Another false alarm in terms of banking systemic risk

The recent turbulence on financial markets associated with the US sub-prime lending crisis has led to some risk reappraisal across credit markets. While it has not reached systemic levels of intensity, there are still serious causes for concern, says Moody's Investors Service in a new report entitled "Another False Alarm in Terms of Banking Systemic Risk but a Reality Check".

The significant level of asset destruction associated with the sub-prime crisis in the US, the orderly demise of a hedge fund facilitated by an important securities firm, concerns about the functioning of innovative financial products in times of stress and signs of credit tightening have prompted many to ask whether this is the tremor that was expected to conclusively ascertain the shock-absorption capacity of the system -- or whether a large-scale financial meltdown is imminent.

"The shock-absorption capacity of the core of the financial system is very high," reassures Pierre Cailleteau, Moody's chief international policy analyst. "In addition, in the current macro-economic and financial environment characterised by ample liquidity, there continue to be marginal risk-takers ready to pick up assets at adjusted prices. As such, the current episode does not seem to raise genuine systemic risk concerns, with Moody's core bank ratings displaying a high degree of resilience in this regard."

Nevertheless, Mr Cailleteau flags up causes for concern in the new report. First, some degree of asset destruction will have to be absorbed by investors and financial institutions alike, and nervousness will linger until the size and distribution of losses is finally known. This is unlikely to be soon and headline risk will probably test markets' nerves.

Second, and more generally, the combination of a significant wave of financial innovation with a relaxation of risk management/underwriting standards has proved to be a dangerous cocktail. "A normalisation in risk appetites will help, but the cautionary tale is that many of the observed deficiencies are likely to be enduring features of our environment -- such as the inability to track risk accurately and predict risk crystallisation at times of stress, the recurrent lapses of market depth and the challenges of valuing highly customised products," Mr Cailleteau says. "This, with hindsight, is the lasting lesson of LTCM."

"In an environment where insecurity is unlikely to disappear, the existence of capital cushions and strong liquidity management at financial institutions is critical. Banks and regulators should not lower their guard," Mr Cailleteau cautions.

(This is the press release of Moody's Investors Service)

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