When considering current industry views on volatility risk, it should be noted that traditionally, profitability of trading and investment banking fed on volatility. The terms “volatility” and “risk” can almost be used interchangeably; good risk management could be defined as effectively managing the varying levels of uncertainty from an expected outcome. The greater the uncertainty of an outcome, the greater the risk (or higher chance of loss), the higher the required risk premium; this is the standard risk equation.
What is most striking about the results from “Vulnerability to Volatility Risk – a Global Challenge,” a survey conducted by the Economist Intelligence Unit for SunGard, is the level of worry, particularly in the U.S., from firms around their vulnerability to volatility risk, with more than half the respondents expressing concerns over their firm’s ability to withstand increasing volatility risk over the next three years.
I see two core reasons that could be underlying this risk-centric headache, particularly in the short term: regulatory response to volatility and/or sovereign instability.
Regulatory Response to Volatility
Regulatory responses to increasingly uncertain markets have significant impact on financial firms, which is evident in the survey results. The expected regulatory response to crisis or potential crisis is to protect the system itself, rather than the firms within it. This is normal and particularly in the U.S., much of the post-crisis talk has been around prevention of systemic risk. In essence, the goal is to force liquidity buffers, collateralization and risk-driven capitalization to levels where a firm’s default is only the firm’s default and not a ‘black hole’ in the financial cosmos, into which multiple other firms are pulled. But the increase in capitalization and collateralization has the impact of removing working capital and market liquidity, which hurts smaller firms the most. They are aware of this regulatory side effect: the survey shows these firms are the least confident.
We also find that the order of risk-based worries goes market, then regulatory, then credit. This is fascinating, since it could mean that regulatory reforms are seen as effective in terms of preventing crisis contagion (reducing credit risk), through higher capitalization and collateralization, but that simply meeting those regulatory requirements becomes a more significant worry. Furthermore, the effect of those regulations being met could reduce capital flow through the market to the point that market valuations, based as they are on liquid flows and values, become more volatile as liquidity is reduced.
Finally, the cost of ‘protecting the system’ results in a reallocation of budget that would otherwise go to ‘protecting the firm.’ This can also be seen in the EIU-SunGard survey, where firms see their current level of stress testing as inadequate, and their preparedness for a more volatile environment as poor at best. However, the fact that respondents tend to feel that their investment in the future state was adequate speaks to the fact that investment in protecting the firm is being drawn from other, more profitable, activities, and should be read in conjunction with the feeling that shareholder value could fall victim to the volatility climb.
Sovereign Instability
In terms of sovereign risk, it is also interesting to reflect on the last few decades having been a remarkably stable platform for European and U.S.-based financial firms. Sovereign risk had been seen as effectively non-existent in these regions, and so a pretty effective risk reward framework had been in effect in terms of investment outside the region (horizontally) and in terms of emergent technologies and industries (vertically), across both core and emerging markets.
What has happened more recently has destabilized this platform. With the U.S.-led crisis of 2008, the ongoing euro zone crisis, and increased political risks in some emerging markets, it is challenging to determine which tremors have their epicenters at the global level, and which at the local. Most risk systems are not configured for such analysis, and even for those that can be, the inputs are less scientific and more based on guesswork, increasing the uncertainty of the result.
Such responses were made within the “Vulnerability to Volatility Risk – a Global Challenge” survey, which also points to the poor opinion of the current stress testing state, as against the more optimistic expectation of the future state (where such schisms are likely to be embedded as standard stresses).
It is also clear, from the EIU-SunGard survey, that senior management teams are becoming more focused on the risks increasing volatility poses to shareholder value and their firm’s health. This is likely a consequence of regulatory pressure and, more importantly, the fact that the recent crisis exposed how vulnerable, to volatility, financial firms within developed markets had become. For some time, the escalating effect certain risky activities could have in a crisis had been less understood or even acknowledged. That has clearly changed.
While you’re here…
- Learn more about the EIU-SunGard survey on volatility risk.
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