Wednesday, June 20, 2012

Bank of England's Robert Jenkins: Golden rule of trading is keep risk within risk taking limits

In his speech at the Global Alternative Investment Management conference, BoE Financial Policy Committee member Robert Jenkins describes the golden rule for trading and then asks if the financial system has broken this rule.

Now ladies and gentlemen: what is the golden rule of trading? It is that you must keep risks within your risk-taking ability. 
It is time to ask the question: have systemic risks exceeded the system’s ability to absorb
the potential losses from the risks it is taking?
Taken together these two question suggest a third:  if every one obeyed the golden rule of trading, how did we get to a position where the systemic risks might exceed the system's ability to absorb the potential losses from the risks it is taking?

Regular readers know that my answer is the financial regulators permitted opacity in the financial system.  Opacity that Wall Street benefited from as a result of over-investment relative to the risk of the opaque investment.

Opacity results in over-investment because market participants do not have all the useful, relevant information in an appropriate, timely manner so they can independently assess risk and adjust the amount and price of their exposures to reflect this risk assessment.

Opaque areas of the financial system that regulators let develop include bank balance sheets and structured finance securities.

The cure for opacity is transparency.

It is only with transparency that we are a) going to find out if there is more risk than the system can absorb, b) find out where this risk is, and c) reset the financial system so that once again risk is within everyone's risk-taking ability.

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