Daniele D’Alvia
Financial risk is a common term nowadays. It affects our life. It is the
main reason of our existence since the start of the contagion risk. It was in
2008 that one of the biggest financial institutions collapsed in America:
Lehman Brothers. Since that moment contagion risk has manifested widespread
effects on financial institutions, and legal risk has been tied up together
with financial risk.
Financial risk, legal risk, and contagion risk all refer
to one common concept: risk, but in relation to different connotations and
qualifications. However, it is not inside the multiplicity that one could find
the “truth”, but it is the same illusion of a singular meaning or disillusion
of different meanings that can provide the reader with a possible answer. To
state it plainly the main question is: what is risk and how the consequences of
financial risk can be prevented in particular?
The meaning of risk: one
single meaning or many qualifications of risk
In the first meaning #financial_risk is related to the risk an investor can face when he buys and sells
financial instruments. Contagion risk is connected in general to the possible
negative effects of dissolution or winding up procedures of companies, and in
particular financial institutions. In the end, legal risk is the most terrible
event or the best future possible, namely the possibility that the rule of law
is broken with a consequent turmoil that can lead to the risk of anarchy.
The discourse on risk from an
epistemological point of view can be complex. If there is risk, there must be
something unknown or that produce an unknown result. Hence, the knowledge about
risk is knowledge about lack of knowledge. The hendiadys of knowledge and lack
of knowledge constitute the central argument of the discourse on risk, but it
explains to a reader very few about the nature of risk and the reason of its
existence. In this light, sometimes the discourse on risk and the recognition
of that hendiadys can produce also a tautological argument on risk. Indeed, if
epistemology deals with the dissemination of knowledge in particular areas of
enquiry, in relation to risk it can be said that it is the same essence of
knowledge related to a lack of knowledge that constitutes a limit itself.
Hence, the risk should be
interpreted by questioning what risk is, and then by saying what the relations
and features to risk are. Furthermore, this approach can discover a new stage
of thinking from an ontological point of view. Indeed, risk under this new
light is the probability of occurrence of an event that may or may not occur.
To this end, the discourse on risk has a new meaning when the word “event” is
examined. This word comes from the ancient latin “e venio”, namely “it
derives from”. So, it is possible to state that the knowledge about risk is the
knowledge of a knowledgeable situation; it is the knowledge of a past
circumstance. Therefore, something is knowledgeable if we live enough in the
future to be capable of knowing the past.
On a time line the discourse
on risk is based on the past. It is a false argument the one, which identifies
risk in the future, because the risk is in the past. Only in this way the actor
of today, if we prefer the speculator can program his conduct in order to take
actions in the future, and consequently trying to be risk averse.
Therefore, the discourse on
risk from an ontological point of view has manifested the objective nature of
risk and it has led to the illusion that risk comprises of one single meaning.
In other words, the ontological meaning of risk is the most important in order
to understand the regulation of capital markets. In this fashion, if we look at
the meaning of risk in financial markets, the contagion risk that has spread
out through the current financial crisis is the result of the conducts of
unscrupulous managers and brokers. Past conducts that have influenced future
events. The financial risk is inside the regulation of financial instruments,
but the regulation of the latter is based on accommodating past circumstances
in order to better regulate them (i.e. regulation on derivatives,
financial innovations, etc.).
The legal risk is the assessment of judges who
made assumptions based on facts that occurred in the past. From that evaluation
there is the risk of a negative judgment.
The Objective vs. Subjective
connotations of risk in financial markets
As a paradox the discourse on
risk becomes more complicated when the ontological meaning of risk is exposed
in financial markets. Indeed, as it has been explained risk refers to an
objective status: the knowledge of the past circumstance, and
hence, the knowledge of a knowledgeable situation is not a subjective
impression. It is not a belief. By contrast, this statement reminds us of the
objective nature of risk in financial markets. The risk is objective and it is
always a “truth” and never a belief.
For this reason, the history
of risk on the time line starts in the past because it is the only moment that
is objective and truthful. The present is subjective and the future too distant
and uncertain. Even legal uncertainty is too subjective and distant to be
defined and assimilated to the conception of risk.
Nonetheless, economics and in
particular theoretical economics have understood that financial markets are not
only dominated by an objective conception of risk, but a subjective conception
of risk is still vital for their functioning. Indeed, financial speculation
(from Latin “speculum” – “mirror”) as opposed to investment is based on
a subjective belief in order to become profitable.
At least Keynes (1936) in
his famous book The General Theory of Employment, Interest and Money can
confirm this understanding by pointing out the difference between knowable in
principle and necessarily unknowable. What is knowable in principle refers to
our conception of risk, but the necessarily unknowable refers to this new
subjective feature of capital markets. On this point, Keynes compared the
financial markets to a beauty contest. Here the judges instead of focusing
their attention on the winner, therefore, on the most beautiful girl, try to
second-guess the opinion of other judges.
In the same fashion, in capital
markets the speculator tends to focus its efforts not on objective reality of
financial assets that are sold or offered on the market, but on the information
that other speculators will trade on in the near future. Hence, the evaluation
of financial assets is not only based on an assessment of past performance of
assets but on the uncertainty of the decision that will be taken by other
speculators. To state it plainly, the objective discourse on risk does not
apply alone in capital markets, because there will be always a subjective
component in the final decision of the speculator. Indeed, this trade on
information before somebody else trades on the same information is vital to
unwind positions early and it is also essential to set the price of the
financial asset[1].
In this
game the value of information for a speculator depends on the uncertain
behavior of another speculator (necessarily unknowable). In addition, because
the markets will always present a lack of perfect information (i.e. information
asymmetry) the value of the financial assets based on new information as well
as erroneous information might lead to mispriced assets. Hence, even a
speculator in good faith can affect the value of the financial assets in a
negative way. This is why supervision of financial markets is required, but
cannot definitively solve the issue.[2]
Final remarks
Risk is connatural to any
activity of human beings and it is the same concept of risk that can prevent
our conduct from being risky. Risk is a universal concept. However, we find in
capital markets the concept of manageable forms of risk that can reveal the
intimate essence of financial risk. To think about manageable forms of risk,
means to acknowledge that risk is located in the past and future events can be
influenced only by looking backwards, and not afterwards.
Nonetheless, this
objective dimension of risk is strictly related to the asset price, but does
not take into account how the price of the asset is determined. Hence, it is
only directed to the fundamental dimension of the asset (the knowable in
principle).
For this reason, supervision
of financial markets as well as the law in all its forms (i.e. soft law,
recommendations, regulations, etc.) are not the final answers to the regulation
of risk in financial markets. This is because they have to solve a subjective
issue that is derived from speculators’ actions by virtue of the implementation
of objective reforms. Having said that, a generally accepted principle in
corporate finance states: the higher the risk, the higher the returns.
The
connatural investment risk in financial assets is always counterbalanced by the
higher profit investors can make. This is the beauty of capital markets, but
also their obscure element of understanding. In the end, the illusion of one
single meaning of risk can be reflected in capital markets as the disillusion
of the existence of objective and subjective meanings of risk.
Daniele D’Alvia is a Ronnie Warrington Scholar at Birkbeck University of London,
where he gives lectures in comparative law and acts as a seminar tutor in
European Union law.
[1] M. K.
Brunnermeier, Asset pricing under Asymmetric Information, Bubbles, Crashes,
Technical Analysis, and Herding, OUP, 2001.
[2] C. Goodhart, The Evolution of Central Banks, The MIT Press, 1988.
[2] C. Goodhart, The Evolution of Central Banks, The MIT Press, 1988.
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