When risk becomes uncertainty

Literature on finance makes a distinction between risk and uncertainty. Uncertainty is imprecise knowledge about future events. On the other hand, risk is that kind of uncertainty which can be systematically assessed through reasonably reliable probability distribution of the outcomes, and therefore measured and priced.

To give a non-financial example, the possibility of the recurrence of floods like those experienced in Mumbai on July 26, 2005, is an "uncertainty"; on the other hand, whether lakes providing water supply to Mumbai will be filled up or not by the monsoon rains, is a "risk".

The former was a unique event and hence not capable of being subjected to probability analysis; on the other hand, the possibility of the latter event can be measured since Mumbai has rainfall data going back 150 years. What has happened on the world financial markets during the last few weeks, starting with the crisis in the sub-prime mortgage market in the US, is, in many ways, an example of measurable risk suddenly converting itself into uncertainty, thanks to loss of confidence and liquidity in the market.

While, at the time of writing, markets are regaining a measure of stability and normalcy, the incident has thrown several interesting issues:

• Is the dividing line between banks, insofar as their "trading" activities go, and hedge funds, vanishing?
• Why have so many European commercial banks been engulfed in the fallout from the sub-prime crisis, which has, broadly speaking, left most of the American commercial banks unscathed?
• Whether structured finance plays a useful role in the economy, for example, by making funding available to borrowers who may not otherwise get it?
• The weaknesses of computerised trading algorithms, as manifested during recent weeks;
• The role and limitations of rating companies; and
• How quickly contagion spreads from a bad debt problem in one segment of the US credit market to engulf the world financial system.

Before looking at these issues in some detail (in subsequent articles), it is as well to keep one perspective in mind: as may be recalled, the mayhem started with defaults in the sub-prime mortgage market in the US. Many of these loans had been marketed by brokers to earn fees, regardless of the paying capacity of the borrower.

The lenders had little hesitation in giving the money, safe in the knowledge that the loans would remain on their books only for a short time, before they securitise and pass on the risk to somebody else. Adjustable rates, zero or little documentation (about the borrower's income or loan servicing ability), and so on, are manifestations of this.

Should the real economy suffer because of the greed of a few in the financial services industry, that would be really sad.

To my mind, financial services should be facilitators and servants of the real economy, and not the other way round. I sometimes wonder whether the whole economic value system has been perverted when "Paper shufflers are doing better than producers; speculators are doing better than managers; traders are doing better than entrepreneurs; arbitrageurs are doing better than accumulators; the clever are doing better than the solid; and behind all of it, the financial market is more powerful than the state." (J Bradford DeLong, University of California at Berkeley, The Economic Times, August 13, 2007).

DeLong himself does not think so, but believes that better regulation of financial markets is called for. He quotes, but obviously does not subscribe to, the injunctions, in both Christianity and Islam, against making money from money. I personally remain an agnostic about the possibility of all of us making a good living by selling ever more complex derivatives to each other.

Derivatives hurting rather than helping the underlying real economy does not seem to be a very benevolent phenomenon. Was it not Warren Buffet who called them WMDs? Even as we worry about whether the Sensex will go up or down, as vultures circle to buy the foreclosed properties, we should also spare a thought for the tens of thousands of sub-prime borrowers thrown out of their houses by the defaults on loans marketed to them on the lure of ever increasing property prices.

Tailpiece: Some thoughts on the Left-PM confrontation. When will we recognise that any international agreement, whether multilateral like the WTO, or bilateral with Pakistan that military aircraft will remain within x-miles of the border, involves a loss of "sovereignty" and stop endless (and emotional) fussing about it. (We have the right to withdraw from any agreement if we feel that our interest will be better served.)

Second, one waits for the day when the Prime Minister takes an equally firm stand vis-a-vis the Left, on issues of economic policy.