Risk Assessment

[GGard97342@xxxxxx]

In a message dated 06/02/2000 19:10:40 GMT Standard Time, hliu@xxxxxxxxxxxxxx
writes:

> There is a serious problem of the systemic socialization of risk
>  through structured finance.

Henry's remarks are all very true.

"Risk management" is a form of insurance, and the principle of insurance is
to spread risk widely, over as many people as possible, and over time. But it
can have the opposite effect, though notionally doing what it is supposed to.

Let me illustrate by another example to add to Henry's.

The most popular investment for ordinary people in Britain has been the
building society deposit. This meant that money flowed into institutions
which were ring-fenced from investing it in anything other than mortgages on
domestic property. The Societies got far more money than they knew what to do
with. One of their ploys to get rid of it was to was to push endowment
mortgages at the expense of repayment mortgages. Endowment mortgages went
from one per cent of the market to 80 per cent. But inevitably the societies
began to see the one hundred per cent mortgage as another way to get shot of
the funds. To protect themselves they insisted that mortgagors borrowing more
than 70 per cent should insure against the risk of not being able to pay.
(The lenders arranged the insurance and collected commission, as they did too
on the life policies backing the endowment mortgages.)

The public got over borrowed and started to consolidate. The housing market
went belly up, and house prices in London fell 40 per cent. Suddenly there
were hundreds of thousands of claims on the insurance policies, whereas in
most years there were next to none. Far from being spread, and insurance risk
had been enormously concentrated in time. Moreover the societies had used
just a few insurers. One very large insurer suffered an enormous set-back.

Second point: (I may have made this point before; apologies if I have.)

If the derivatives market were properly conducted it would follow the
principles of the second oldest profession, the bookmakers. Henry comments
that the counterparty to every derivative owner is a speculator. A bookmaker
hates to speculate. He balances his book, and lays off any excess position.
The bookmaker makes his profit by fixing the odds in his favour, not by
taking a position. The derivatives market should be run on the same lines,
with commissions providing the income. The "speculator" who is the
counterparty does not need to be a financial institution, whose downfall
would be catastrophic.

But the banks were greedy, and sought, I was told by an official of RBS,
permission from the Bank for International Settlements to take positions.
They wanted to ignore the wisdom of the ages as learnt by bookmakers. The BIS
spent years debating what reserves a bank should hold in respect of
derivatives business, and finally came up with the Mark II version of the
Basle Accord. It came into effect on 1st January 1998.

The Basle Accord Mark I of 1988, which came into full effect in Fiscal 1993,
caused problems for Japanese banks in particular, and it is easy to suspect
that Mark II also caught Far Eastern banks light on reserves, and remedial
action had to be taken in advance of the date of implementation, probably in
the form of some retrenchment in activity. So just before the due date the
foreign exchange market crashed, (just as the land market crashed in Japan
after Mark I). The Mark II Accord has a killer clause in it with regard to
recent risks, and the halving of the Korean Won must have been devastating.

The Japanese Government reacted to the crisis by suspending the
implementation of Basle Mark II.

I am retired and not in a position to research fully the truth of these
suppositions. Could not a few young economists be persuaded to get away from
putting inaccurate data into computerised emulations based on dodgy
assumptions, and do some urgent and worthwhile and wholly practical research
on the implementation of the Basle Accords? One suspects that far too many
entrants to economics faculties are failed mathematicians anxious to find a
use within economics for sophisticated but unrealistic mathematical
techniques.

Keynes was a mathematician by origin, twelfth Wrangler in his year, but he
seems to have recognised the limitations and was dismissive of his disciples
who did not.

"There have been have been three great inventions since the beginning of
time: fire, the wheel and central banking." (Will Rogers.) Is the BIS is the
paradigm of central banking?

Geoffrey Gardiner