Marginalizing risk.

AuthorSchwarcz, Steven L.

Table of Contents I. Introduction A. Dispersing Risk B. Market Failures II. Analysis A. First-Order Consequences 1. Information Failure 2. Model Failure 3. Human Processing Failure B. Second-Order Consequences 1. Information, Model, and Human Processing Failures 2. Collective Action Failures III. Solutions A. Should Government Attempt to Regulate the Problem? B. Designing Regulation 1. Regulating the Information, Model, and Human Processing Failures 2. Regulating the Collective Action Failures 3. Limiting Risk Dispersion IV. Conclusions I. Introduction

Risk dispersion, which is widespread in modern finance, is intended to reduce risk from the standpoint of any given investor. (1) Although conventional wisdom has been that risk dispersion is unambiguously good, this Article argues that it may not work in the face of hidden correlations and that it produces social costs that arise from weak monitoring. As a result, investors and other market participants underestimate and under-protect against risk, with few worrying about where dispersed risk goes or whether risk dispersion can impact the stability of financial markets. This "marginalization" of risk appears to have contributed, at least in part, to the recent financial crisis. (2)

This Article begins by examining the reasons for risk dispersion. The Article then analyzes why risk dispersion can, and sometimes does, marginalize risk. Finally, the Article examines whether government should attempt to regulate risk dispersion and, if so, how such regulation should be designed.

  1. Dispersing Risk

    Why does modern finance disperse risk? Finance can be broadly divided into debt finance and equity finance. (3) This Article focuses primarily on debt finance, (4) though its overall principles should theoretically have application to equity finance. (5) A major focus of debt finance (hereinafter, references to "finance" mean debt finance) is reducing risk on investments in order to reduce the interest rate on borrowed funds--thereby reducing a borrower's cost of funds. (6) Under modern finance theory, investors can protect themselves from risk by diversifying their investments. (7) To the extent risk is negatively correlated, or uncorrelated, with market risk, the randomly distributed risks of a diversified investment portfolio theoretically "would tend to cancel out, producing a riskless portfolio." (8)

    Investment risk, however, is often at least somewhat correlated with the market in which the investment is made. (9) For example, even if a particular company produces a uniquely valuable product, the company's stock price will be adversely affected in a collapse of the market in which that stock is traded. It therefore is desirable not only to diversify investments within a market but also to diversify investments across markets ideally seeking markets that are themselves uncorrelated with the risk of other markets. (10) Risk dispersion is an important way to diversify investments both within and across markets. (11)

    To understand why risk dispersion can diversify investments within markets, consider the relatively simple examples of loan syndication and sales of loan participations. Assume that a bank's customer needs to borrow $10 million. If the bank makes that loan, it would take on $10 million (plus interest) of investment risk, because the borrower may fail to repay. (12) A bank typically will reduce this risk by dispersing it, either by joining a lending syndicate whereby other banks share in making the loan, or by selling interests ("participations") in its loan to other banks. (13) For example, the bank may individually commit to lend only $2.5 million in a $10 million lending syndicate, (14) or it may lend the full $10 million but then sell participations in 75 percent ($7.5 million) of its loan to other banks. In either case, the bank will end up having more diversified investments than a $10 million loan to a single borrower. (15)

    In recent years, computerized mathematical models have facilitated even more sophisticated techniques of dispersing risk in order to diversify investments. Consider, for example, securitization markets, (16) in which risk is dispersed from owners of assets to investors in securities backed by those assets (so-called "asset-backed securities" or "ABS") and to other market participants who may guarantee those securities. (17) Within a given market, the asset-backed securities are divided not only into relatively small amounts but, more significantly, into multiple classes, or "tranches," with different repayment priorities. (18) Computers make it practical to track the underlying cash flows from the assets backing the securities and to allocate those cash flows to payment of the appropriate securities. (19) This range of risk dispersion not only helps investors diversify their investments and thereby reduce risk (20) but also, indirectly, maximizes the overall investor base. Because different investors have different risk profiles, (21) offering securities with different repayment priorities will attract a broader range of investors. (22)

    Diversifying investments across markets. Risk dispersion is also used to diversify investments across markets. Investors traditionally diversified their investments across markets by investing in both debt and equity securities. (23) But investments can also be diversified to some degree across "markets" by investing in debt securities with uncorrelated sources of payment. For example, ABS--in which risk is dispersed from owners of assets to investors in securities backed by those assets and to other market participants guaranteeing those securities (24)--can be backed by virtually any type of predictable underlying payment source. (25) To the extent different underlying payment sources are uncorrelated, the investment risk on securities backed by those different payment sources will also be uncorrelated.

    For example, the source of payment of an ordinary corporate bond is the income of the bond's issuer. Most corporate issuers earn income by engaging in a business enterprise. Risk on corporate bonds is thus correlated with the industry sectors of their issuers. (26) Business activity can also be influenced by the economic environment, further correlating risk on corporate bonds with the economy of the regions in which the issuer does business. (27)

    ABS, however, can include sources of payment that are largely uncorrelated with ordinary corporate bonds and that, potentially, are also largely uncorrelated with other types of ABS. For example, risk on securities backed by a statistically diverse pool of consumer credit-card receivables should have little correlation with risk on bonds issued by a ship-building company. Similarly, risk on securities backed by consumer credit-card receivables should have little correlation with risk on securities backed by commercial mortgage loans.

    Part of the "art" of investment diversification, however, is determining the practical degree of correlations. It will never be zero. As the financial crisis has shown, some degree of correlation will always exist in a global economy. (28) Although investment diversification is a primary reason for dispersing risk, there are other reasons as well. For example, asymmetry in market information can be reduced--and risk more efficiently allocated--by shifting risk on financial assets to investors and other market participants (such as third-party credit enhancers) who are better able to assess the risk. (29) Risk dispersion, therefore, can create benefits. However, the following discussion shows how risk dispersion can create market failures that, among other harms, cause market participants to misjudge or ignore potential correlations.

  2. Market Failures

    Risk dispersion causes market participants to pay less attention to the retained risk. This is reasonable to the extent the lower level of attention is proportionate to the lower level of risk. But risk dispersion can also lead to market failures, causing market participants to underestimate and under-protect against risk. (30) For example, prior to the financial crisis investors believed that ABS provided an investment market that was uncorrelated with traditional debt markets (31) and that, even within the ABS market, many investments were diversified. (32) But when ABS investments backed by subprime mortgage loans began defaulting, other ABS investments backed by other types of assets began defaulting as well. (33) Few had seen the correlation between the subprime mortgage loans and those other assets. (34) The marginalization of risk caused by risk dispersion appears to have made investors and other market participants insufficiently diligent to recognize or worry about this correlation. (35)

    Moreover, when the ABS market collapsed, its collapse impacted other debt markets. Although the ABS market had been seen as uncorrelated with ordinary debt markets (like bonds and commercial paper), (36) there was a correlation: most debt securities--even ABS--are rated by rating agencies. (37) When investors lost faith in the ratings of ABS, their loss of faith extended to the ratings of all debt securities. (38) Again, the marginalization of risk caused by risk dispersion appears to have made investors and other market participants insufficiently diligent to recognize, or at least to appreciate the significance of, this second correlation. (39)

    Consequences of Marginalization. Marginalization of risk can have two orders of consequences. First-order consequences would be harm only to the market participants that underestimate and under-protect against the risk. (40) Second-order consequences would be harm that extends beyond (although it may include) those parties--such as harm resulting from a financial crisis or systemic collapse that is caused in whole or in part by a market participant under-protecting against the risk. Thus, first-order consequences would arise if a...

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT