Jorge Luis Borges was a great writer whose writings were succinct and full of deep insights, woven around a wry sense of humor on some occasions. His ‘book’ titled Labyrinths is actually a collection of short essays – a must read. He could never understand why people wrote massive tomes. Inspired by his views, I look at topics which can be expressed short.
Let us start with a seemingly simple observation – management of risks means that someone is willing to bear risks accruing to another. Most people think of risk management as a function alone. While it is certainly that, it is much more, especially in the case of financial risk management, where it is a basket of financial products that help manage risks, whether it is a credit default swap, a swaption, a securitized product (simple or complex) and so on. While the sheer breadth of such products is fascinating, what holds our interest here is the fact they are products. And products need buyers.
People who buy financial products do so because it fetches them a return. It is no different in the case of financial products meant for managing some risks for some people. In the case we are discussing, the buyers are invariably institutions although there may be some high net worth individuals. These are typically well informed buyers who will invariably have a body of researchers who help decide what and whether to buy – invest.
Not to labour the obvious, anyone designing such products has to keep in mind this, as the cycle is not complete without buyers (investors). However, such investors – some of them giant companies – usually have many options for investing their funds, constantly looking for better returns, in sync with risk undertaken. Thus, any risk management product has to address someone’s risk and another’s risk appetite. Sounds strange? Actually quite normal. This is how this business is run and much of the controversies and complaints arise from this core aspect.
Anyone even cursorily aware of the housing mortgage collapse in 2008 and after in the US (and elsewhere) will be familiar with the scenario which combines banks keen to get some risks off their books with hungry investors looking for better returns for their investible funds. Yes, there was a massive malfeasance here but the principal dimension is the same – you can only design a financial risk management product by incorporating someone else’s risk appetite.
