60 Finance and economics The EconomistJanuary 27th 201812 vestment banking itself is less important
these days, accounting for about half the
overall business. In contrastthe firm’s
wealth-management income has grown
sharply since the crisis, and hasbecome
even more central to its operations since it
bought into Citigroup’s wealth-manage-
ment business in 2009. Controversial then,
the move appeared foolish a yearlater
when the process of integration faltered.
It is now cited as an obvious and unre-
peatable opportunity. Revenues and pro-
fits have grown quickly. Margins, Mr Gor-
man said, had reached levels only ever
achieved by a broker in 1999 during the dot-com bubble (by Smith Barney, whose rem-
nants were picked up in the Citi acquisi-
tion). That, he suggested, might mean they
were peaking. In response, Steven Chubak,
an analyst at Instinet, a broker, created
side-by-side comparisons ofthe two busi-
nesses to illustrate how much their ap-
proaches differed. Three-quarters of Smith
Barney’s revenues, compared with a fifth
of Morgan Stanley’s, came from transac-
tions, ie, from commissions on stock and
bond sales, and so were highly volatile.
The emphasis since has shifted.
Fees charged as a percentage of assets
are the most important source of income.But mortgages and other loans to clients, fi-
nanced by deposits, are a second, fast-
growing one. The loans are backed by the
borrowers’ securities holdings, helping ex-
plain why credit lossesto date have been
almost non-existent. Attracting deposits is
not as hard as might be expected from the
affluent customers Morgan Stanley pur-
sues. Of course they already have bank ac-
counts, but many conventional retail
banks pay almost no interest, are starting
to charge for current accounts and, in effect,
are encouraging clients to look elsewhere.
As this trove of information grows, giv-
ing Morgan Stanley data on clients’ in-M
AY YOU live in boring times. Finan-
cial markets have become dull, if
profitable. The S&P500 index, America’s
leading equity benchmark, has notched
up its longest-ever streak without a 5% re-
versal. Bond yields may have inched up
in recent months, but are still at the bot-
tom of historical ranges. Institutions
famed for their trading prowess, such as
Goldman Sachs, have seen profits dented
by the quiescence of the markets.
This lack of market volatility owes
much to the steadiness of monetary poli-
cy since the depths of the financial crisis.
Central banks have kept short-term rates
low and have intervened to push down
bond yields through their programmes of
quantitative easing (QE). The classic
method of pricing financial assets is to say
they are worth the discounted value of fu-
ture cashflows; since central banks have
kept the discount rate steady, prices have
been steady too.
The late Hyman Minsky, an econo-
mist, thought that longbooms sowed the
seeds of their own destruction. He argued
that, when the economy wasdoing well,
investors tended to take more risk (such as
taking on more debt). These speculative
positions are vulnerable to a shock, such
as a sudden rise in interest rates, which
can turn into a fully fledged crisis.
In these days ofsophisticated markets,
speculatorsare not restricted to their own
capital or even to borrowed money to buy
assets to bet on the good times continu-
ing. They can use derivative instruments
to bet on prices. Indeed, there is actually a
market in volatility.
The steadiness of the S&P500 shows
that actual, or realised, volatility has been
low. But investors can also hedge against a
sharp move in the stockmarket (in either
direction) by taking out an option, giving
them the right to buy or sell equities at agiven price within a set period. The price,
or premium, they pay for this option re-
flects a lot of factors. But one of the most
important is how choppy investors expect
the market to be in future. This measure is
the “implied” volatility of the market and
is the basis for the well-known Vix, or vola-
tility index.
Speculators who believe markets will
stay calm can sell (or “write”) options on
volatility, earning premium income. The
more sellers there are, the more the price,
or premium, will fall (and the lower the Vix
will be). The danger, then, is that a sudden
pickup in volatility could result in specula-
tors suffering losses. A linked issue is that
investment banks use a measure called
“value at risk” to help determine the size of
their trading positions; reduced volatility
will encourage them to take more risk.
Since volatility tends to rise when asset
prices are falling, this could be accompa-
nied by much wider financial distress.
Two recent papers* from the New York
Federal Reserve have examined this issue.
The authors point out that low volatility
tends to be persistent; historical data show
long periods of calm interspersed withshort spikes in the form of crises (see
chart). So low volatility today is not neces-
sarily a warning sign. The authors write:
“On average, extremely low volatility to-
day predicts low volatility in the future,
not higher.”
However, the Vix measures the im-
plied volatility over justa one-month ho-
rizon. It is possible to calculate implied
volatility over a two-year period, creating
a slope akin to the yield curve, which
measures interest rates for different lend-
ing durations. Back in 2006-07 this volatil-
ity curve was very flat, suggesting that in-
vestors thought that conditions would
continue to be rosy. That may explain
why so many were caught out by the pro-
blems in the subprime mortgage market.
This time, the Fed says the volatility
curve is steeply upward-sloping (since
1996 the slope has been steeper only 15%
of the time). This suggests that investors
are not complacent at all, and think that
volatility may soon return. Investors
seem to think the Vix may be as high as
20% (compared with around 11% today)
within the next one or two years.
The obvious catalyst for such a change
is monetary policy. The Fed is pushing up
interest rates and slowly unwinding QE;
the European Central Bank is scaling back
its bond-buying. So far, this process has
occurred without any great alarms. But
there may yet be a “tipping point”, when
higher rates cause problems for investors
and borrowers. In any cycle there is al-
ways some institution that has taken a lot
more risk than the rest. If a storm comes
this year, the world will discover who has
gone out without a coat or umbrella.The times they aren’t a-changing
That eerie calm...Source: Thomson ReutersLong-term averageCBOE volatility index (VIX)Over 30 indicates a high
level of uncertainty1990 95 2000 05 10 15 1802030406080Buttonwood
Volatility has been low, and that encourages risk-taking...............................................................
*“The low volatility puzzle: are investors complacent?”
and “Is this time different?” by David Lucca, Daniel
Roberts and Peter Van Tassel
Economist.com/blogs/buttonwood
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