Dubai deserted and again risk systems are left in the dirt

Yesterday's information that a Dubai government-sponsored organisation had asked its creditors for a 6 months moratorium on a huge loan had stock market participants scurrying for the exit. The explanations offered were that a) it would hit European banks, who had sponsored some of the most ostentatious building projects on earth b) that the moratorium was a harbinger of a wave of defaults on sovereign debt c) the US markets were closed owing to the ritual feast that sees upward of 26m turkeys slaughtered or d) "I don't know what is going on, so I'd better sell".

Sure, it is bad enough if a government sponsored entity in a wealthy Gulf country goes belly up. But the amounts involved, apparently some $50bn, are small change compared to what we have gotten used to during the past 15 months, so surely the banking sector could absorb that loss – which anyway appears in fact only to be a demand for a bridge financing. But it is hardly an indication that we are on the cusp of a major melt-down in government debt.

Such fears appear to be built on a misunderstanding of government debt. Most government debt is issued in the country's own currency and can be repaid simply by printing more money – probably increasing the inflation in the passing. Creating inflation would in itself reduce the real value of the outstanding debt, which is probably why most debt defaults are also preceded by a period of domestic inflation.

It is a very different game if a country has issued a lot of debt in other currencies. In that case, the country needs a current account surplus to pay back the debt, and in a situation where the currency is in free fall, this could be very tricky and the debt default theme could become real. Currently there is a lot of talk about sovereign defaults, and Japan is often mentioned because of a skyrocketing government debt. But Japan's debt is denominated in JPY and nearly 95% of it is held by domestic savers. So a government default there would surely be spectacular, but would mainly imply a major redistribution of wealth between the generations.

So we probably should not fear a default on Dubai debt too much.

Something else can be learned from the market reaction over the last couple of days. We have (again) seen a classical "lemming" scenario where suddenly market participants appear to be heading for the exit at the same time. It is precisely such a situation that risk management systems cannot handle. Yesterday we saw the strongest spike in market volatility we have seen for months. The reason was of course that the normal correlation between market segments was cancelled and all segments move in unison. This change in behaviour simply cannot be captured in mathematical models, if those models have to be able to react quickly to changes in market conditions. A day like yesterday was exactly one of those days where all the risk systems in the world aimed at "controlling" risk again had to throw the towel in the ring. The reason is that those models are all based on "normal" situations and cannot quickly enough capture when the dynamics of the market suddenly changes. So for days like yesterday, such models were absolutely useless. Today brought calm back to the markets and the episode is likely to be quickly forgotten. But what if today had seen a similar market fall, and the same on Monday? Then the market could have lost 10 per cent and the risk control systems would still not have had time to react.

I think that it is cause for more than just discomfort that we have built nearly all risk systems in the world on assumptions that over and over again are proven wrong. And that nobody has had the smarts to create risk control on the basis of the fact that market increases, it is mostly accompanied by a falling volatility, but market falls are always coinciding with a strong spike in volatility. Some new thinking is necessary.