Financial Calamity As Banks Arguably Create More Risk By Ironically Managing Risks
Financial calamity as banks arguably create more risk by managing risks
There have been numerous amounts of attempts to mitigate risk, or furthermore insure against problems. Whilst these are fairly legitimate actions to take, the implements that allowed this scenario to occur, actually have contributed to the current problems in the financial market as well.
Essentially, what had happened was that mainstream lenders and banks had become over confident as they all came under the impression that they knew how to take on the inevitable risk and therefore make more money effectively. As these banks and lenders started to make more money with more risks, they reinforced their own view that they had figured out. They came to the conclusion that they had in fact spread their risks effectively, but in complete contrast, it all turned extremely bad. It was a combination of the system being heavily grounded with poor statistics, poor theories, misunderstanding of probability and ultimately greed.
What allowed this to happen?
Derivatives, financial futures, credit default swaps, and related instruments came out of the turmoil from the 1970s. The oil shock, the double-digit inflation in the US and a drop of 50% in the US stock market made businesses look harder for ways to manage risk and insure themselves more effectively. The finance industry started to embellish, as more people started to look into how to insure against the downside when investing in something. Economic geniuses came up with a so called formula of how to price an option The Black-Scholes model. This was a huge hit, once options became priced; it became much easier to trade. An entire new market in risk was born.
As people became more successful more quickly, they used derivatives not to condense their risk but to take on even more risk to theoretically make more money. Greed started to kick in. To a degree, people were making more speculative bets. A handful of companies were in fact investing in more risk on margin, meaning that you did not have to show correct full values in advance, which allowed people to make big profits and furthermore big losses.
Issue with Credit default!
The market for credit default swaps market was monumental, exceeding the entire worlds economic output of $50 trillion by the summer of 2008. The worlds largest insurance of financial services company (AIG), had severe credit default of close to $400 billion each time. This meant plenty of exposure with little regulation. The trade in these swaps have created an entire fresh interlink dependency chain, a very weak chain at that. The problem was that any loss or substantial risk would spread quickly. Derivatives were not the main reason for the modern financial meltdown, but it certainly contributed and sped up the process. These derivatives have redeveloped the financial market and it seems like this new development will be here to stay, because of the simple demand for insurance and aim to mitigate the risk.
Regardless of the positives of the market system, as everyone has come to accept for many years now, it is far from perfect. As well as other aspects, experts such as economists and psychologists think that the financial market is lacking a handful of human qualities. These things are the confirmation bias (continuously searching for facts to support your own view) and additionally the superiority bias (the belief that one is better than the others, or possibly better than the average and can make good decisions all the time). Attempting to control and use these human facets of human nature to improve the financial market seems a steep order, especially when costs are shooting up continuously and drastically at modern times.
by: Toby Fletcher
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Financial Calamity As Banks Arguably Create More Risk By Ironically Managing Risks