Friday, June 11, 2010

Co-locating Risk and Rewards

If risks and rewards are not located at the same place it indicates that the system is broken. In a fundamentally sound system, higher risks yield higher rewards while lower risks yield lower returns. Stability and resilience of earnings or profits is characteristic of lower risks. High risk earnings tend to be volatile. However, when a sector gets stable high earnings without as much volatility we must conclude that system is broken. This is typical of financial system. 

The risks are being accumulated at government agencies while rewards will be released privately. It is one of the reason why Too-big-to-fail was a hazard. In simple words, TBTF held governments hostage forcing a transfer of risks and penalties to the public system. 

Firms routinely exercise strategies and tactics to shift risk out of the firms domain while retaining the rewards within the firms' domain. This, to my mind, is the goal of the bargaining power struggle well characterized by Michael Porter. Porter also suggested, as I interpret, that the system will stabilize at the point of fairness.

A fair firm is one that has returns in line with the risk it takes. It is able to take such risks because of knowledge and understanding of the process. However, through regulation and other intervention, it is possible to tip the bargaining power dynamics one way or other. I believe that is exactly what led to current crisis.

A crisis-detection system should use this property to flag potential crisis.