The Limits of Financial Risk Management: Or What we Didn't Learn from the Asian Crisis

Abstract

In retrospect, the Asian financial crisis was the canary in the coal mine that global leaders failed to recognise. While both the Asian crisis and the current one were the product of excessive leverage, moral hazard and poor risk management, the lessons drawn from each appear to be rather different: the Asian crisis was largely seen as the fault of Asian governments, while the current crisis has been primarily blamed on market actors. Does this mean that we have learned collectively from the mistaken assessments of the previous crisis? Yes and no. After tracing the links between the response to the Asian crisis and the drive towards securitisation, this article suggests that while the international financial community has avoided repeating the first major error that they made after the Asian crisis – by recognising that the problems now lie as much at home as abroad – they continue to make a second and more profound error in their response to the subprime crisis: financial leaders continue to believe that a large part of the solution is to be found in greater transparency, more accurate risk assessment models, better due diligence – in short, to provide the markets with a truly comprehensive picture of the financial instruments that are being traded. I suggest that there are two crucial problems with this assumption. The first is that it is highly unlikely that it will ever be possible to truly calculate and quantify the indeterminacies that are at the heart of the process of securitisation and the originate to distribute (OTD) model. The second is that even if it were possible to develop such a comprehensive picture of the indeterminacies involved in securities markets, it is not at all clear that financial markets will have the capacity or the interest in making effective use of that information. These limits to financial risk management not only raise some serious questions about the kinds of regulatory solutions that are currently being proposed, but also make it all the more important that we develop a politically accountable response.

Keywords:

• risk
• finance
• crisis
• subprime

Notes

For an interesting discussion of the parallels and differences between the two crises, see Ee and Xiong (2008).

I have written elsewhere about the central role of ambiguity in international financial governance (Best 2003, 2005) as well as, more recently, about the distinctions between risk, uncertainty and ambiguity as ways of conceptualising indeterminacy (Best 2008). For the present article, I will draw on the conceptual distinctions made in this 2008 article, in which risk is understood as a way of conceptualising indeterminacy that seeks to make it amenable to probabilistic calculation; uncertainty, following Frank Knight (1946), is that which exceeds efforts at calculation because of the unknown character of the future; and ambiguity (or intersubjective ambiguity as I have labelled it in the past) is a kind of indeterminacy produced by the necessity of interpreting and communicating our knowledge of the world around us. While we often try to conceptualise ambiguity through the tidier categories of uncertainty and risk, those efforts tend to fail precisely because of the challenges of interpretation.

See also the Bank for International Settlements’ 1998 annual report for a standard analysis of the causes of the Asian crisis (BIS 1998).

It was initially only one of three key pillars of this new architecture, the other two of which were the Sovereign Debt Restructuring Mechanism (SDRM), designed to create global bankruptcy court of sorts, and the Contingent Credit Line, which enabled states to pre-qualify for assistance by meeting tough standards before facing a financial crisis (an earlier version of the recently introduced Flexible Credit Line). In the end, both of these initiatives failed and the standards and codes initiative remained the only significant reform to the system (for an excellent discussion of the politics behind the SDRM's failure, see Helleiner 2008).

This was in spite of pressure by the UK and the G7 to be stricter about ensuring compliance (Brown 2001a; G7 1998).

These metaphors of course cry out for a broader feminist analysis (for some interesting discussions of the gendered character of finance and financial scholarship See de Goede (2005: ch. 2); Bedford (2009).

There are, of course, more radical proposals by critical scholars and non-governmental organisations. Dani Rodrik has argued for the importance of capital controls, and various civil society organisations have been arguing for a more radical transformation of the global financial system (Bretton Woods Project 2008; Rodrik and Subrahamanian 2008).

Some of the most recent scholarship on the financial crisis has noted this new emphasis on macro-prudential and systemic-level regulation (see for example Germain 2009; Helleiner 2009).

The politics of risk definition have become particularly evident in the context of the current crisis, as certain kinds of catastrophic risks such as the failing of an investment bank, are deemed to be unacceptable enough to socialise the costs of preventing them, while other everyday risks, such as the risk to individuals of relying on the markets to provide for a reasonable retirement income, have been seen as acceptable. Yet, as the recent crisis has shown, the accumulation of these individual smaller-scale risks can contribute significantly to the kind of large-scale risk that prompts the bailing out of major investment firms.

Keynes’ classic analogy for investors’ strategy was a newspaper competition in which contestants were successful if their selection of the six prettiest faces from 100 photographs was closest to the average: ‘We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be’. He concluded that such conventional judgements were fickle and vulnerable to self-fulfilling patterns of excessive optimism and despair (Keynes 1964: 156).

For a discussion of the limits of market participants’ use of the ROSCs, see also Mosley (2009).

As this article was going to press, there were some hopeful indications that more ambitious forms of regulation, such as global financial transactions tax or a new Glass–Steagall Act, might be gaining political fraction although it is still far from clear whether they will ultimately become law.

I am borrowing the phrase ‘lean-to of reason’ from Tyler (2005).