In the great boom of the 2000s, banks took on more risk, and with increasingly complicated financial derivatives they felt they were able to hedge against the risk. There was such confidence in the pricing of risk that the cost of taking on risk fell. This of course encouraged financial institutions to sell more risky (i.e. subprime loans) and increase the amount of risky assets in the market. It is easy to be wise after the event. But, the Bank of England produced reports in 2006 and 2007, warning of the dangers of the risk banks were taking.
But, even the Bank of England didn't have the confidence to push this agenda further. One feels that this period was characterised by a 'herding' effect. Because everyone was behaving in a certain way, it encouraged people to feel it must be OK. It's similar to the effect of the dot com bubble - because everyone else is buying dot com shares it must be OK. There is an element of human psychology - the majority must be right. But, unfortunately this is often not the case - as we are painfully appreciating now.
This is from a recent speech by John Gieve – Deputy Governor for Financial Stability 19th Feb 2009
One weakness in the system was the failure of banks and many other investors to appreciate, price and manage risk. It was not that banks were blind to the froth in financial markets. The Financial Stability Reviews in 2006 and 2007 and highlighted the declining price of risk, the build up of global imbalances, the growing dependence of banks on wholesale funding, and the risk that structured credit markets could seize up in a downturn. When we took that message to Chief Executives of banks in London and New York, they generally accepted the analysis and agreed that a correction was bound to come. However, almost to a man
(and they were all men), they took comfort from the sophistication of their risk management systems and hedging strategies. They were confident they could ride out the storm.
But as it turned out their systems were preparing them for a shower not for a hurricane. The limitations of their risk models were cruelly exposed in August 2007. One CFO remarked last year ‘We were seeing things that were 25-standard deviation moves, several days in a row’, which in plain English means that according to their models, the outright impossible was happening on a daily basis...