3 Laws of risk - 2012 Edition

The European crisis is escalating, and it seems credit default swaps will once again become a transmission agent of crisis to many parts of the financial system. It's time once again to revisit an old post from 2008, now updated with the latest understanding of how this CDS  crisis may play out this time around among the banks. Links courtesy of Bloomberg and Zero Hedge.

The 3 Laws of Risk 

1. For every potential return created, we create an opposite potential risk. If banks wish to earn good income in this volatile environment, they need to be willing to take on risk. Why not sell CDS protection to the more risk-averse parties? Or at least, to those who think they need to rein in some risk.

2. Risk, once created, cannot be destroyed or absolutely decreased. In fact, systemic risk can be doubled just by sharing it with another party (via CDS), and can correspondingly multiply system-wide with the amount of parties involved.

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. They are all inter-connected. And all it takes is one party in the chain to not make good on its promise to pay, and many hedges become non-existent. Thus, any additional risk positions entered into by a party, on the expectation that that position had been hedged (with the defaulting counterparty), transforms into pure additional risk for that party. Hence, this party is potentially the next link in the chain to break, and to transfer the additional risk on to its own counterparties, who may have also entered into even more risk positions of their own, with the understanding that they too had been hedged.

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 that tries to hedge its risk by entering into a swap with another party only succeeds in transferring the original risk to another party. Any firm that expects all of its hedges to hold in a large systemic crisis could end up with all obligations corresponding to that now worthless hedge, plus any additional obligations where it agreed to be the counterparty to another party trying to hedge its own risk.

2. Any firm that tries to take on incremental risk, any of which is greater than its capacity to bear, on the assumption that the additional risk will be hedged, could end up with excess obligations corresponding to that excess risk, once its hedging counterparty to that risk defaults. Any obligations it is unable to meet transfers risk to its counterparties, who now have more risk, and much less solid position, than they previously thought.

3. Each party in the chain that offers to be a counterparty creates additional counterparty risk that was not there before. Hence the more firms involved in a chain of counterparty swaps and derivatives transactions, the greater the resulting risk created in the system, since each counterparty could be the weak link  that starts to unravel the whole chain.

4. The more interconnected a system, and the more of these types of transactions it has, the greater the likelihood of a systemic meltdown. 

5. There is no such thing as a benign or risk-free environment. You can never create an environment where systemic risk has been controlled or made benign by hedging. It only means risk has been put at rest. But the more risk is put at rest, the greater its potential blowup energy, especially if it masks the excess risks that individual parties took that they, individually, could not meet themselves. You may have only succeeded in causing it to implode more fiercely, once the bubble chain starts to unravel.