The Dangerous Illusion That Risk Can Be Offloaded Onto Others

October 2, 2015

This confidence in central banks raises a pernicious systemic risk.

Do you drive carelessly because your auto is equipped with airbags? Perhaps not. But would you drive more cautiously if you were perched on the front bumper? If even the slightest collision would crush the driver's legs to pulp, I think it is safe to say we would all drive with a higher awareness of risk and with greater caution.

The faith that airbags and dashboards protect us in all conditions and times is misplaced. If vehicles were truly safe, how is it that 32,700 people lose their lives in vehicle accidents every year in the U.S. and hundreds of thousands of others are injured?

The risk, we are assured, is statistically low: "only" 21 Fatalities per 100,000 Licensed Drivers (practically zero, eh, except that it adds up to 32,700 people killed each year).

What statistics do not adequately describe, of course, is that most of those accidents occured in high-risk settings in which the drivers' focus and/or ability was impaired, even as they reckoned risk was managed/limited by the equipment, their safe driving record, etc.

In other words, the somewhat inebriated gent who slips behind the wheel on a dark rainy night senses the heightened danger; but reassured by the fact he's never been in a fatal accident, by his car's airbags, by the low statistical odds of getting killed, etc., he roars off into the unlit darkness. The odds of an accident in these conditions are much higher than the average listed in statistical abstracts, yet they are glossed over by the apparent "low odds" of the drive ending badly.

This is the Paradox of Risk: the more risk is apparently lowered, the higher the risk we are willing to accept. If the drunk wheeled off into the darkness on a bicycle, he probably wouldn't get far; he'd more than likely lose his balance and end up scuffed and sore but very much alive in a ditch. The real risks of navigating a dark road while impaired by alcohol are very much exposed on a bicycle.

Ironically, the real danger arises when the driver is reassured by "safety" features and past experiences which appear to limit risk or even make it disappear. This is the situation we find ourselves in today in global financial markets: the central banks are assumed to be the air bags of the system, limiting any losses to a few scratches rather than a complete wipe-out.

This confidence in central banks raises a pernicious systemic risk: assuming the "100-year flood" can't happen every 6 years or so. I have from time to time highly recommended The Misbehavior of Markets and now is the perfect time to check this book out, for the author, fractal pioneer Benoit Mandelbrot, explains in simple mathematical ways how Modern Portfolio Theory, i.e. the management of risk, is based on a faulty conception of risk and statistical chance.

In a nutshell: while modern portfolio management is statistically based (all those "standard deviations" you always see referenced in quantitiative analyses), the markets behave fractally. Fractals are known as the geometry of chaos, for they describe how seemingly stable systems can quickly, and unpredictably, degrade into chaos.

But as Mandelbrot explains, "100-year floods" actually occur with startling regularity in all markets. Put another way: you cannot disappear all risk with fancy statistical models and credit default swaps, etc., that offload the risk onto others, i.e. counterparties.

In other words, all you're really doing is masking the risk--you're not eliminating it. And in hiding the real risk, you are lulling the market participants into a pernicious choice architecture in which their willingness to take riskier and riskier actions is rewarded and encouraged, while caution is punished.

This is how you get a total systemic collapse of the entire choice architecture. And by this I mean not just the financial system, but the backstop provided by central banks and counterparties.

In a system that is now correlated to central bank policies, the idea that some counterparty will cover your losses is illusory. The entire notion that risk can be offloaded onto others is magical thinking: that when the system implodes, the counterparties will magically escape the highly correlated collapse.

This is another Paradox of Risk: central bank intervention/financial repression provides the illusion thay systemic risk has been disappeared, and this pushes all asset classes into correlation. The idea that some assets will escape the implosion is also illusory; what appeared uncorrelated can suddenly correlate overnight, destroying the entire fantasy that risk can be offloaded onto others.

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