Saturday, November 07, 2009

Systematic risk, market and the State.

Market participants have taken taking system-threatening risks in the securities market. Many commentators have taken this to mean that government should intervene to prevent them doing so in the future. I explained previously why this won't work, but now I'd like to focus on how the State encourages and facilitates the taking of "systematic risk". First a definition, "systematic risk" is a risk that could rationally be considered to endanger the entire system it is taken within, necessitating a change to another system if a misfortune occurs. A system is "an assemblage or combination of things or parts forming a complex or unitary whole" (

The theory behind the call for more regulation is simple, market participants have a motive to protect themselves from risk, but no sufficient motive to protect the market from systematic risk. Because any prevention of systematic problems costs the person or institution, but they don't gain the full benefit. Their own risk goes down and that's a benefit, but it's small compared to the full cost of the risk across the market. So the preventer pays the full cost of prevention but doesn't gain the full benefit. It's like paying to purify a entire river so you can take a clean shower. Therefore people theorise that a "domino effect" could happen where one firm goes bust sending one or more of their creditors bust leading to the bankruptcies of their creditors and so on leading to too many bankruptcies for the system to handle.

This analysis ignores the fact risks that could result in defaults to your own creditors are more expensive. Naturally there are creditors out there who will loan to risky people or companies. Just as naturally they charge more than more conservative creditors so announcing that you are taking a risk likely to endanger repayments costs a firm money. This includes any exposure sufficient to destroy the firm no matter how apparently safe the firm you're exposed to. Passively concealing the nature of your risk-taking costs just as much since creditors and investors naturally assume that if what you were doing were safe you'd rush to tell them of it. Actively lying about what financial risks you're taking is called fraud and it's easier to detect and harder to actually profit by than you'd think. Investors and creditors (as well as potential short sellers) have an incentive to ferret out the lies. So any "domino effect" would have to overcome continual barriers to this like bulkheads in a well designed submarine.

A risk to an entire system is more likely if a single factor affects all participants directly, or at least a large number of participants directly and the rest through their connection to those directly affected. A risk is more likely to be systematic if could cause sudden problems, without time for participants to adjust their actions to minimize the problem. Government intervention is of course the most likely thing to create such risks due to the sudden and universal change it causes.

The most obvious government intervention in financial markets is the setting of the "risk free" interest rate by central banks. Since all economic processes include a delay between input and output this affects all economic processes. It also profoundly affects the prices of productive assets. Paying more than the return on an asset divided by the interest rate loses money. For instance if a factory had profits of $1M a year and you paid $10M for it, interest rates of 10% lose you money. So high interest rates mean low asset prices and sudden increases in interest rates mean sudden reductions in asset prices for all participants. This can lead to capital adequacy problems, i.e. a company not a big enough difference between the value of it's assets and it's liabilities. Financial institutions need this gap to be big to reassure investors, creditors and regulators that they're not about to go broke. The usual response to capital adequacy problems is to sell off assets to reduce debt. If many firms have the same problem of course the market is swamped with assets and a good price can't be got for them. This is because the opportunity cost to the buyer of buying your cheap assets is buying someone else's even cheaper assets. Since the government can subject everyone in the system to this same risk the government IS a systematic risk.

So called "credit ratings" were in effect licenses to commit fraud. Since by definition investors in funds lacked either the motivation or the knowledge to investigate individual investments. Therefore they hire someone to do so and get them the best combination of risk and return. Without the previously mentioned motivation or knowledge they had to rely on credit ratings as a proxy for risk. Fund managers delivered not the best combination of risk and return but the best combination of return and credit rating. To make a promise intending to deliver something entirely different is fraud. No fund manager will be prosecuted though because they will all say "But we invested in safe things, look they're all AAA rated.". Indeed the government required that some funds (especially retirement funds) invest only in things rated highly by it's designated defrauders, Moody's, Standard & Poors and Fitch.

Ratings agencies didn't rate unsafe firms or securities highly because the owners and issuers paid them. Although this seems like a good idea a little thought we show that's a bad strategy. If you label every piece of rubbish as caviar why would anyone want to eat in your restaurant? Ratings produced solely because someone pays you to say something are worth about as much as the paper they're printed on, that being how much competitors could produce them for. The only point in producing a rating is having people believe you, and over the long term saying things that aren't true doesn't help that. The reason that ratings agencies went the short term route of simply saying what others wanted them to say is that they have no competition. It's a government-enforced cartel that fund managers can't even refuse to deal with. If they had real competition then people who invest according to what the most credible firms said. But since they don't have to compete they can simply maintain the same low standards as the other two firms and rake in the cash.