February - March 2007

At January's annual World Economic Forum in the exclusive Swiss ski resort of Davos, there was much discussion about whether or not global financial markets are appropriately pricing risk.

Indeed, many of the public statements made by the Forum's high-profile attendees featured the words "complacency" and "excessive" with regard to this issue. Such concerns stem from a rapid growth in new credit products which, along with a superabundance of global liquidity, has increased the risk appetite of even conservative financial institutions, with the result that risk premiums (investment returns in excess of those available from government bonds) have narrowed considerably, as more and more investors chase higher investment returns.

Given that one of the basic laws of investment is that a higher return requires the assumption of a correspondingly higher risk, many observers view this development as harbouring a dangerous threat. In particular, the growing use of innovations such as credit default swaps (effectively, insurances against a lender's inability to repay debt and a particular favourite of hedge funds), have been singled out as having the capacity to ultimately undermine market stability. The sceptics argue that, while such instruments are relatively safe as long as the liquidity is there to actively trade them, an adverse change in general risk perceptions might leave a holder with an untradeable asset, which could have profound consequences if there were an absolute need for that holder (a hedge fund, say) to realise cash. In the worst case, say the doomsters, as the fortunes of borrowers and lenders are often interdependent when it comes to such instruments, there is the additional potential of "systemic" risk that might even engender a market collapse.

So, should private investors be worried about the trend towards "cheaper" risk? On the other side of the debate, proponents of these innovative and sophisticated credit products maintain that they have added a depth to the market that will help cushion the effects of an unexpected crisis. The inherent risk in these instruments, they say, is broader spread than in traditional credit investments, because of the additional participation of institutional investors who had previously avoided them. According to this argument, the amount of risk has not increased, but has been redistributed and consequently diluted. Advocates also point out that financial markets are more resilient to shocks than hitherto, having weathered several potentially destructive developments in the recent past (exploding oil and commodity prices, sporadic geopolitical instability, hedge fund collapses etc.) with relative ease. Although difficult to objectively quantify, champions of the new-generation credit products naturally see them as having contributed to this resilience.

Is the growing use of complex credit instruments a boon to the global financial marketplace? Do they really enhance market stability by spreading risk? Or are the fears of the Davos pundits justified? Is there excessive complacency in an institutional investment community that is abandoning traditional prudence in the pursuit of ever-higher returns? Well, we are unlikely to find out until there is a catastrophe of sufficient magnitude that will test the assumptions of both arguments. In the meantime, the two sides will doubtless continue to accuse each other of being dilettantes or reckless adventurers, depending on their respective viewpoints. In the end, however, the final arbiter will, as always, be the market itself.