Principles of Quantitative Development

10.1 EPILOGUE

If the financial crisis of 2008 taught us anything, it is the need to view the process of trading in its entirety, often expanding our perspective even beyond the boundaries of one financial institution. Had we had the benefit of such a big perspective, we could have appreciated the unsustainable levels of over-leveraging that crept up behind our credit risk management methodologies using credit ratings. In hindsight, we now know that credit rating is perhaps inadequate. It is similar to issuing credit lines on a customer's credit rating. In Singapore, our regulatory authority (Monitory Authority of Singapore) allows banks to issue a credit limit up to twice the customer's monthly salary, which it believes to be a reasonable leverage. However, we have no limit on how many banks can issue credit lines and cards to one customer based on this limit. So you can end up having a net credit limit that amounts to many times more than what would be a reasonable leverage. Similarly, banks and corporate counterparties may have unsustainable levels of leveraging against their credit rating. As we all know now, over-leveraging is never a problem during boom times. It comes back to haunt us only when markets begin to shrink.

Another benefit of hindsight is our knowledge and appreciation of how credit and market risks have merged into a new kind of risk that we have no defence against. When credit instruments like CDS became tradeable and speculative products rather than insurance ...