They Also Serve Who Buy and Sell
PETROU, KAREN SHAW
They Also Serve Who Buy and Sell Avoiding financial panic wasn't as easy as it looked. BY KAREN SHAW PETROU Much has been written— and all the praise has been more than deserved— about the...
...If weakness in a single firm could create so much systemic risk, it's not hard to imagine the market carnage that could have occurred on September 11...
...Are the markets out of the woods now...
...structure may not seem like much in the scope of the current human tragedy, but a functioning, free economy is essential if each of us is to have a job to come back to and the same home to house us and the same hopes for our children that we had the day before the planes struck...
...No one can really say, since these woods are the darkest of Black Forests...
...These rainy-day investments withstood a torrent, and their designers and the companies that invested in them also deserve thanks...
...Derivatives are contracts in which the risks created by potential market moves (such as changes in interest rates) are traded...
...Much less has been said—and almost none of it outside the financial press—of the heroics performed at the Treasury, the Federal Reserve, and the nation's financial companies to save the American way of life...
...Of course, it didn't...
...Many of the back-ups had been built to withstand the Y2K catastrophe that never came...
...BY KAREN SHAW PETROU Much has been written— and all the praise has been more than deserved— about the selfless emergency rescue workers who sought to save lives after the terrorist attacks at the World Trade Center and the Pentagon on September 11...
...Proposals to impose special capital requirements for operational risk, for example, would only add cost to the banking system as it struggles to meet the credit needs of a rebuilding nation...
...Some of the world's largest financial firms were literally blown to bits with billions of outstanding obligations to other institutions, but no one panicked and the financial system held...
...Not all of that huge sum is at risk in ordinary times, but extraordinary circumstances create unprecedented risks...
...One small example: The day before the attack, the Federal Reserve had about $200 million out in what are called discount window advances—the emergency funds available to banks that need extra liquidity...
...Despite an off-the-charts threat, our financial markets didn't crumble along with the buildings that housed them...
...Americans may take for granted the fact that cash came out of their ATMs without halt seconds after the planes hit the World Trade Center, but no one with market experience would have been as sanguine...
...Financial markets now depend as much on instruments called derivatives as they do on direct financial obligations...
...The incredible interconnectedness of financial markets—combined with the fact that many of these connections met under the Twin Towers— makes the banking system and financial markets vulnerable to panics when the unexpected occurs...
...Saving our financial infraKaren Shaw Petrou is a managing partner of Federal Financial Analytics, Inc...
...This may sound arcane, but the daily trading volume of derivatives today is about $140 trillion...
...Further, the ability of derivatives and other financial contracts to trade in an orderly fashion depends as much on confidence as it does on actual market activity...
...Indeed, just the suggestion that one large hedge fund might not pay its bills on time led the Federal Reserve in 1998 to orchestrate a bailout...
...In the next days and weeks, considerable thought will be given not only to how well the financial system did, but also to where its weaknesses lay...
...In the three days after the attack, discount window advances increased to a historic $80 billion, with the Fed improvising new financial instruments as it went along...
...Self-congratulation should always be tempered by introspection, but there is a danger that the financial system will be overregulated to avoid so much reliance in the future on ingenuity and steadfastness...
...Not all our financial firefighters manned the barricades at the Fed or Treasury...
...In 1987, the last time Alan Greenspan's mettle was tested, financial institutions were on one side or the other of conventional stock, bond, or deposit positions...
...Most companies showed that they came dressed with both belts and suspenders, and it would be unfortunate if regulators tried to add duct tape or staples to their ensembles...
...Today, that's no longer the case...
...Even more important, in the days before the public financial markets reopened, the Federal Reserve and Treasury manned their battle stations and kept foreign and institutional investors from panicking...
...Despite this, these potentially high-risk markets went about their business—not as normal, of course, but in a way that staved off the financial cataclysm for which the terrorists had hoped...
...Equity values went down and government bond prices went up, but record volumes were handled without a glitch...
...Within each of the nation's big banks and securities firms, backup systems fired up in an almost flawless fashion when the front offices were knocked out...
...It's good to know, though, that those who keep the lights on in the financial markets did a far better job than any of them might have expected until called to the test...
...All of them had been built at a cost of billions of shareholder dollars spent to ensure operational certainty, not to earn an extra dollar...
...The stability of financial markets is all the more astonishing when one considers their rapid evolution over the last decade...
Vol. 7 • October 2001 • No. 3
