Three Mountains (12) - Risk is Real

Risk is unavoidable for people who are finite and free. God has made us free, so we have to make decisions. We are finite, so do not have perfect information on which to base our decisions. Hindsight is more perfect, so it proves many of our decisions wrong. An important aspect of decision-making is minimising the risk of bad consequences.

Risk cannot be eliminated, but it can be transferred to others.

• Insurance is tool for minimising the risk carried by one person, by sharing it between a much larger group.

• Limited liability transfers some of the risk of business failure from the owners to the clients of the business.

• Financial derivatives can be used as tool for transferring risk from one institution to another.

• Deposit insurance shifts risk from the banks to taxpayers.

Governments attempt to eliminate risk, but they actually transfer it to other people. Their regulations often encourage people and institutions to ignore risk.

The Global Financial Crisis was the result of bad judgement based on failure to understand risk. This foolishness was widespread throughout the economic and political system (see Credit Crunch Characters).

• Households took on massive risk by paying ridiculous prices for houses, because they assumed that house prices would keep up going forever.

• Households took on big mortgages assuming rising prices eliminated the risk.

• Governments encouraged banks to ignore risk and give mortgages to people who could not afford them.

• Banks assumed that insurance against default had eliminated the risk, so they purchased these financial instruments as if they were risk free when in reality, they had swapped one form of risk for another.

• Financial institutions bought CDOs, assuming that clever mathematical models had eliminated all risk.

• Investment banks boosted their profits by being levered up to thirty to one, but ignored the risk of a decline in asset values.

• The risk of a large monoline insurance company failing was ignored.

• The risk of that credit ratings agencies might be wrong was wrong.

Foolishness and stupidity were rampant in the financial system, but good times make fools appear wise, so risk was totally ignored.

Foolishness cannot be eliminated regulation. Regulations cannot stop foolish behaviour. The only cure is for people and institutions to get a better understanding of their risks and make mitigation.

Better banking is a key. Two questions should be asked before a loan is made.

• Will the borrower be able to pay the interest and repay the loan when it comes due?

• What assets is the borrower offering as collateral for the loan?

These questions have been forgotten over the last decade, but they will become more important again. To get finance, businesses and households that demonstrate an ability to make the repayments will be able.

Read more at Blessed Economist