Assess macro-prudential policies and tail risk

 

The focus on tail risks cannot be separated from Fed and government macro-prudential policies, the global and domestic financial safety net. Measuring the safety net is a critical input in any tail risk analysis. What will be the policy response of the central bank and government? What will be the speed of the response? What will be the size of the response? Tell me the type and form of the safety net and I should tell you the amount of tail risk I will face. 

The March liquidity crisis is a perfect case study. The tail risk was significant but upended and reversed through government bond purchase and the announcement of other market support mechanism. For the investors who got overly defensive in late March, it was return disaster. For those who rebalanced at the end of month or held their positions, it was a time huge success.

If the government will respond swiftly to arrest any strong market decline, the amount of private insurance or hedging can be reduced. If the government will supply and bear the cost of the safety net, how much extra or reinsurance should I buy? Accounting for these policies is making the Joseph Stiglitz phrase of "socialize losses and privatize gains"  operational as part of your tail analysis. 

There has been research on how macro-prudential policies should be counter-cyclical, yet in reality, we are seeing "pre-emptive" monetary policy to stop market declines early in an effort to reduce any negative wealth effect on the real economy. Hence, we are seeing rates stay low longer in an effort to ensure stable wealth to further support any recovery.

An argument that has been going around for decades is that the polices of the Fed, starting with the "Greenspan put" and currently with the "Powell put", have shortened and reduced the amplitude of any financial crisis and thus reduced the benefit from holding defensive strategies like trend-following managers. This may be true, but it can be uncertain whether future policies will remain static.

The question for tail risk management is the level of decline at which the Fed will support the market. Of course, the fiscal side and policy can also be used to support financial prices. In other countries, we have seen intervention in market rules such as banning short sales. A simple analysis or simulation without including policy choices will generate a false narrative. 

However, policy risk and uncertainty have to be modeled. What happens if the government changes its reaction function? What if the Fed does not move to support markets quickly, or even worse what if the policy tools used to support the markets are less effective? While there really is no constraint on the Fed balance sheet, the combination of a zero bound and muddled forward guidance can change market expectations quickly. 

Whether you like it or not, tail risk analysis requires a policy reaction, safety net, function both for the upside and the downside tail.