14 The Management of Bond Investments and Trading of Debt
Default does not need to come only from the leveraged investors’ side. In the area
of business debt, companies that go bankrupt range in size from big entities to a
swarm of smaller firms. In consumer debt, households have had difficulties paying off
their credit card payments, doctor’s bills, mortgages, and other financial obligations
like credit card debt, which was virtually unknown before the late 1970s but today
constitutes one of the main elements in securitized assets.
1.5 Leverage, common risk, and strategic risk
Leverage exists everywhere in the economy. Whether the investor buys bonds, pur-
chases stocks, or does some other transaction, the instrument he gets has embedded
in it a certain amount of gearing, and therefore of risk. Moreover, as we have seen in
the preceding sections, practically every company runs on borrowed capital. Figure 1.4
looks at the assets and liabilities side of balance sheets of financial entities in Euroland.
In many financial institutions the assets side of the balance sheet is essentially an exer-
cise in leveraging.
In order to better appreciate this reference, it is proper to remember that even with
the 1988 Capital Accord (Basel I), banks generally operate with an equity cushion of
only 8%. In itself this means 1250% gearing approved by regulators. Alternatively,
Basel II provides banks with the possibility to use the internal ratings-based (IRB)
method to calculate their capital requirements.
10
Notice, however, that whether IRB,
8-percent or any other approach is used, this is a practical compromise; it is not a the-
oretically established limit based on a long trail of knowledge regarding:
Credit exposure, and
The aftermath of shocks.
As a reminder, when in the early 18th century John Law originally issued paper
money through his Banque Royale, he kept gold and silver coin reserves at the level
of 25% of printed money. This meant leverage by a factor of 4. Within a few years,
however, gearing accelerated and it saw to it that the coin share of reserves decreased
as leverage increased. In the aftermath, there was a run on the bank which was saved
through intervention by the Regent of France. Later on, the Banque Royale again
became overleveraged and finally it crashed.
In the opinion of regulators, under current conditions commercial banks can live
with 8% reserves because, as far as their banking book is concerned, they are rela-
tively long-term investors. Accidents do happen, however, as with the 1929
Depression in the United States and the Russian meltdown of 1998 – when there were
runs on commercial banks and a number of credit institutions ran out of cash.
Things are different (not necessarily for the better) with the status of the trading
book, and the derivative financial instruments in it. With the 1996 Market Risk
Amendment the regulators require a daily measurement of exposure by banks,
through the value-at-risk (VAR) model.
11
VAR numbers are supposed to give a snap-
shot of the bank’s current market risk exposure through the computation of recog-
nized but not realized gains and losses (see Chapter 14).
Democratization of lending and socialization of risk 15
70%
ASSETS
60%
50%
40%
30%
20%
10%
0%
LOANS
DEBT
SECURITIES
EXTERNAL
ASSETS
EQUITY
FIXED
ASSETS
OTHER
ASSETS
50%
LIABILITIES
40%
30%
20%
10%
0%
DEPOSITS DEBT
SECURITIES
CAPITAL
AND
RESERVES
MONEY
MARKET
FUNDS
EXTERNAL
LIABILITIES
CURRENCY OTHER
LIABILITIES
Figure 1.4 Percentage share in the consolidated balance sheet of Euroland financial
entities at the end of 2000 (including the eurosystem): (a) assets; (b) liabilities.
(Source: European Central Bank)
Aside from the fact that VAR is a weak and mathematically inconsistent model with
several shortcomings,
12
under no condition should value at risk be interpreted as a
predicator of future exposure in the bank’s trading book; even less so of the institution’s
longer-term financial health. Moreover, VAR is not all-encompassing. It only answers
one-third to two-thirds of market risk measurement requirements depending on:
The institution
Instruments in which it trades

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