The risks that the financial sector has devised techniques to manage are not the everyday risks of an uncertain world: they are risks almost entirely created within the financial sector itself.
If you ask people in the industry to justify recent financial innovations, they will explain that they allow risks to be managed more effectively. Yet if you asked people in the street whether recent developments in financial markets had made them feel more secure, they would assume you had taken leave of your senses. The most serious economic crisis of modern times is a direct result of instability emerging from global financial markets.
Individuals can use financial markets to provide protection against risks such as car crashes and house fires. But life cover has traditionally been bundled with savings products, with the recent outcome that savers have been poorly served and young parents rarely have the cover they need. Defined benefit pension schemes are fast disappearing, so that the investment risk associated with saving for retirement has been largely transferred to households.
The principal financial risks faced by individuals are loss of employment, breakdown of relationships and illness. The practices of many large employers once effectively insured workers against the risks of the business cycle, but lifetime employment is increasingly a thing of the past. You can only buy unemployment and redundancy insurance in small amounts on unattractive terms. You cannot buy divorce insurance at all – this is a textbook illustration of the moral hazard problem. The only advanced country that has not effectively socialised healthcare is moving rapidly towards doing so, and greater public funding of long-term care is now widely discussed.
The risks of ordinary life are mainly handled by families and social institutions, and the contribution of markets to handling such risks is generally diminishing. Consumers benefited from financial innovation when securitisation allowed institutions to sell credit aggressively. But it is now evident that this was just a mistake. The costs of this underpriced credit were met by bank shareholders and taxpayers. Margins on mortgages are now at historically high levels.
Of course, many of the new opportunities to manage risks were aimed at businesses rather than individuals. Corporate treasurers can now hedge many transactions that previously remained on the balance sheet of the company. But this is a complex argument, as the current travails of BP illustrate. BP’s policy of not insuring against operating risks means that most of the costs of its oil spill fall on BP shareholders, rather than the shareholders of large insurance companies.
The shareholders of BP and the shareholders of insurance companies are more or less the same people: large institutions holding the stocks as part of broadly diversified equity portfolios. The risks of a Gulf of Mexico oil spill are widely shared. But the innovation that made this possible is the 19th-century invention of the limited liability company with dispersed ownership.
Better corporate risk management yields benefits overall to the extent that it reduces market volatility and lowers the cost of capital. There was a time in the late 1990s when some people argued that this had happened, although they tended to give the credit to good monetary policies and global political stability rather than financial innovation. But more recent experience of the past decade has shattered these beliefs.
The explosion of derivative markets and the application of sophisticated mathematics to risk modelling is a tribute to how theories can readily be given practical application if the rewards are sufficiently large. But the risks that the financial sector has devised techniques to manage are not the everyday risks of an uncertain world: they are risks almost entirely created within the financial sector itself. The benefits to the non-financial economy are slight, if they exist at all.
That is what Adair Turner, the chairman of Britain’s Financial Services Authority, had in mind in querying the social value of modern financial developments. Paul Volcker’s jaundiced answer that the only useful recent financial innovation had been the ATM is very much to the point.