07
Oct
10

Banks are about risk

Here’s an excellent meditation by Noah Millman on the question of “what are banks for?

The classic function of a bank is to turn savings into capital. They borrow from the public in the form of insured deposits. They then deploy this capital in the form of loans of various kinds. Their job, in other words, was to evaluate and hold risk – the risk of those loans. And for taking that risk, they earned a return.But in the world we actually live in, banks have labored to make themselves appear to be service businesses that earn fees rather than risk-taking businesses. Indeed, risk is a bad word – and remains a bad word with the financial reformers. The new job of banks, say both the banks themselves and their regulators, is to be financial intermediaries. They don’t lend money against a house as collateral; they intermediate between a mortgage borrower and an investor in a mortgage-backed security. They don’t lend money to a business; they intermediate between a company looking to borrow money and an investor in a collateralized loan security. They don’t even take deposits; rather, the intermediate between short-term corporate borrowers and investors looking for near-cash instruments. And of course they intermediate between the various participants, hedgers and speculators, in the wide variety of over-the-counter derivatives markets.

Millman goes on to talk about the hidden sources of risk in, for example, Citigroup’s subprime CDO portfolio management.  He comments that the current obsession with reducing risk wherever it can be found only serves to push that risk into places where it’s hidden and hard to measure — boy did that turn out well in 2008 — and that simple, easily-assessed portfolios are more robust than complex ones that’re carefully crafted to avoid triggering any of the risk criteria enshrined in regulation.

What we have now is a financial system that is leveraged to risk modeling to an enormous degree, and what we’re basically doing is doubling down on that bet right after it failed in the most massive fashion. We are trying to “get the risk right” and to stop banks from taking overly risky bets in the future. But you can’t get the risk “right” – not in the only sense that matters, namely, when the next crisis will hit and how a particular book will behave when it does.

It seems to me that if we’re trying to avoid similar crises in the future, what we need to incentivize is not the elimination of risk but rather the simplification of the banks’ books. We don’t need to increase the capital charges on low-rated bonds and loans – we need to increase the capital charges on high-rated bonds with embedded derivatives, on derivatives counterparty risk, and so forth.

[…]

If the incentives are strong to eliminate residual risk that is impossible to measure, it will be much harder for banks to make money by pushing risk out into the tails of the distribution. They’ll have to go back to making money the old fashioned way: by lending it to the real economy. Which will mean taking risk. But it’s risk that we can see. And it’s risk that produces some social benefit, by actually turning deposits into capital. Which is what the banks exist to do in the first place.

If you think we’re going to get anywhere close to that ideal, you’re a lot more optimistic than I am.

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3 Responses to “Banks are about risk”


  1. October 10, 2010 at 19:43

    Another problem related to banks selling themselves as a service industry is that there is a large and growing sector of the populace who truly believe that interest rates are a kind of calculated way of screwing people over rather than a way of (at least allegedly) insuring the risks represented by the loans they make.

    I had an argument yesterday with a smart person who cannot understand why those evil banks can’t just renegotiate all those problem loans and make them go away. The fact that a half percent of interest could mean the difference between a lending institution remaining solvent or having to close its doors made no sense to her. Because she sees interest purely as a service fee, as pure profit – she thinks that as long as they’re making some interest, banks should be rolling in dough.

    • October 10, 2010 at 20:19

      Oy.

      Interest rates are mostly about risk, but they’re also mostly out of the banks’ hands: particularly on things like problem mortgages, interest rates are how investment bankers (read: pension funds) fulfill their contractual obligations. I’m guessing that this person didn’t make a connection between “bank lowers interest rate on mortgage” and “granny has to eat cat food for dinner because her pension went bust”, either.

  2. October 10, 2010 at 20:35

    ‘Course not.

    This is another one of the many subjects that make me want to line up all the sleaze-bag politicians and media hacks who’ve twisted them to suit their own self-interest in front a firing squad.

    These really are not terribly complex issues but because the facts around them have been so horribly twisted and bastardized by sources people still, for some reason, trust – they are unwilling to embrace reality.

    And it scares me…


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