Sharp Deterioration of Financial Conditions

Diagnosis

Apparently, in fundamental terms, the main risk in financial markets is a rapid market downturn as a consequence of the war in the Middle East. Initially, there was alarm, affecting asset prices in general, before balancing out with a rather optimistic economic outlook (stock market, fixed-income spreads, and low perceived risks in economies dependent on foreign capital). Only long-term interest rates have not been affected. The problem with all of this is that the material outlook is not encouraging.

In principle, risks should remain somewhere, with some investor, and be reflected in asset prices. When this doesn't happen, because it's unclear who bears the risk and it's not reflected in prices, we can say that the risk is underestimated or is rather uncertainty (we cannot model it).

But there are other elements, besides the war, that are significant sources of vulnerabilities. It is possible to list them. Sovereign debt, the valuation of risky assets, and the interconnection between banks and non-bank financial institutions (NBFIs) exacerbate risk events. We will write about this in other Notes.

There is clearly an appetite for risk in financial markets, at least in the most developed countries. For example, local investors have been partly displaced by institutional investors or investors from developed countries, as in Chile and Brazil (which are prime examples).

Therefore, this inconsistency—for some, coherence for others—must be resolved at some point. The outcome may be positive, or it may not. The risks, in any case, are that the good news, primarily reported by the AI, will not be enough to sustain this encouraging outlook. This is an extremely important element, but one that is only just beginning, compared to everything else.

Abrupt

But we want to focus on the part of the diagnosis that highlights the sudden, abrupt, or rapid decline.

Although it may not seem so, if we annualize the data on economic stability, we are experiencing remarkable tranquility. There are clear turbulences, but the economy is much more stable than before, including events like Covid or the 2008 crisis.

The problem is rather the sudden volatility.

Since the 1990s, bursts of volatility have become a clear expression of financial markets. The average volatility may be lower, but there are more frequent episodes of extreme volatility. Since 2000, we have accumulated more than half the number of such episodes as occurred in the entire 20th century.

This is not the place to assign causality, especially considering the many factors that could explain it. A good example is interest rates, although we can see expressions of volatility in periods of relatively stable rates, or at least rates in expansionary territory. A comparison of the VIX index, considering short-term interest rates, is a good example.

In other words, we are seeing financial markets that, even within a context of lower average volatility and more resilient economies, experience violent and sudden episodes of volatility.

Other factors contributing to this characteristic of modern markets could be fiat currencies, market liberalization, and the expansion of debt (financial inclusion). All in all, we are in vulnerable markets, but with rapid recovery potential. The problem? Every recovery comes with a higher level of debt.

Rise, fall, and debt. Part of the current financial infrastructure is debt, which manifests itself in subsequent volatility. If it isn't more leverage, it will be an aggressive expansion of monetary policy. We are not financing the virtuous cycle through savings, as the most basic law and finance textbooks on financial markets tell us, but with a lot of debt.

Procyclical Leverage and VaR

We don't know the cause, but we do believe there is an indication, the explanation for which is based on financial and legal grounds.

We know that credit availability varies in financial cycles because, using only intuition, we conclude that there are more projects with a positive net present value (NPV) that require financing during peak periods of the cycle (strong economic indicators). Conversely, deleveraging occurs when we are in the trough of the cycle. Easy to understand.

But we see that intermediaries tend to quickly alter their debt in changing economic conditions. Their leverage is high during boom times and drops aggressively during periods of stress.

For those of us in the legal and financial fields, we know that this coincides with collateral requirements, since during times of stress, the requirements for accessing credit (in whatever form it takes) increase. During boom times, however, the requirements tend to be relaxed.

This is often linked to the capacity to take risks, because when leverage decreases, risk appetite diminishes, especially due to the requirement for collateral (particularly in the stock market or OTC markets). The opposite is true when the economic environment is favorable.

Evidence suggests that this aligns with a widely used financial model: Value-at-Risk (VaR). This model measures risk based on the distribution of minimum losses, establishing the probability that the realized loss will exceed the modeled loss. Studies clearly demonstrate that VaR per unit of equity remains stable throughout different cycles; that is, it increases and decreases as risk is eliminated. Therefore, since it remains stable, intermediaries adjust their leverage accordingly.

The problem with this is that we are not all using the same model; in other words, we don't all view our assets in light of the changing economic landscape using a model that combines risk and debt. Specifically, the problem is that VaR is not legally reflected in contracts. That is, legal intermediaries (e.g., brokers) and financial intermediaries (e.g., banks) model their exposures based on a framework that views the environment and the future in a particular way; while their creditors, as reflected in the contracts, do not consider this. The former adapt to the environment because they view the landscape flexibly as it changes. The latter operate without this flexibility.

In other words, the intermediaries' creditors limit leverage through a fixed probability (VaR allows this probability to be adjusted). Legally, this is reflected in the establishment of debt limits and non-compliance obligations (not to issue, not to lend, etc.), especially covenants. All of these latter clauses do not vary according to the economic environment.

And here's the most relevant point: Reality does change, so banks, brokers, rating agencies, etc., adapt, but their obligations do not. The result of imposing a constant probability of default is what we observe: a sharp or abrupt expansion and contraction of the debtor's (intermediaries') balance sheet, regardless of the entity's capital level.

What we mean, then, is that the contracts (obligations) require (deleveraging) throughout the cycle in a way that is financially unjustifiable. This creates an inconsistency between the actual needs and the contractual needs of the intermediaries.

Therefore, we believe this is a factor contributing to the violent fluctuations.