As banks fail and stock markets plummet, the questions on many investors’ lips are: How could rising delinquency in subprime mortgages, which account for less than 1% of the world stock of debt, trigger one of the biggest financial crises of all times? And how do we reverse it?

The answer to the first question lies in the two-word mantra of bankers and regulators over the past decade: “risk sensitivity". Like all mantras, this sounded good but was dangerous in its oversimplification. The pursuit of “risk sensitivity" led to a reorganization of bank assets away from lending on the basis of the banker’s private views about the borrower — regulators considered this hard to quantify and suspect — towards lending on the basis of an external credit rating. The higher the rating, the lower the capital banks had to set aside against the loan. Regulators saw this as not only risk-sensitive but transparent and quantifiable. Banking by numbers was oh so modern.

Illustration: Jayachandran Nanu / Mint

One of the implications of this risk sensitivity is that bankers were given incentives to enhance the credit rating of lending to reduce their capital charges and improve their profitability. They did so in multiple ways with Bear Stearns, Lehman Brothers and AIG often acting as the brokers. The result was that the unit of lending was no longer a known borrower, but an indivisible hodge-podge of bits of originated and purchased loans, and hedges that, when combined, justified good ratings.

The focus on the rating led to the complexity that inevitably follows from using quantitative models to try and combine enough risky things to make the whole safer. But when something happened to question the rating of one package of loans, the complexity of these packages led the ratings of all packages to be questioned. Assets with the highest ratings, against which banks carried very little capital to protect them from the less than 1% probability of default, are now trading at 90 cents on the dollar. This is more of an uncertainty premium — reflected in liquidity — than it is a credit risk premium.?It?is the revenge of relationship banking.

One of the other consequences of lending by rating is that banks cannot easily quarantine the suspect parts of these loan packages because they are integral parts of the rated instrument. Because banks cannot easily do so, they did not trust other banks to have done so, so they stopped lending to each other. This forced the less liquid banks to fail, which encouraged the remaining banks to hoard liquidity, snatching it from the mouths of their clients whenever possible. This is how some problems in one small part of a subset of the financial system can bring the entire edifice down.

The good news is that the problem is partly artificial and therefore solvable. The trouble is that banks and others don’t know how to value their assets because of the way they have been “organized", not that their assets don’t have any value. The vast majority of governments, corporations and individuals are servicing their debts. The bad news is that to reorganize loans and allow a greater dispassion in their valuation requires time. The definition of a crisis of confidence is that there is no time. This points to a few ways of reversing the current free fall of credit, markets, and economic activity.

First, as my friend Willem Buiter has suggested, the central bank could guarantee all short-term interbank loans — there is more than enough room for interbank rates to fall even if the central bank charged for this guarantee. It may buy the authorities some time and it would serve to revive the interbank market rather than disintermediate it. Second, if the cycle of asset write-downs has depleted a bank’s capital, it makes sense for governments to inject capital in return for debtors accepting some partial debt for equity swap. There is value locked up in these balance sheets. Third, we need to bring back buyers of credit, fast. The government could use 10-year loans to capitalize long-term buyers of credit instruments — such as an insurance company or an investment fund with lock-ups — prepared to hold assets either to maturity or long enough to pay back the government’s capital. This gets around the mark-to-market problem, the problem of the public sector pricing and owning complex credit instruments, and may even encourage other investors to follow suit. It is not a million miles away from JPMorgan’s rescue of the US financial system a hundred years ago. It is sad how little we have learnt about the market’s frequent insensitivity to risk.

Published with permission from Avinash Persaud is chairman of Intelligence Capital. Comment at