Allocating risk

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The next topic is what I call
risk allocation.

Maybe the most important thing to get
is that risk typically does not disappear.

Financial intermediaries typically
don't just dissolve risk

and make it go away.

What they do is allocate risk,

and they might allocate risk away from
certain individual savers

but ultimately other people,

whether they're bondholders,
or shareholders, or taxpayers,

will end up bearing risk.

So they're mostly in
the business of risk allocation.

They can dissolve risk
or dissolve some risk --

through diversification.

For example, --

let's say that we have savers
who want short-term --

short-term assets.

Ideally, they can withdraw
their money at any time,

but, not every saver wants
their money now, --

or money at any one time.

Then, if you're a bank
with a diversified set of savers,

you can invest in long-term assets, --

maybe not 30-year assets,
maybe five-year assets, whatever,

and issue --

short-term liabilities and count on
not every saver coming

into your bank and asking
for a withdrawal at the same time.

So, by having
a diversified group of savers;

not every saver wants
money at the same time;

you can acquire long-term assets,

back them by short-term liabilities,

and thereby, almost achieve
a sort of a magic,

of making the term risk

or the liquidity risk
go away by diversifying,

whereas if you were a bank
with just one saver,

and that saver could
withdraw money at any time,

then you couldn't
safely invest in long-term assets

because that saver might walk in tomorrow
and want their money back,

and then you're stuck with
the money in long-term assets.

So there's a little bit of diversification
that you get from having many savers --

funding at the same time,

and it doesn't necessarily have to be
on the terms of a demand deposit

where they can immediately get their money,
you can also imagine this with --

three months' certificates of deposit
as a savings vehicle

and five-year bonds as the assets
that the intermediary holds.

So you get some advantage
of diversification on liquidity risk,

you also get some advantage of
diversification on default risk.

So if I have many mortgage loans, --

the chances of my losing,
you know, 80 to 90%, --

or even 50% of my investment, is much less
than if I just have one mortgage loan.

And so, the more
geographic diversification

and other forms of
diversification we have, the better.

So again, diversification,
to some extent, --

allows you to offer
relatively low-risk liabilities --

where, even though
each asset has higher risk, --

because the collective portfolio
of these higher-risk assets, --

if it's diversified, --

is going to be of lower risk

than the risk of
an individual asset, of one asset.

So, diversification does allow you --

to reduce risk in some sense,
in the system.

But once you get beyond the ability
to reduce risk by diversification,

all you're doing is reallocating risk.

So, if the term risk in this mortgage;
remember, we have this weird 30-year,

completely flexible term, --

and let's say I offer a 10-year bond, --

and then the buyer of the 10-year bond
takes on a great deal of the term risk,

that is, they might prefer to get
their hands on the money right away,

and in fact, they have to wait 10 years,

so they're bearing some term risk.

But, then, if I'm the intermediary,
then my shareholders are bearing

the remainder of this risk,

the risk that the mortgage
will prepay earlier,

the risk that the person will keep
the mortgage beyond 10 years,

you know, all the way out to 30 years.

So this term risk can get reallocated
by issuing a 10-year bond;

it doesn't go away.

So kind of a naive and idealistic way
of thinking about financial intermediation

is that they find people
who are willing to bear the risk,

that they find better allocations of risk

by finding who is willing
to actually bear the risk.

But in a world of regulation

and in a world where there's often
some form of government protection,

either explicit or implicit,

this allocating risk can take, --

and also in a world where

a lot of people just don't understand
the risk they're taking,

and this includes
professional investors and executives,

a lot of times allocating risk amounts
to finding the weakest party to take it,

including the weakest link
in the regulatory chain.

So, often, the risk allocation process
amounts to finding the weakest link,

finding the business executive
who doesn't understand

the risk that he's putting
onto his shareholders

or find a way to put risk onto taxpayers

without regulators
knowing enough to stop it.

So, if there's a tendency for risk
to show up where it's least expected,

that's not entirely a surprise,

because there is this natural process
in which allocating risk

amounts to finding the weakest link.

So, we'll be talking a lot about that
in forthcoming lectures.