What keeps bankers awake at night?

WHEN the great, the good and the media assembled in Davos for the World Economic Forum in January, one topic dominated the financial agenda—risk. That ought to be a good sign. For it is when those in charge are feeling complacent that disaster is most likely to happen. Investors also seem nervous. A survey of fund managers by Merrill Lynch, an investment bank, found 82% expected volatility to rise this year.

However, as the Bible says, “by their fruits ye shall know them”. Banks are still financing leveraged buy-outs, junk bonds are offering their lowest spreads since March 2005, and the cost of insuring against a share-price fall, as measured by the Chicago Board Options Exchange Volatility Index (Vix), is low (see chart below). Financiers may be worrying about risk, but they do not seem to be doing much about it.

That apparent dichotomy reflects a broader debate. Some argue that the “great moderation” in economic numbers such as inflation and GDP growth has reduced risk for investors. Furthermore, the greater sophistication of financial markets has improved the pricing and the distribution of risk. Recent tests of the system, such as the collapse of Amaranth Advisors, a hedge fund, last year, have proved its resilience.

Sceptics retort that the calm of markets is an illusion caused by benign economic conditions and excess liquidity. The greater dispersion of risk means nobody knows where it is. And as Warren Buffett, the billionaire investor, has remarked, “It's only when the tide goes out that you learn who's been swimming naked.”

Into these choppy waters has stepped Britain's regulator, the Financial Services Authority (FSA). Its latest Financial Risk Outlook, an annual exercise, is a study in defensive drafting. You should be reassured that: “the risk of a financial stability event occurring is relatively remote...” But not too reassured, as the FSA goes on to say “...although there is a range of plausible event risks that could crystallise.”

More useful are the FSA's “alternative scenarios” about what could threaten the stability of the system, including a flu pandemic, a deterioration in personal-credit quality, and (somewhat tautologically) a reappraisal of risk by investors. The regulator worries that financial companies “underestimate the likelihood of severe events or, where mitigating action is envisaged, they overestimate their ability to take action that is both effective and timely.”

It is the job of regulators to worry, but if anything, the FSA sounds more sanguine than some of its international counterparts. Jean-Claude Trichet, the president of the European Central Bank, said at Davos that investors needed to prepare for a repricing of assets because of potentially unstable conditions. “We don't know fully where the risks are located,” he added.

This lack of information is indeed one of the regulators' main problems. A generation ago, risk was concentrated in the banking industry. That was good in one way, since regulators could monitor the banks' lending and impose reserve requirements. But when a bank failed, the effects were widespread because of the impact on depositors and other banks.

Nowadays, the banks have parcelled out the risk to hedge funds, pension funds and insurers. But has risk gone out the front door, only to come in the back, because of the banks' trading and financial relations with those same counterparties?

Information is also constrained by the off-market nature of many of these transactions. Many derivatives are traded “over the counter” rather than on a public exchange; companies are deserting stock exchanges for the arms of private-equity groups; new issues of bonds and equities are increasingly made via private placements rather than public offerings. This makes it hard for regulators to discern how markets would react in a crisis, especially since there has not been a severe global recession since the early 1990s.

Two things worry people. The first is the “carry trade”, which involves investors borrowing a low-yielding asset (often the yen) and buying a higher-yielding one. Past financial-market wobbles have been associated with periods when the carry trade was unwound. No one knows precisely how much capital is involved. But Tim Lee, of Pi Economics, reckons as much as $1 trillion may be staked on the yen carry trade. Were the yen ever to rise sharply (making the trade unprofitable), there could be hell to pay in the markets.

The second is the low cost of credit, and the rapid growth in credit derivatives, which allow investors to insure against default. The rise of the derivatives market has coincided with a very low default rate. Were defaults to rise, the ability of the markets to absorb losses (and clear trades) might be severely tested.

At least these risks can be observed. Until they can be quantified, it makes sense, as the FSA suggests, for finance firms to ensure their paperwork is in order, and to stress test their systems while conditions are benign. The worst time to call a plumber is in the middle of a freeze. And perhaps investors are more aware of risk than you might think. Although the February 2007 Vix contract is low, those who want to protect against volatility until May 2008 have to pay a 40% premium. So not everyone is complacent.