The 3 laws of risk, and their implications for an inter-connected financial system

The last half-dozen years has seen a steep rise in the use of Credit Default Swaps in the banking system. That’s a principal reason the financial crisis has reached the epic proportions it has. One, this created moral hazard among banks who, feeling they have managed risk away, began to take on more risk, and two, the greater risk was dispersed more broadly across the financial system.

When one bank wants to manage its risk of a financial contract being defaulted on by a major counterparty bank, it buys a credit default swap the way a normal person buys accident insurance. Another bank that sells the swap, acts as the default risk counterparty. As I described in an earlier post, that counterparty bank’s assumed risk is much like that of an insurance company covering a specific event risk.

In the case of credit default swaps, the event risk is a major bank becoming insolvent, and defaulting on its obligations. If the risk event being insured against does not happen, the CDS seller pockets the premium as profit. If the bank sells enough derivatives CDSs, this transaction can become very profitable.

What happens if the insurance buyer and seller are in the same line of business? What happens when the party being covered by a CDS insurance is also in the same line of business? In the last half-dozen years, commercial banks have been significant buyers and the sellers of credit default swaps. The buyers were buying protection from default by still other banks.

Because banks have taken out billions of credit default swaps with one another, banks have succeeded in becoming intermediaries of risk. If a major financial counter-party fails, what happens to the entire financial system? This financial crisis has amplified for us what I would consider as three basic laws of risk. There could be more, but let me focus of the three, and they all apply to what the CDS experience has come to demonstrate:

The 3 Laws of Risk

1. For every potential return created, we create an opposite potential risk. If banks wish to earn investment income, they need to engage in a financial transaction. The more transactions they entered, the greater the potential income and risk.

2. Risk, once created, cannot be destroyed or absolutely decreased (unless potential return is also decreased or given up). It can only be transferred, shared, or dispersed. As mentioned, banks managed their greatly increased credit risk by engaging in mortgage bond securitization and entering into CDSs.

3. In a system where risk has been shared and dispersed among interconnected institutions, any random adverse change in risk in any locality will adversely change the risk in other localities of the system. This is true of all kinds of risk, whether credit default risk, market risk, volatility risk, interest risk, currency risk, sovereign risk, or capitulation risk. They are all inter-connected. This is where the financial system is in now.

These three laws then lead us into extrapolating five major implications of risk on a financial system.

5 implications of risk on a financial system

1. Any firm trying to earn additional return by taking on the risk of another party, either by entering into a swap, selling an option, guarantee, or insurance to the other party, incurs a potential risk of loss that runs up to a maximum of the loss of the counterparty. AIG and Citibank, more than any others, have learned this the hard way.

2. Any firm that tries to hedge this risk by entering into a swap with another party only succeeds in transferring the original risk to another party. That’s what Lehman’s bondholders were successful in doing.

3. Worse, if each party in the chain that offers to be a counterparty in this risk management process tries to earn a minimal return on the transaction, it creates additional counterparty risk that was not there before. Hence the more firms involved in a chain of counterparty swaps and derivatives transactions, each trying to make a return for itself, the greater the resulting risk created in the system. Again, AIG and Citibank learned this the hard way. Hence, any and all returns earned from entering into these types of transactions should not paid out to employees or shareholders of the firms, but kept as capital buffer in the event of such systemic meltdown.

4. The more interconnected a system, and the more of these types of transactions it has, the greater the likelihood of a systemic meltdown. Due to risks of moral hazard, which includes potential need of a bailout by innocent taxpayers, inter-connected firms crucial to the continued functioning of the system should not be allowed to enter into derivative transactions. American taxpayers learning this the hard way now.

5. There is no such thing as a benign or risk-free environment. You can never create an environment where risk has been controlled or made benign. It only means risk has been put at rest. But the more risk is put at rest, the greater its potential blowup energy. You may only succeed in causing it to implode more fiercely, and in unexpected ways. This makes the case for having a centralized clearing house that more important. With a clearing house, we can better track where in the system risk is building up, and we can correspondingly require greater collateral protection before something unexpected blows up.

Economic growth will now have to come from real value creation. There is only so much growth that can come from shifting resources around. The latter is not sustainable as a stand alone source of growth. Risk comes with all value-creating activities.