Hedging Macro Risks

The approach to risk management discussed above has implications for the banking industry in emerging markets in which there is a high degree of macro risk and correlation amongst all assets’ values. In this context, a common sense rule of asset diversification would suggest that an emerging-market bank that invests part of its assets in domestic government bonds increases its exposure to local macro shocks: the value of government bonds will be low precisely when the value of the loan book is low. Therefore, in such economies, banks should hedge the exposure of their loan book more than they would normally do in the context of advanced economies, for example investing in non-domestic assets—be they bonds or otherwise.  This issue came up during the recent crisis in Turkey. Turkish banks, as most emerging market banks, own large fractions of the domestic public debt: the general macroeconomic crisis which depressed the value of the loan books also brought the Turkish government close to defaulting on its bonds. Also the value of other assets in the banks’ balance sheets and their own equity value collapsed, resulting in a credit crunch and a further fall in the loan book values. On the basis of our previous analysis one would conclude that lack of proper monitoring and of proper risk diversification amplified the crisis. Our guarantee-based approach to risk management would have suggested the need for additional equity capital for the banks to continue their operations. Certainly the private sector had no incentives to provide such equity, which eventually came in the form of a blanket government guarantee on all bank deposits. The actual value of this off-balance sheet equity was itself dependent on the IMF’s financing and on the government’s successful fiscal retrenchment effort. Some G7 countries had advocated default on all public debt, and therefore also on the government guarantee, as a way to relieve Turkey’s budget from the burden of interest payments. It is now clear that such a course of action, destroying both on-balance sheet and off-balance sheet banks’ equity, would have caused a bank run and a worsening of the crisis.