Transparency, Risk Management and International Financial Fragility

Authors: Mario Draghi (Goldman Sachs), Francesco Giavazzi (IGIER, Università Bocconi and CEPR) and Robert Merton (Harvard Business School)

The widely publicized failure of large corporations, the losses sustained by pension funds in the recent bear market, and the international crises of the last decade have revealed widespread financial fragility. Executives and policy-makers have intensified their efforts to assess and manage risk as a result. Written by a team of distinguished economists with extensive experience in financial markets, institutions and public policy, the fourth volume in the ICMB/CEPR Geneva Reports on the World Economy, Transparency, Risk Management and International Financial Fragility presents and evaluates a novel framework for evaluating and managing risk. The Report analyses specific situations in which significant unanticipated and unintended risks can accumulate. The authors focus in particular on the implicit guarantees that governments extend to banks and other financial institutions, and which may result in unseen accumulation of unanticipated risks in the government's balance sheet.

Using the structural analogy between guarantees and options, the authors show that a government's exposure to risk arising from a guarantee is non-linear. For instance, in the case of a government which guarantees the liabilities of the banking system, the additional liability transferred onto the government's balance sheet by a, say, 10% shock to the capital of firms is larger the lower the capital is to start with. Recognising this non-linearity in the transmission of risk exposures is essential to the reduction of the accumulation of unanticipated risks on the government's balance sheet.

Analysis of recent international financial crises recognise that the implicit guarantees governments extend to banks and corporations create the potential to greatly weaken government balance sheets. Attention, however, has mostly focused on the reasons why such guarantees exist, rather than on their measurement and the exposures they create. This Report provides a framework for correctly measuring the extent of a government's exposure to risk and how that exposure changes over time.

Finally, the Report discusses how risk exposures can be controlled, hedged and transferred through the use of derivatives, swap contracts, and other contractual agreements. The authors find that in emerging market economies the domestic financial market typically allows very limited diversification of risks. For instance, internal diversification through industrial policy is inefficient and costly to reverse. In such a situation, diversification through international capital mobility is the obvious alternative. The transfer of the ownership of real and financial assets, however, is only one way to achieve diversification, and it too can be costly to implement and even more costly to reverse. Often, implementing these approaches to diversification conflicts with political objectives and constraints. Over-the-counter derivative contracts provide an appealing non-invasive alternative way to transfer risk. Equity swaps, executed on a large scale, allow a country to diversify risk without shifting the ownership of assets or otherwise disturbing the domestic financial practices.

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