Sunday 22 October 2017

You can't regulate away risk and we will pay a high price for attempting to do so

SINCE the onset of the global financial crisis in 2008, 'risk aversion' has become the catchphrase of many when talking about the financial sector.

But has the emphasis on risk aversion done anything to get us out of the mess we are in?

It has not.

Everything in life involves risk and throughout history those who have taken risks in a controlled way have been well rewarded.

The current attitude towards risk has already produced some serious consequences and is in danger of causing even greater ones, not just to financial markets, but to society in general.

Risk aversion causes deflation as people either do not invest or they invest in low yielding so-called 'safe' assets. This causes asset prices to fall and then languish, as can be seen in the prices of shares on the stock markets.

Putting cash into low-interest assets, such as deposit accounts in banks, means that little extra income is earned and so demand for goods and services in the future will not grow very much.

Of course, investment bubbles in different assets and their eventual bursting occur often, but avoiding these by putting cash into low-yielding assets such as government bonds -- mainly German, UK and US government bonds -- is not a way of avoiding bubbles.

Assets

The price of these assets has gone up considerably and they are now in bubble territory themselves. A massive sell-off of these could be severe.

There is simply no such thing as a risk-free asset as the eurozone bond markets have shown. Risk levels change and sometime low-risk assets can become high-risk ones.

Poor risk regulation in the past is now replaced by more intensive risk regulation. At least this was the intention.

But, as has happened in the past when regulators become aware of market problems (usually far too late), they then impose rules to make investors sell certain types of assets which means they have to all pile into ones the regulators consider to be safe.

This, in turn can create a bubble in the low-risk asset.

This happened in the early 2000s when regulators decided it was dangerous for pension funds and insurance companies to invest in stock market shares, so forcing these two industries to seek yields in other assets, such as in the credit markets. This created a bubble that eventually burst.

These two industries then went on to invest in low-yielding government bonds that will not yield enough to pay their long-term liabilities.

Also, risk-averting activity by regulators leads to low volumes as investors stop trading, which makes investing more difficult for those who still want to invest.

This is because for investors to implement their investment strategies they require other market participants to trade with them.

For example, if an investor is currently looking to build a position in a certain stock and there is no one willing to sell to him, it makes it very difficult to implement the position.

A further consequence of low market volume from risk aversion is increased volatility. Volatility in thin markets increases as many investors hold back, only to move into the market when a good opportunity seems to present itself.

Movements

As everyone piles in, extreme market movements are the result. This has occurred on numerous occasions over recent years as the EU has announced new ways to tackle the eurozone debt crisis.

In the lead-up to various EU summits, trading volumes are very much reduced and then suddenly as new measures are announced there is a surge in trading activity leading to increased volatility.

Regulation is definitely required, given some of the abuses we have experienced. However, regulation must become a lot more inclusive.

Investors should have a much more powerful position in deciding how the industry is regulated. Allowing politicians to have an excessive influence in financial regulation is wrong.

Politicians are not investment professionals. The main concern of politicians is getting re-elected.

What can be seen is that risk aversion is generally driven by forces that lack investment and market knowledge i.e. it is driven by risk-adverse regulators.

Investors should be allowed to invest, based on their own views and experience. A good investor will understand the risks that they are taking and make investments in a risk-controlled way.

Poor investors who do not understand risk will be taken out of the market due to underperformance and losses.

Mark Ridgway is the founder of Dublin-based Granite Hills Investments Granitehillsinvestments.com.

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