BANKING: by Jeffry Babb News Weekly
Financial risk, both a blessing and a curse
, August 4, 2012
The primary aim of Australia’s financial sector is the management of risk.
Risk is the potential that a chosen action or activity — including the choice of inaction — may lead to a loss. Like many financial terms, “risk” is derived from Italian, in this case, risco or rischio.
There is no such thing as a risk-free investment or a risk-free transaction. A bank covers the cost of its capital and deposits by charging interest and building up reserves as a hedge against loss. An insurance company will cover a risk by charging a premium and issuing a policy.
“Risk” originally described the banker’s exposure on a bill of exchange. Many financial terms come from Italian because the Italians, particularly the Florentines, were Europe’s pre-eminent bankers from the late Middle Ages until the Renaissance. Chief among the Florentine bankers were the Medicis, who ruled Florence in fact or name for some 300 years.
The Florentines in large part invented modern banking. The waning of the Middle Ages saw an explosion in trade. The Jews dominated banking in Europe up until the early Renaissance due to the prohibition of usury by the Catholic Church. Usury was defined as lending money at interest.
Jews were also prohibited from usury. But, according to the Jewish scriptures, as interpreted by the rabbis, Jews could not lend to other Jews, but could lend to strangers, whom they interpreted as being Christians.
With international trade booming, merchants needed trade finance, so the banks issued bills of exchange. By discounting these bills, the bankers could charge interest without appearing to do so.
Today, banks use bank bills in almost exactly the same way. Say you want to borrow $1,000 from XYZ Bank. The bank will sell you the bill, but you will actually get only $995. The $5 is the bank’s “risk”, or interest. The term “bill” comes from the Italian billette, or a note, a bill of exchange, a letter of formal exchange, and finally, a cheque.
In a financial sense, risk is the probability that an investment’s actual return will be different from that expected. So, a bank’s primary function is the management of risk.
Risk is both good and bad for a bank. If there were no risk, banks wouldn’t make any money. That is where their profit margin comes from. On the other hand, if they miscalculate their exposure to risk, they could lose money or even endanger themselves.
The term bank is also Italian, from banco or bench, from which a money-lender traded. If by some unhappy circumstance the bank failed, the bench would be broken. Breaking the insolvent banker’s bench was called banca rotta from which comes “bankrupt”.
So essentially, modern banking comes from two things — trade and the management of risk.
The Italians perfected banking as we know it today. They invented the deposit account, the line of credit and double-entry book keeping.
The Papacy, one of the most diversified and wealthy bodies of early modern Europe, needed the services of the bankers and insisted that, when money was lent “at a risk”, interest should be charged. After the Reformation, the prohibition against usury broke down quickly.
However, the great benefactions to the Church and the arts by the Medicis and other bankers can be largely attributed to the fact that they had a weight on their minds caused by the fact that, according to the Church’s doctrines, they were guilty of the sin of usury and wanted to make atonement.
Muslims are still banned from lending money at interest, but the “Islamic banks” have found ways around this prohibition.
The disastrous consequences of miscalculating risk were clearly seen in what has come to be known as the global financial crisis (GFC). In the old days, when you took out a mortgage, you paid it back to the bank over 20 years or so, and that was that.
When the American banks started making NINJA home loans (No Income, No Job, No Assets), the loans were sliced and diced into CDOs, or collatoralised debt obligations. They were confusing to the extent that even the bankers didn’t know what they were buying.
The ratings agencies — Standard and Poors, Fitch and Moody’s — gave the CDOs ratings which reassured investors that these CDOs were safe investments.
Some weren’t fooled. Warren Buffet, known as “the Sage of Omaha” for his brilliant investment record, called these highly complex financial products “financial instruments of mass destruction”.
The ratings agencies, supposedly the gatekeepers of the financial world, had failed at their job.
In Australia financial collapses of recent years have been due to roguery rather than the misjudgement of risk.
The Big Four Australian banks have made a major effort to source more deposits in Australia, but still rely on the international money markets for 20 per cent of their funding.
However, if the collapse of Lehmann Brothers, once a giant of Wall Street investment banking, taught us one thing, it is that even the biggest bank can’t survive if it loses the confidence of its peers.