Risk is not the enemy. It is the obsession with eliminating risk that creates problems. Anyone following the fallout from the market crisis of 2008 and its most recent milestone, the passing of the sweeping financial reform bill, could be excused for associating financial risk with smallpox, polio and other scourges against which we have found a way to inoculate ourselves. Thats a dangerous mindset.
In reality, the crisis is the perfect example of what happens when financial professionals try to engineer risk-free investment products. The flight from risk at all levels of the financial landscape drove the growth of insurance in finance, with banks and financial institutions reduced to mere intermediaries, or marketers of complex risk-reduction products.
Consider the rampant growth of the Credit Default Swaps (CDS) market in the run-up to the crisis. The gross market value of CDS contracts, which were designed to insulate investors against the risk of a corporate bond default, grew 178 percent in the second half of 2007 versus 53 percent during the first half of that year. Just as the credit derivatives markets were about to implode, institutional investors were piling in at record numbers in the hopes of erasing risk. But risk doesnt just disappear it simply gets redistributed.
And who was left holding the bag when all those risk-free/low-risk products turned out to be anything but? The unwitting risk taker in this scenario was the individual: the retiree with his assets in a low risk portfolio, the parent with the college savings plan.
This happened because the financial services industry was wrongly incentivized to reduce risk at the long-term expense of its customers. The shareholders of financial firms rewarded profitability above all else, while their customers sought safety. The result was the creation of new financial products that brought in big profits while creating what turned out to be a false sense of security. There is an inherent imbalance in this relationship.
As we look ahead to 2011, new approaches to risk management must contain and confine the growth of these types of asymmetric relationships between large firms and their principals and investors. If it is more profitable for a financial firm to engineer risk-reducing products that create windfall profits for investors at the expense of customers, our financial markets will become locked in a cycle of self-induced boom and bust failure. This is a risk that is easy enough to spot; just follow the money.
Likewise, financial market participants in the post-reform world would be wise to focus their risk management efforts on risk recovery rather than complete risk avoidance. Models that purport to deliver portfolio-wide Value-at-Risk cannot be relied on to provide visibility into the relationship between individual balance sheet items and overall firm-wide financials. That level of scrutiny still requires fundamental portfolio analysis that reveals how different assets will behave in different market scenarios.
The biggest risks are not those that can be charted in predictive models or backstopped by the government; they are unpredictable black swan risks that cannot be regulated or traded away.
Managing risk in this kind of environment is not a black-and-white, good versus evil process. It demands that we abandon the notion of risk-free investing and instead focus on a more practical approach to dealing with ever-present financial risk and improve our abilities to recover when risk rears its head. Who is on the other side of the financial transaction? What do they have to gain if you lose? What do you have to gain if they lose? What are the counterparty risks and how do we value them? Is there a scenario in which we can all win? It sounds simple, but these are the kinds of tangible risks that were ignored in the financial crisis and that ought to be confronted.
Intuitive as this approach may be, the marketplace continues to focus on ridding the world of risk. The financial reform bill devotes 2,319 pages to various oversight provisions designed to protect investors from it. But investors need to realize that no amount of regulation can remove risk from the financial system (nor should it!). In fact, what investors really need is to recognize that risk is an integral component of the financial opportunities they seek and to learn to confront it when it occurs. Eliminating all risks would remove the opportunity for profit and still lead to investment losses when the unlikely risks become likely.
Charles S. Tapiero, Ph.D. is Topfer Chair Distinguished Professor of Financial Engineering and Technology Management, Department of Finance and Risk Engineering, NYU-Polytechnic Institute, firstname.lastname@example.org