The financial crisis should lead risk managers to think again about risk transfer
The great economist Walter Bagehot (1826-1877) describing the money market, wrote: ‘The main point on which one system of credit differs from another is ‘soundness’. Credit means that a certain confidence is given, and a certain trust reposed. Is that trust justified? and is that confidence wise? These are the cardinal questions’
The events of the past weeks should lead risk managers to think again about risk transfer in the light of Bagehot’s words.
For, like energy, a risk does not disappear from the universe; it merely takes new forms. But in seeking to transfer risk – whether by packaging and selling debt, hedging through credit default swaps or other derivatives – banks appear to have assumed the risk had been removed, as if by some magic eraser, leaving them free to take on more. But as we have seen, the risk was not erased. The moment Bagehot’s necessary confidence and trust failed, the chain of hedged positions unwound with vertiginous rapidity, to the degree where institutions with assets which were supposed to be worth billions one day, teetered on the edge of failure the next.
“The moment necessary confidence and trust failed, the chain of hedged positions unwound with vertiginous rapidity
The risk is now being transferred again, this time to governments and the taxpayer; from credit risk to finance risk, to political risk, and now – if Scotland’s Sunday Herald’s headline ‘Prudent borrowers angry at having to bail out the risk-takers who failed’ is to be believed – to a corrosive reputation risk, where banks are tarred with being ‘spivs and speculators’.
Risk management is at the centre of this storm. It may not entirely be the profession’s fault, for, as one risk consultant put it to me, ‘People paid in millions don’t listen to those paid in thousands’. Nevertheless, the misperception that a risk can be made to vanish lies at the heart of the crisis. It is worth remembering that there is no such certainty.