Arnold Kling  

The True Sources of Risk

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Avinash Persaud writes,


Credit risk is best hedged through diversification across uncorrelated credits. Liquidity risk is best hedged through diversification across time. Market risk is best hedged through a combination of diversification across assets and time (having time to decide when to sell). In the past, risks of similar statistical magnitudes were considered fungible and simply flowed to whoever was prepared to pay for it. But while banks with short-term funding and many branches originating different loans have a deep capacity for holding credit risks, they have a limited capacity for holding market risks and little capacity for holding liquidity risk. Insurance companies and pension funds on the other hand have limited capacity for credit risk, but more for market and liquidity risks.

I could have excerpted much of the essay. Read the whole thing. Thanks to Mark Thoma for the pointer.

One of Persaud's points is that if you look at risk from a statistical perspective, then it does not appear that any institution has a comparative advantage in bearing a particular risk. However, from a structural perspective, some institutions do have an advantage.

My view is that the fundamental risks, such as business cycle risk, interest-rate risk, currency risk, and so on, are inescapable. However, regulatory incentives affect both the aggregate exposure and the concentration of exposure.

Incidentally, Persaud mentions that bank size is not a risk issue, but it is a politcal economy issue. That echoes my own view.


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COMMENTS (5 to date)
Chris Koresko writes:

But how does one cover regulatory risk? Delay investment until the political climate is more favorable? Move it offshore? Spend money on lobbyists?

Is there a straightforward way to estimate the impact of regulatory risk avoidance on the overall economy?

Blakeney writes:

Chris,

Robert Higgs has written about this in "Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War". For a readable overview of the economic approach to this type of problem, try Robert Pindyck's paper "Irreversibility, Uncertainty and Investment" (Journal of Economic Literature, 1991). The basic idea of the Pindyck paper is that, other things being equal, an investment is more valuable if you can delay committing to it than it is if you can't delay. Higgs applies this idea to the uncertain political climate of the New Deal, when business owners in various industries had reason to think they might be nationalized, or at least become subject to much more stringent regulation, in the near future.

W.M. writes:

"Credit risk is best hedged through diversification across uncorrelated credits."

Except that, as has been demonstrated a few times now, when it matters most, correlation of previously uncorrelated credits quickly trend towards 1. Just ask the Nobel Laureates of former LTCM.

Joe Calhoun writes:

W.M.: He does say best hedged, not perfectly hedged.

Chris Koresko writes:

Blakeney,

Thanks for taking the time to provide these references. I don't currently have access to an academic library so the Pindyck paper will be hard to get, but I've downloaded the Higgs article and look forward to reading it.

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