FIs Can Bolster Equity Participation Only By Mitigating Risk

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In an attempt to drive more investments into markets for equity and other higher risk asset classes by the Indian population, 97% of which reportedly prefers safer avenues like savings and deposit products, Mr. Vishal Kapoor, Head of Wealth Management, Standard Chartered Bank, appeals to investors to “take some risk” and offers the assurance that “…on (the) average, it’s good for you!”

When I hear terms like risk and average used together, I’m reminded of an old anecdote told by a professor in the Mechanical Engineering department of IIT Bombay. Urging students to understand problems intuitively and think of solutions at the real-world level instead of blindly using mathematical formulas and equations, the professor used to narrate an incident – hopefully fictitious – where a six-foot student drowned in the nearby Powai lake. Apparently, the student thought he could simply wade through the lake since it was known to have an average depth of only four feet.

Bankers had better realize that, when it comes to deciding how to invest their hard-earned money, most people – barring rare exceptions like the aforementioned six-foot IITian – worry about their individual circumstances and take little comfort from averages. Therefore, instead of trying to assure a risk-averse public of the “average” goodness of equity and similar products, financial institutions should try and structure these products in such a way as to lower their inherent risk. After all, if risk aversion is the problem, what can be a better solution than risk mitigation? Common prescriptions like investor education, effective distribution and incentives can only have marginal impact.

To mitigate risk, financial institutions could renew their promotion of “capital protected” products – minus their customary fineprint, please – as a means to drive more investments into equities and other higher risk assets.

This entry was posted on Sunday, November 7th, 2010 at 2:13 AM and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

Rajeev Jog

First off, it's impossible to guarantee protection of capital. Even sovereign debt engenders the risk of national default. Remember Argentina? Greece was a near thing. Even US (and other OECD) Government obligations bear the implicit risk of inflation (as will happen to foreign investors as the US Federal Reserve undertakes is trumpeted Quantitative Easing soon.

The typical approach in modern finance has been to use a distribution and look at second and higher order moments such as standard deviations. Even this approach has flaws as was spectacularly demonstrated by the 2007 financial meltdown where Wall Street made spectacularly rosy assumptions about the risk profile of mortgage-backed derivatives. Witness David Li's notorious “Gaussian Copula (sic)” model which provided a handy analytical framework to justify what was (in hindsight) plain, unadulterated greed. (see http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all )
http://twitter.com/s_ketharaman s_ketharaman

@Rajeev: Thank you for your comments. I agree with you about the intrinsic challenges faced by banks and FIs in trying to create capital protected investment products. At the same time, such products have been offered in the past. I've already alluded to the one offered by UTI in India in my post. Apart from this, I know another one offered by Barclays Capital in the UK, which was based on commodities as the underlying asset. Can't FIs re-introduce such products? Or, do you think that such products were relics of the pre Great Recession era and no bank or FI will dare repeat them in hindsight?
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Rajeev Jog

It's not that capital protected investment products have not been offered in the past (and will not be in the future).

The challenge for the offeror is to do this in a credible and profitable way without running afould of all the agency risks that it creates. This subject is at least worth a book if not several volumes but I will allude to just two issues:
a) At least in the US (and I suspect worldwide) there has been a trend away from defined-benefit pension plans to defined-contribution pension plans. The reason for this is it is very hard to [B]guarantee[/B] investment returns over long time horizons. (Analogous to the mythical IITan who drowned in a lake of average depth 2', the average long-term equity return may be 8% but for any given period it is hard to guarantee this return, and “black swans” occur with her frequencies than commonly believed). Municipal and state governments in the US were late adopters to the defined contribution philosophy with the result that several cities and states will be driven into bankruptcy if they don't reform their pension plans. Even that is slow in happening. For example, where I reside (San Jose California) the pension obligations are going to start eating up 50-70% of the city's operating budget (because returns are guaranteed by the City and the capital markets haven't been obliging enough the City has to make up the difference out of operating capital). With much hand-wringing the Mayor (who is mostly sensible) pushed through two city-wide ballot initiatives (2010 Measures U & V) that changed the pension plan but only for FUTURE employees. Heartening to note despite scare-mongering ads from the fire-fighters union suggesting that your home could burn down because of the pension reform proposals voters approved the measures with about a 70% “yes” vote.

b) the agency risk I referred to was the whole phenomenon of the collective delusion/greed of Wall Street over the past 20-30 years where investment bankers were paid obscene bonuses for ignoring the risks inherent in mortgage-backed derivatives while the taxpayers picked up the downsides. This will be repeated every 10-15 years as long as there is no *personal* liability for this. My suggestion to prevent this is make part of the tax code provisions for mandatory disgorgement of previous compensation following any taxpayer funded bailouts, and the revival of the quaint concept of debtor's prisons for any failure to pay (above a minimum threshold).