R Ravimohan: Watch out for black swan

Market-disrupting black swan events such as the East Asian crisis, the tech bubble burst and the credit-pricing crisis have been frequent. Markets need to devise better ways to deal with them.

Black swan refers to events that have a low probability of occurrence, but if and when they do occur, their impact is very high, like the appearance of a black swan in a bevy of white swans. This term is being increasingly used in the financial context, after a series of events disrupted the markets beginning with the East Asia crisis, the tech bubble burst, the Latin American and Russian currency collapse, the accounting and corporate governance issues and now the credit pricing crisis, triggered by the crash of the sub-prime market. These events have occurred in a relatively short period and with discomforting frequency and regularity. Markets will do well to take notice and to understand if they are really so random and unpredictable, and to devise better ways of being prepared to face these events in the future.

Black swan events are not new. Financial markets and businesses have faced them all along and have extant methods of dealing with them. By and large these measures have involved examination of sources of risk and classifying them as probable and remote and dealing only with those risks that are considered probable, real and proximate. Risks that are estimated to have a low probability of occurrence are disregarded from consideration either for pricing the risk or for enjoining risk protection measures. The dilemma for the market is to price the risk adequately to minimise eventual loss, yet not make the cost of risk protection so high to make the transaction itself unviable. Markets' effort to strike the right balance in this regard is challenged by the competitive environment, where there is always an aggressive player who is willing to discount the risks. In this struggle, it is often the black swan risk events that get shoved under the carpet, as they are distant and remote. The danger, of course, is their high impact occurrences wipe out years of profits in one fell swoop.

For instance, the financial markets term these as event risk and exclude them from risk calculations. Some examples of how this works can be found in stock exchanges' margining systems, bank lending clean loans, guarantee and insurance coverage, value at risk models and indeed financial research. For instance, banks estimates credit worthiness of its potential borrowers based on probable eventualities occurring and take collateral in case they need additional comfort. In both estimating the cash flow from operations and the sufficiency of the value of the collateral, the bank estimates most likely scenarios and excludes extreme impact situations which have low probability of occurrence, as otherwise the cost of borrowing will go up. So would be the case if insurance were to cover all risks. Almost all commercial agreements have a "force-majeure" clause which is supposed to include all "God induced events", meaning they are beyond the control of humans.

There are obviously no golden rules and the market prices these risks based on its judgement and expectation of future events. The risk pricing goes low as the confidence in the market rises, until the black swan event happens when the risk pricing shoots up as the market looses confidence. The sub-prime issue is a good example. Loans were made to sub-prime borrowers at very low interest rates. These were securitised and sold as low-priced investments. The black swan event developed as real estate prices tanked in the US, the interest rates rose and hence the market value of these investments crashed. It is clear in hindsight that the market had not priced these risks right early on. It is also equally clear that at the current pricing these transactions are not viable and would not have happened in the first place. Is there a middle ground where the pricing is more prudent going into the transactions, leading to a more sedate but sustainable market growth, and which may lessen the risk of abrupt disruption as indeed it has now happened? Should the market do anything about it? Can it do anything?

There could be possibly two approaches to build defenses against the black swans in the financial markets. One is to build a reserve by making a provision from the profits of every normal year, which could be utilised in the event a black swan occurs. This could be considered a future-active prudential provision. The other measure could be to include in the model for calculating price risk, an element towards black swan events. For instance, if the probability of such events occurring is estimated at 1 basis point and the impact is expected to be 10 per cent loss in market value, then potential loss would be 1 per cent, which makes it too stiff a provision to carry under normal circumstances. But a suitable proportion of this potential loss (say, 20 per cent) could be factored into its risk pricing calculations, instead of completing ignoring it. Statisticians and tech-jocks can easily come up with the right theory and modify all risk pricing models to incorporate this adjustment. This will systemically reduce the steep and sudden price movements by keeping the risk price closer to the peak and increasing threshold for transactions ab-initio, automatically allowing only the more robust transactions to the market. This prudential pricing along with the reserve that would have been created will not only smother the impact, but also give additional maneuverability to the market in those adverse circumstances. For instance, the losses in the event of extreme market developments, could be set off against the reserve. This will reduce the selling impetus that usually accompanies these events to avoid severe mark-to-mark losses. The breathing space thus gained by the market could be very useful in avoiding market disruptions.

Regulators could take the lead in fashioning appropriate prudential norms for creating the reserves towards black swan events. They could also look at getting a better disclosure on total market value related assets in the system against which such reserves should be created. Accounting authorities can facilitate creation of proactive reserves for the purpose of allowing subsequent losses directly to be set off directly against these reserves to reduce market swings. Last but not least, governance should be enforced more strongly at the financial institutions to moderate exuberance in the face of extreme aggression.

The author is managing director and regional head, Standard & Poor's, South Asia and the views expressed in this article are personal. He can be contacted at r_ravimohan@standardandpoors.com