Risk and Risk regulation

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Hello world

One might think that risk taking behaviour has caused much of the financial and therefore economic turmoil of those last decades, but here is a different take.

Sure, the actions of central banks and governmental “Keynesian” policies have for the longest time fostered a series of cycles where busts and booms follow each other. The excess money created out of thin air fosters investment in non profitable projects/assets and makes it more difficult for the investors to identify the real cost of their resources. This provokes a fast(er than normal) growth which at some point someone realises is fictitious, and then the bubble explodes and here comes the recession. To combat it, rates are pushed down, spending is increased and on to the next bubble.

But there’s more to it than this “simple” story (that many economists still seem to struggle to understand, at least officially… ). Another point is related to the risks taken by banks and investors on markets, and how those risks provoke market crashes that then transfer to the economy. Or so it is said. To prevent that, after each bust a culprit is designated and regulations are promoted. The culprit is usually a “risk” that supposedly the “banks” did not judge correctly. The Basel committee on banking supervision (the bunch of the main central banks and finance regulation national bodies) is in charge of making that right and does so by imposing very complex (and binding) regulations.

However, one may well recognize that a lot of the “risk regulation” have actually increased the general risk of the banking system worldwide.

A first element to understand on that topic is that obviously if you regulate very strictly how people can lend and borrow, and how they can invest on the market, then everyone will end up with very similar portfolios. If that is the case and something bad happens, then everyone will be struggling at the same time, increasing the chance of transferring market events to economic collapse.

Secondly, a rule needs to be fixed to be “a legal rule”. But the needs of risk and the reaction of actors on the market actually call for perpetually adjusting rules. Only through the regulation by competition is that achievable without resorting to arbitrary decisions and dictatorship.

Therefore every new “risk regulation” actually has fostered crises. The reaction to the “derivatives problems” of the late 90’s prompted the inclusion of Value-at-Risk. But this measure (the n-th quantile -usually the first percentile- of the distribution of losses for a given time horizon -10 days in general) is an incentive to take risks that are further down the tail of the distribution. These risks do not change the VaR (and therefore the capital charge) but do count and get “rewarded” by a larger expected return. So this regulation has increased the chances of extremely large losses, thus making the banking industry more fragile.

Then, there is the real estate problem. Seeing how banks were taking “too much” loans risks, the regulators decided to limit the amount the banks could lend. But though that all loans were not risky in the same way. They made real-estate very cheap in capital. Sure, prices always go up and with mortgages the risk is non existent, no? Well, that plus the Community Reinvestment act (1977, supercharged in 1995) pushed banks into lending way too much for real estate in the US (and the rest of the world, too, with some exceptions). By so doing a bubble took place, then burst. The “safe loans” were now toxic and almost killed the economy (2008).

What best then than making lending to governments of stable countries the cheapest of them all? Well, say for example lending to governments of the eurozone… That way, these idiots bankers and insurer won’t be taking bad risks, right? Well, fail again, the Greek default (that everyone officially still refuses to call a default) costed the banking sector (and the tax payers in Europe) a yuge amount. ‘Cause, you know, if your make lending to anyone but a eurozone government very costly, people will lend to these governments. And if a government is very bad with its finances, it will borrow a lot… and Greece was VERY VERY very bad. So here it comes, another crisis caused by “risk regulation” that prevented certain (well priced) risks to be taken and forced other (not so well priced, thanks to that very regulation) risks to be excessively taken.

Time to stop regulating risk, I’d say… And time to let the investors be responsible for the risks they take. In positive ways when they make profit, and in negative ways with they make losses. Should the various government and regulating bodies make that clear and give back the power to the shareholders, I’m sure that banks would stop taking so much bad risks. But well, they might also stop funding stupid governmental societal projects and the welfare state. So, I guess they won’t do that and we’ll soon have the next crash/crisis, probably linked to both central banks manipulating the fiat currencies and risk regulations making investors take bad risks.

Freedom!

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