Ways to Reduce Risk in the Globalised Financial Markets

Consider this. A person wants to achieve a particular goal. He invests his resources in the way of time, effort, and money, to achieve that goal. But, because there are many uncontrollable external factors affecting the outcome, he cannot be sure that his investments will lead him to his goal. So, if he does not reach his goal despite his investments of time, effort, and money, his investments will be worthless. The chance that this may happen is “risk”. Thus, in order to reduce risk, he must predict the uncontrollable external factors better and align his efforts accordingly. And that can be done by acquiring more information on the external factors.

Financial risk enters the economic system when companies decide to make financial investments in their businesses. These companies face the risk of losing the invested money, if their investments do not meet their goals. This risk is the fundamental financial risk of the economic system. All the other financial risks are “derived” from this risk. The risk that shares, bonds, mutual funds, loans, insurances, reinsurances, securitised debt obligations, commercial papers, and the more exotic instruments face is that the business investments that their money is ultimately funding might not meet their goals. For example, financial risk in the system may flow from the investing company, to the bank that lent it the money to make that investment, to the insurer that insured the bank’s loan, and finally to the shareholders of the reinsurer that reinsured the insurer’s insurance. And if the government bails out the reinsurer from its troubles, it simply passes on the cost to the taxpayers. But, in the very end, somebody has to bear the risk and pay the cost.

As mentioned above, in order to reduce risk, one must predict the uncontrollable external factors better and that can be done by acquiring more information on the external factors. In today’s globalised financial markets, four things complicate that process.

First, as risk flows from one entity to another in the financial system, as illustrated in the example above, it becomes more difficult to measure, especially for the entities that are farther in the chain. As the investing company is directly involved in the business project, it has the most amount of information about the risks associated with that project. But the successive entities have a decreasing amount of information about the same. Thus, they cannot predict the risk well.

Second, through a discipline named “financial engineering”, many financial institutions have been able to create mind-bogglingly complicated financial instruments by “mixing-and-matching” and “slicing-and-dicing” the underlying assets. Many a times these “assets” are nothing but some loans, such as subprime mortgages. It is arguable that the people that buy these exotic instruments have no idea about what they are really buying. Which leads to a scenario where nobody has any idea about which business investment his money is ultimately financing. And if you have no idea about what you are investing in, how would you calculate the risks associated with it?

Third, the actual risk gets exaggerated through the practice of speculation. Things may not be really bad, but the fear of losing money makes people overly cautious, which starts a self-feeding cycle that makes things worse. It’s akin to a bank-run, where a false rumour that a bank will go bust leads to a disproportionately large number of people claiming their deposits with the bank, which results in the bank actually going bust.

Fourth, and perhaps the most important thing that complicates the process of risk calculation, is that the financial returns to the individuals and the institutions “managing” the moneys are disassociated with the financial returns to the individuals and institutions that actually “own” the moneys, aka the end investors. For example, the returns that the asset management companies and their managers earn are completely disassociated with the returns that are earned by the investors employing their services. This leads to a moral hazard on the part of the asset management companies and their managers, where they start focusing on maximising their benefits as opposed to their clients’.

For these problems, I propose two solutions that will reduce the risks in today’s globalised financial markets.

First, instead of paying the financial institutions and their managers the same amount of money irrespective of their performance, decide a percentage of commission and pay them exactly as per the rate of return that they have earned on the funds managed by them. Financial companies and their employees would be a lot more responsible in making decisions about the funds they manage if their own livelihoods were at stake.

Second, create a stabilisation fund for each individual market. The amount of money in each of these individual stabilisation funds should be a pre-defined percentage of the total size of the respective markets. The percentage for each market should be decided separately, based on the amount of volatility that market experiences. This fund should be employed in the market when its regulators think that a speculative “bank-run” type situation has kicked in the market. This measure will greatly help in avoiding the collapse of financial markets and in providing security to the investors. The money for such a fund should be pooled in from the market participants themselves, on the basis of the fairness principle.

The above mentioned solutions strike at the roots of the problems facing today’s global financial markets , viz. inaccurate decision making by the employees of financial institutions because of the lack of an efficient reward system and high volatility in most financial markets because of the lack of a sane and stabilising player. I speculate that these solutions will help combat the issues effectively.