Until regulators get as smart as the City, we will be stuck with political solutions to financial problemsby Mark Hannam / November 25, 2007 / Leave a comment
Confusion of the incidental with the essential has been characteristic of much recent media coverage of the financial markets. More concerned with breaking stories than with telling them properly, and with assigning blame rather than explaining cause and motive, financial journalists have struggled to provide a coherent account to their non-expert audiences of the repricing of risk premiums.
It is not surprising that the public remains in the dark when it comes to financial risk. Risk issues are hard to explain to people who lack knowledge of mathematics and statistics. Debates about immunisation, nuclear energy and train safety, for example, all suffer from the low level of risk literacy among the public. Discussion of financial matters is likewise conducted under a veil of ignorance.
Most people do not check the credit ratings of banks before making deposits, nor do they read annual accounts, nor do they consult the FSA website, let alone the small print of their bank’s terms and conditions. When someone withdraws money from his bank because he does not trust the Bank of England’s promise that his savings are safe, he forgets that the £20 notes he has hidden under his floorboards are valueless scraps of paper, except for the promise made by the Bank of England to pay the bearer on demand the sum of £20.
Not everyone who works in the City is fluent in finance, but many of the more numerate people in our society choose to make their living by working in finance. Understanding and managing risk is central to the working lives of such individuals. Whether they are involved in originating financial investments, researching and rating them, trading them or buying them for themselves or for others, in each case they are obliged to know what risks they are running and whether these are appropriate to their level of responsibility and their appetite for risk.
It is the management of risk, not the reduction of risk, that preoccupies the best minds in the City. Risk, technically, is the standard deviation of the historical returns for a given investment; and the risk premium is the financial return this investment provides to its owner over time. The only way to achieve zero risk is to settle for zero returns on a consistent basis, which is as poor a strategy in finance as it is in life. So the relevant questions are these: what…