Different levels of systematic risk

30 cash), high risk liquid assets are preferred by the banks. All liabilities have become more risky since also NFCs’ solvency degree has decreased. Yet, especially equity and then bonds have increased their risk premium (see Effect 8 for elaboration). Securities are more liquid than bank loans, so banks are expected to increase their holdings of securities on expense of bank loans. The effect for the NFCs is a rebound in equity and bond prices, while bank loans are expected to decrease steadily (as some are redeemed and new financing is rejected). The change security financing for NFCs, also depends on the behaviour of other security holders’

and their share of the securities market. Banks do not set the market price by themselves.

Effect 6. Banks granting loans to NFCs traditionally create a strong relationship with these.

The loans granted are usually significant to the bank as well as the NFC in order to reduce marginal cost (for both), moral hazard (for the bank) and the interest rate (for the NFC).

Enhanced short-term volatility in the security market can - under a financial crisis - reflect speculations and result in valuation not reflecting true value. A rational change in expectations to either cash flow or risk results in a larger value reductions for high risk portfolios than low risk portfolios. Large value reductions will (for reasons explained later) enhance the probability of irrational volatility in prices. Thus high risk portfolios will be more exposed to short-term irrational volatility stemming from signalling.

Banks normally do not use signalling to gather information on bank-loan debtors.

Instead they rely on screening and monitoring. This method enables them to focus on rationally assessed risk without being affected by irrational signalling and herd behaviour. It is therefore likely that banks move towards their competitive advantage; that is transforming deposits to loans. In addition the interdependence between the banks and the NFCs tends to be stronger than between NFCs and other security holders. This reduces the NFCs incentive to conduct moral hazard and increases the banks incentive to grant them the loans needed and thus reduce the default risk of the NFCs. The effect for the NFCs is (i) relatively stable flow of new loans and (ii) value reduction in securities as banks sell these at the expense of loans.

31 plays a role. Volatility in liberal markets has the most systematic risk, because market players are more interdependent. Liberalization of markets increases competition and thus lowers the cost of borrowing, including transaction costs. The results are higher demand of capital as more debtors experience positive NPV projects. In addition lower transaction costs make it easier and cheaper to invest. This enhances the liquidity and correspondingly lowers the liquidity risk. Higher demand and higher supply increases the real money supply (real M3)⁷ via gearing. This increases real GDP (which is a good thing), but it does so by enhancing the interdependence between different market actors and thus it enhances the systematic risk.

Systematic risk all over the world can have been misinterpreted before the financial crisis, because (i) humans place too much weight on recent events and (ii) investors become increasingly confident in the trend if prices move consistently for a longer time (Brealey et.

al, 2008, p. 368-71). Prices had increased over a long time and consequently the probability of negative outcomes was underestimated. Thus, even if the investor recognizes the normal distributive nature of returns, the expected return was overestimated. (iii) The variance in portfolio returns equals, σ² = ( , where = expected return and = actual return (Brealey et. al, 2008, chapter 8). The expectation to the variance is often estimated with the use of historic returns. Just before the recent crisis, the expectation to the variance (risk) in the market portfolio was underestimated as the historic time horizon was limited to recent returns.

Therefore risk was wrongly interpreted as very low.⁸

The change in perceived credit risk is expected to be higher in market-based countries, since systematic risk is higher. When systematic risk is higher, so is the real volatility.

Therefore the difference between the expected volatility (perceived risk) and true volatility (real risk) is higher in market-based countries. The true volatility is not expected to be reflected in the prices before the crisis in any country, but the miscalculation is expected to be larger in market-based countries. After adjusting the perception of risk, investors require an additional risk premium. Not only is the premium itself higher in market-based countries. The additional premium will also have larger impact on the market price since the market-based countries were perceived as more risky to begin with. This argument is valid for bonds, equity and bank-loans alike.

Effect 8. The increase in credit-risk premium (Effect 7) is expected to decrease the value of equity more than the bond value, and the bond value more than the value of bank-loans. The

7 http://stats.oecd.org/mei/default.asp?lang=e&subject=14

8 Historic volatility in prices does not necessarily tell anything about the future, and if it did, how far back should we look? What events are to be repeated?

32 reason why the value of equity is decreased more than bonds and bank loans is that: (i) Equity owners require the highest premium per unit of credit risk, i.e. given a certain default risk.

Thus, whatever such perceived risk is changed to, the change will affect the premium of equity owners the most. (ii) Higher duration for equity than for bonds and bank-loans leads to a larger decrease in equity prices given the same change in risk premium for all types of finance.

It is only the perception of default risk that increases⁹ - not other types of risk. All creditors, no matter whether they lend through bonds or bank-loans, are equally entitled to the NFC’s assets in the event of default. Therefore, increase in credit risk premium is expected to be the same for all creditors. The difference lies in two factors: Bonds will normally hold longer duration than bank loans. Thus a given increase in the premium will result in larger value reductions for bonds than for bank-loans. Secondly, the risk of bank loans is higher due to transformation risk in all its aspects. An additional risk premium will therefore have a lower percentage impact on the value of bank loans given the same time to maturity.

Effect 7 is thus expected to impact the required return of equity percentagewise more than the interest rate of bonds, and the interest rate of bonds is expected to increase more than that of bank-loans. The effect would be readable in the level of external finance. However, as long as the premium is rationally assessed larger value reductions in equity and then bond prices should not affect NFC mix of new external finance. What it can impact is the amount of profitable new investments and in that case we would mainly see the effect in the value of net-transactions.

Effect 9. The contagious effect of the crisis was heavily reinforced by risk-sharing through Asset Backed Securities and Credit Default Swaps. They are a result of a more liberal system (and creative minds), but Effect 7 and Effect 8 will also exist even though these two financial instruments did not exist. Systematic risk in the US was therefore not only higher due to higher involvement of FIs in securities (which is motivated by a more liberalized financial system), but also due to additional risk sharing motivated by Asset Backed Securities and Credit Default Swaps. However, it is not obvious that market-based countries per definition lead to a larger use of Credit Default Swaps and Asset Backed Securities. It is only a precondition. Thus, I do not believe these two types of financial engineering play a larger role in a general comparison of the two types of systems than they do in Effect 5.

9 It is true that liquidity risk also increases in the period of financial distress, but such risk is not directly linked to the perception of risk associated with the investment. It is more a symptom.

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