Capitalideasonline.com – 18 Oct 2008

In a book worth reading “Speculative Capital”, the author, Nasser Saber, writes on systemic risk. Although written sometimes ago, it is relevant even today.

“Systemic risk begins to take shape when the mass of speculative capital is locked in a particular arbitrage position-say, between Treasuries and junk bonds. These fully loaded positions are arrived at by way of consideration of financial factors. But, because of the social nature of finance, they remain highly vulnerable to political and social events. And frequently, the “trigger” events are social and political. The Russian government, for example, defaults on its bond obligations. The general credit in the market deteriorates. The spreads between junk and US Treasury yields increase and individual funds suffer losses. They must either provide additional equity capital or be liquidated. But they have no equity capital; recall that they are highly leveraged. In this way, they are liquidated and the pool of speculative capital as a whole incurs loss. That is system risk.

Under these conditions, the extent of the damage to the system is a function of two factors. One is the size of the adverse move: the more volatile the markets, the bigger the moves and the greater the amount of equity that is lost. The other is the leverage ratio of the individual funds: the higher the ratio, the lower their margin of tolerance to market swings. With the operation of speculative capital constantly increasing the volatility, and the need for comparable returns pushing towards higher leverage, the momentum of the markets dominated by speculative capital is towards the greater risk of bankruptcy. In other words, it is not the failure of one or a few firms, but the common strategy, which triggers systemic risk.”

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