The curious case of the risk floor April 28, 2013 at 5:08 pm

Karl Smith has a theory:

… lets imagine a simple model where we have two sources of risk. There is background you cannot avoid. And, there is personal risk that you create by through your own choices.

Policy makers have since Thomas Hobbes been attempting to drive down background risk. They have larger been successful. As a result our lives are getting more and more stable.

As that happens, however, folks are going to tend to take on more personal risk. There is a tradeoff between risk and reward. As you face less background risk, for which you not rewarded it makes sense to go for more personal risk for which you are rewarded.

When I take on more personal risk, however, it bleeds over slightly into everyone else’s background risk. People depend on me. If I take risks and lose so big that I debilitate myself then my family and my friends will surely suffer. But, so will my employer, my creditor and the businesses who count on me as a regular. When I go down, they go down.

So, putting it all back together and we come up with something of a risk floor, if you will.

Now, I should say at once that I don’t wholly buy this. But it is an interesting idea, and there is some evidence to support it. For instance, Australian research on compulsory cycle helmets suggests that cyclists that feel safer as a result of their helmet take more risk, resulting in little change in cyclist mortality* despite the new policy. However, it is not obvious that we can generalise from evident physical danger to financial risk.

Suppose we can though. That would mean, as Smith implies, that risk reducing policies can, if we are near the floor, cause risk to pop up again in a form that might be harder to spot. That suggests that a polluter pays approach, where we try to charge for the risk being taken rather than prevent it. Direct fees to price systemic externalities, then, rather than capital to prevent them. One might imagine that if FDIC deposit insurance fees were truly fair, then they would comprise a floor element plus a systemic surcharge (which was at least quadratic in bank size). Such an approach would attempt to charge for the cost of failure rather than capitalising the risks that might lead to it. As I say, I’m not necessarily recommending it, just suggesting that it is an interesting alternative.

Such laws are however good at discouraging cycling.

3 Responses to “The curious case of the risk floor”

  1. There is a lot of evidence to support the hypothesis that safety regulation can be ineffectual, or even counterproductive, due to the adjustments of risk taking behavior. The first documentation is from the 1960s, when Sam Peltzman (my thesis advisor) documented it in US auto safety regs. It is now referred to as “the Peltzman effect” and has proven ubiquitous. Another example: “protective” equipment in sports.

    Whether it translates to financial risk taking is an open question. But it’s plausible, and it would be worthwhile to try to devise tests/natural experiments to see whether the Peltzman Effect applies to finance, too. My bet is that it does.

  2. As a general matter, IMO attempts to control risk taking by controlling actions/behavior/activities (ring fencing, Volcker Rule, mandated clearing) are inadequate because they do not alter the fundamental incentives to take on risk. Shut a door, they’ll find a window. The pricing alternative does operate at the level of incentives, but that said, setting the prices is devilish hard, and any such form of “risk price control” will lead to the same kinds of inefficiencies as other sorts of price control.

  3. Down right Pigouvian of you!

    Unfortunately, experience has shown that the FDIC will ultimately be subject to political pressure to mis-price the fee (remember the deposit insurance fee went to zero before the crisis; zero can never be the correct price).

    Said another way, fees (and indeed capital) can’t survive a political economy in the long-run.