to manage the cashflow/ earnings volatility. In other sectors, such as energy and metals, these tools are already an integral part of industry best practice but previously lessexposed sectors, such as chemicals and fast-moving consumers goods, are now looking at these tools.
The aim is to have a clear understanding of net exposure, which is often a combination of a number of transactions including foreign exchange components. Commodity price risk management tools involve a range of financial instruments, physical contracts and the pricing mechanism for the sales contract. For a number of commodities, proxy hedges (using a hedging with a different commodity than the underlying exposure) are deployed due to the lack of liquid hedging markets. In these circumstances, the basis risk needs to be quantified and monitored.
In making these hedging decisions, companies are using a number of metrics and sophisticated optimization tools that allow companies to determine their risk appetite and evaluate hedging strategies accordingly. However, to implement these approaches companies need to improve the transparency of their exposures and include a cross section of functions such as procurement, sales, treasury and controlling to ensure alignment and coordination of actions. Hedging Commodities Risk: Lessons Learned Figure 6: Commodity Price Volatility
Addressing governance gaps and avoiding regulatory overreaction
The financial crisis has underscored the need for policy responses that account for the global nature of crises. It has revealed the limits of the current financial architecture, shown the inadequacy of early warning systems, and exposed deficiencies in the coordination among policy-makers, regulators and supervisors. At national level, the financial crisis also exposed the limits of supervision that is geared only to local entities and neglects the systemic implications of financial institutions with global reach. There can be little doubt that global governance and the institutions charged to develop the frameworks and carry out such governance should be strengthened.
However, this is easier said than done. The historic development of different legal systems, to point to just one difficulty, virtually ensures that regulatory authority will continue to reside primarily with national bodies. Hence, the financial architecture of the near future should focus on setting broad standards for coordination and cooperation among regulators that improve the surveillance of economic and financial activities and support the implementation of corrective measures. Regulation can help create a climate of confidence, stability and certainty that promotes innovation, growth and competitiveness. However, poorly designed or implemented regulation can also drive up the cost of doing business, operate as a barrier to trade and capital flows or simply shift risk into less regulated parts of the system. One extreme, but plausible, scenario that should be considered is a regulatory overreaction to the recent crisis which increases transaction and compliance costs while ultimately proving ineffective in the face of the "next" crisis3. Policy-makers and regulators must be careful to weigh the costs and consequences of regulatory shifts to ensure that they produce a net benefit in terms of both system efficiency and stability. From the corporate perspective, the current uncertainty about the extent of the changes that may happen over 2009 is difficult to manage. The changes need to be measured but to reduce uncertainty they must be communicated swiftly to allow business to track them across their markets and take the necessary actions.
|The Global Risks 5i Framework Applied to the Credit Crisis|
The "5i" framework based on insight, information, incentives, investment and institutions discussed in Global Risks 2007 can also be applied to analyse the global credit crisis. It can help us to identify the risks, assess their interaction and design mitigation activities.
| ||Insight: Financial innovation appeared to increase the financial system's efficiency by spreading risks to a wide spectrum of market participants. However, the failure to cut through the opaqueness of many structured products and assess the multilayered leverage pyramid created systemic risk. Hence, forward-looking risk management must identify interlinkages and account for low probability/high severity events.|
| ||Information: Financial markets must always cope with imperfect information and moral hazard. Transparency is the antidote to remedy deficiencies arising from the asymmetric distribution of information. The growth of the credit bubble can be partly traced back to the fact that investors were in the dark about the magnitude of liabilities accumulated in structured investment vehicles due to their complexity and that they were not covered by the consolidated reporting of banks and broker-dealer institutions. |
| ||Incentives: Market participants respond to economic incentives. The separation of risk origination and risk ownership within the originate-to-distribute (OTD) business model introduced by banks over the last 30 years led to a lack in due diligence and accountability.|
| ||Investment: Financial markets depend on structures that support the flow of information and the timely settlement of trades. Credit default swaps, for example, were and continue to be traded over the counter only and the settlement of contracts used to take weeks (now days). Hence, creating a central clearing facility for credit derivatives and enabling them to be traded on regulated exchanges would help improve the market structure and reduce both settlement and systemic risk.|
| ||Institutions: The global credit crisis demonstrated a major governance gap and the need to improve prudential oversight and regulation. Financial market stability is a public good, and globalized financial markets require a globally coordinated effort to create and maintain this public good. The financial architecture of the future must have an element that transcends national borders. To ensure success its institutions should include broad representation in rulemaking bodies, macro prudential surveillance and have agreed procedures for systematic enforcement.|
|Geopolitical risks and oil dependency|
By focusing on the geopolitical dimension (comprising risks of terrorism, interstate wars, state failure and transnational crime) and oil price risk, the following graph illustrates the interaction between two classes of risks that are usually considered to be Siamese twins. Three points emerge.
| ||First, oil-producing and oil-consuming countries form two very distinct and separate clusters.|
| ||Second, oil producers are exposed to geopolitical risks in varying degrees, with Norway on the low end and Iraq on the high end of that particular risk spectrum. Mexico and Great Britain, although oil producers too, are set apart and much closer to the oil-consuming countries of Europe.|
| ||Third, it is worthwhile noting that Hong Kong SAR and Singapore are both clustered with the European countries instead of with their geographic neighbours in East Asia. They demonstrate a lower exposure to geopolitical risk, while maintaining a relatively high exposure to a rising oil price.|
The analysis points to broad scope for collective action. High oil dependency exposes consumer countries indirectly to geopolitical risk. Advanced economies in particular are shown to have a powerful incentive to reduce their oil consumption not only for environmental reasons (to cut carbon emissions), but also for reduction of their indirect exposure to geopolitical risk.