The True Sources of Risk
Avinash Persaud writes,
Credit risk is best hedged through diversification across uncorrelated credits. Liquidity risk is best hedged through diversification across time. Market risk is best hedged through a combination of diversification across assets and time (having time to decide when to sell). In the past, risks of similar statistical magnitudes were considered fungible and simply flowed to whoever was prepared to pay for it. But while banks with short-term funding and many branches originating different loans have a deep capacity for holding credit risks, they have a limited capacity for holding market risks and little capacity for holding liquidity risk. Insurance companies and pension funds on the other hand have limited capacity for credit risk, but more for market and liquidity risks.
I could have excerpted much of the essay. Read the whole thing. Thanks to Mark Thoma for the pointer.
One of Persaud’s points is that if you look at risk from a statistical perspective, then it does not appear that any institution has a comparative advantage in bearing a particular risk. However, from a structural perspective, some institutions do have an advantage.
My view is that the fundamental risks, such as business cycle risk, interest-rate risk, currency risk, and so on, are inescapable. However, regulatory incentives affect both the aggregate exposure and the concentration of exposure.
Incidentally, Persaud mentions that bank size is not a risk issue, but it is a politcal economy issue. That echoes my own view.