To live, to love, to exist – all involve risk. Yet despite being so pervasive, risk is often misunderstood as separate from our objectives, as if it had an adjustable dial. It is now time for the financial industry to stop viewing risk as something to be avoided. Its ubiquity ought to be accepted and honored with a more comprehensive risk management approach.
Europe in particular is weighed down by excessive risk aversion when in fact risk taking needs to increase. This is not to recommend an ill-considered rush into high-risk investments. Rather, to allow for safer risk taking, we need to make risk capacity the new Holy Grail of financial resilience. This is the bedrock of sustainable economic growth and prudent behavior by financial firms.
Risk isn’t homogeneous. Liquidity risks, market risks and credit risks are different and require specific hedging approaches. They cannot be added up. To hedge liquidity risk – the risk that if forced to sell an asset now, one may have to accept a lower price – investors need time on their side, courtesy of long-term liabilities or long-term funding. The reverse is true for credit risks: the more time there is for a credit event to happen, the more likely it will. The trick here is to diversify across a variety of credit risks that are triggered by different events.
PLAY TO YOUR STRENGTHS
Yet market forces, such as an increasing reliance on market-funded instruments and the unintended consequences of regulation, drive the financial system towards buying and selling similar assets at the same time. Such herding is dangerous. To keep the financial system safe, we need to strengthen natural diversity in behavior based on natural capacities to absorb risks.
The financial system itself is heterogeneous by nature. Different firms and individuals have different risk capacities. What’s crucial is to tailor the right risk to the right institution: a life insurer or pension fund with long-term liabilities can absorb liquidity risk, but not credit risk. Long-term institutions should invest in long-term assets. Short-term institutions, with short-term funding or liabilities, should invest in liquid assets with credit risk, earning the credit risk, not the liquidity risk premia.
Seven years after one of the biggest financial crises, this is one of the lessons we still haven’t learned: no amount of capital is enough to make the financial system safe if firms take risks they do not have a natural capacity to absorb. If firms assume the right risk, however, they can still be safer.