Guide to Analysing Companies

THE CHANGING FACE OF MARKETS
3
01 Essential Finance 10/11/06 2:21 PM Page 3

---

required to hold under the Basel rules on liquidity, so-called
because they were devised by the Bank for International Settle-
ments, which has its headquarters in Basel. Drawn up by the
Basel Committee on Banking Supervision, a body that includes
representatives from the world’s main central banks, the new
rules were designed to make banks more sensitive to market
risk while at the same time giving them greater flexibility in
running their businesses.
The new system did not have to wait long for its first test. In
1998, the financial markets were jolted first by Russia’s decision
to default on its external debt, and then by the near collapse of
Long Term Capital Management (ltcm), a US hedge fund
which included two Nobel Prize winners among its directors as
well as heavyweights on Wall Street. Hedge funds are largely
unregulated investment funds that take big (and risky) positions
in the financial markets, often on exchange or interest rates. In
this case, ltcm bet wrongly that the prices of certain securities
would move closer together; instead, they drifted apart. Re-
quired to put up more money by the institutions with which it
had contracts, the fund became overstretched and eventually
had to be bailed out by a group of banks gathered together by
the Federal Reserve.
Some observers fret that regulations based on var models
contribute to the volatility of financial markets by leading to a
vicious circle, in which traders are forced to reduce their posi-
tions in the market in order to put up fresh money, which puts
renewed pressure on prices, and so on. In other words, the var
rules make an old problem worse by forcing participants to get
out of the market when they can least afford to, and by forcing
banks to reduce their lending when borrowers most need it. 
Two recent studies suggest that these fears may be exagger-
ated. The first, by Philippe Jorion, a professor of finance at the
University of California, found that financial markets have
been no more volatile since the introduction of derivatives.
Moreover, says Jorion, var rules should not be viewed as a
panacea for market ills. “They provide no guarantee that market
losses will not occur,” he says. Indeed, there is evidence that, far
from exacerbating a fall in prices, derivatives help to stabilise
markets by spreading risk. The second study, by Alain Chaboud
4