Mark Hannam
homeaboutarticlesessaysreviews

articles

Rethinking Risk

Printable version

The Doubly-Excluded:
consumer credit regulation in the UK


Corporate Governance: origins and challenges

Proposals for a price cap on high cost short term credit

The Need for Roots?

Syria: the Economic Implications of the Civil War

In Praise of Non-Bank Finance

The Price of Money

Numbers 4 Good

Borrowing Freely

Sceptics Knock Success

Life, Liberty and Access to Credit

Osborne's Banking Reforms: A Hedge Too Far

Always Spend Wisely ....

A Truly Ethical Foreign Policy

Southern Africa: 2020 Vision

Mervyn Turns a Tidy Profit

Private Banking for the Poor

Teaching Jurisprudence in Namibia

George - Don't do that!

Do the Math

Two Cheers for the Walking Wounded

That's Fair Enough

What Crisis?

How to Stop the Next Bubble

Muhammad Yunus

Rethinking Risk

Confusion of the incidental with the essential has been characteristic of much recent media coverage of the financial markets. More concerned with breaking stories than with telling them properly, and with assigning blame rather than explaining cause and motive, financial journalists have struggled to provide a coherent account to their non-expert audiences of the repricing of risk premiums.

It is not surprising that the public remains in the dark when it comes to financial risk. Risk issues are hard to explain to people who lack knowledge of mathematics and statistics. Debates about immunisation, nuclear energy and train safety, for example, all suffer from the low level of risk literacy among the public. Discussion of financial matters is likewise conducted under a veil of ignorance.

Most people do not check the credit ratings of banks before making deposits, nor do they read annual accounts, nor do they consult the FSA website, let alone the small print of their bank's terms and conditions. When someone withdraws money from his bank because he does not trust the Bank of England's promise that his savings are safe, he forgets that the £20 notes he has hidden under his floorboards are valueless scraps of paper, except for the promise made by the Bank of England to pay the bearer on demand the sum of £20.

Not everyone who works in the City is fluent in finance, but many of the more numerate people in our society choose to make their living by working in finance. Understanding and managing risk is central to the working lives of such individuals. Whether they are involved in originating financial investments, researching and rating them, trading them or buying them for themselves or for others, in each case they are obliged to know what risks they are running and whether these are appropriate to their level of responsibility and their appetite for risk.

It is the management of risk, not the reduction of risk, that preoccupies the best minds in the City. Risk, technically, is the standard deviation of the historical returns for a given investment; and the risk premium is the financial return this investment provides to its owner over time. The only way to achieve zero risk is to settle for zero returns on a consistent basis, which is as poor a strategy in finance as it is in life. So the relevant questions are these: what type and size of risks do we want to take? What do we do to change our approach if something unexpected happens?

There are no definitive answers, although some work better than others. But once in a while, market participants all conclude that the current best answers are, in fact, not that good and need to be replaced by better ones. At this point, risk premiums are reassessed and investment prices rise or fall accordingly. That is what happened in August this year.

The problem for the regulators and central bankers is that, to paraphrase Tolstoy, while all rising markets resemble one another, each falling market falls in its own way. This means regulators have to be at least as well informed about risk management as the market participants whom they regulate, so that when something starts to go wrong they understand what is going wrong this time, rather than trying to respond to what went wrong last time.

In particular, they need to distinguish between cases of moral hazard (irresponsible behaviour by market participants) and logical hazard (ignorant behaviour by the general public). The problem in Britain this summer has not been the pledging of public money to underwrite the irresponsibility of lenders, but rather the pledging of public money to underwrite the ignorance of deposit-holders. It is of huge discredit to the FSA and the Bank of England that they allowed the predictable consequences of a long overdue repricing of risk premiums in the financial markets to play themselves out in the nation's high streets rather than its boardrooms.

There has been plenty of talk about the new system of financial regulation in Britain established in 1997: are the lines of responsibility clear and do the various parties co-operate sufficiently? This is almost certainly the wrong question. The problem is not with the structure but with the calibre of the people within the structure. When it comes to understanding financial risk, regulators appear to be more like members of the public whose interests they are supposed to defend, and not enough like the market professionals whose activities they are supposed to oversee.

What needs to be done to prevent another embarrassing run on a solvent bank? The public will continue to act in ignorance of best practice with regard to risk management and without fully understanding the products they buy, nor the banks from whom they buy them. Market professionals need neither our assistance nor our sympathy. We should assume that they knew and understood the risks they were taking, and foresaw the likely consequences. Some will be fired, some will lose their bonuses, but others will quickly figure out new ways to make money. This is how it should be: those who live by the spread die by the spread. Most importantly, given the predilections of many politicians in Europe and America, the financial markets do not need more regulation. But they do deserve better regulators.

The FSA and the Bank of England need to adopt a new approach to the recruitment and training of staff. They need to hire from the marketplace and not the universities. They need to find poachers and turn them into gamekeepers. They probably need fewer employees, but of much higher quality and paid much higher salaries.

Until the regulators and central bankers are as smart as the market professionals they supervise, we will probably have to settle for hasty political solutions to financial problems: in the most recent case, a government that is willing to nationalise the liabilities of the banking industry, but not its assets.

Printable version

© Mark Hannam 2009

back to top

home| about|articles|essays|reviews|contact