Tuesday, November 22, 2011

What is the contribution of the financial sector?

The Bank of England's Andy Haldane and Vasileios Madouros published an interesting column on VoxEU in which they asked "what is the contribution of the financial sector?"

Specifically, they focus on the distinction between risk-taking and risk management.

They observe that if risk-taking were a value-added activity,
Russian roulette players would contribute disproportionately to global welfare.
Risk-management, on the other hand, is a value-added activity.
The financial system provides a number of services to the wider economy, including payment and transaction services to depositors and borrowers; intermediation services by transforming deposits into funding for households, companies or governments; and risk transfer and insurance services. 
In doing so, financial intermediaries take on risk. For example, when they finance long-term loans to companies using short-term deposits from households, banks assume liquidity risk. And when they extend mortgages to households, they take on credit risk. 
But bearing risk is not, by itself, a productive activity. The act of investing capital in a risky asset is a fundamental feature of capital markets. For example, a retail investor that purchases bonds issued by a company is bearing risk, but not contributing so much as a cent to measured economic activity. Similarly, a household that decides to use all of its liquid deposits to purchase a house, instead of borrowing some money from the bank and keeping some of its deposits with the bank, is bearing liquidity risk....
What is a demonstrably productive economic activity is the management of risk. Banks use labour and capital to screen borrowers, assess their creditworthiness and monitor them. And they spend resources to assess their vulnerability to liquidity shocks arising from the maturity mismatches on their balance sheets. Customers, in turn, remunerate banks for these productive services.
Risk management is not solely the province of banks.  All market participants are suppose to manage their risks.

The key to managing risk is access to all the useful, relevant information in an appropriate, timely manner.

Without this data, there is no way to assess the risk of a given exposure.

Regular readers know that the current level of opacity engulfing structured finance securities and banks is similar to not seeing the bullet chambers while playing Russian Roulette.  Buying these securities is not investing, but rather blindly taking risk.

Risk management is like playing Russian Roulette, but being able to see if there is a bullet in the chamber and stopping before the trigger is pulled.

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