A philosophical dialogue on financial risk: the (dis)illusion of a singular meaning

by | 7 Mar 2016

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?
Escher relativity

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.

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