Is Risk the Best Theory for Capitalism?
Issue summary
James Kwak and Simon Johnson asserts that the risk is a crucial component in making profit. When imprudent risk is taken, the outcome can be harmful. Despite the negative consequences of risk, the value of risk in business remains vital. Barry, on the other hand, assert that much focus is put on risk as an essential component yet risk was the main cause of economic collapse in 2008. Risk entails undertaking various issues in business. In most corporations, risk is a critical factor in achievement of objectives, goals, and mission.
Risk is a condition that is always present in business and financial activity. For many years, people in business have focused in managing risk. Tort and contract law are some of the issues meant to allocate risks. In the modern investment and finance, risk management and risk diversification play a vital role. Risk is a good thing in business.
Risk in the financial crisis
Leverage is the common place to focus on excess risk. High leverage is not a risky, but it depends on how the money is used. Lehman Brothers Holdings Inc. seem to be a critical example that focus on risk. Liquidity risk is what most people are not prepared. The government tends to take risks from financial institutions due to lack of confidence. Even if the government takes financial risk, risk is not eliminated. Investors pull all their resources together and tend to invest in safe nations. Financial crisis can lead to political consequences.
Systematic underestimation of risk
Market participants underestimate the risks. One of the reasons is psychological. They believe that absence of crisis raise confidence. There are various mechanism that have been developed to manage risks. Bond rating agencies play a crucial role on risk management. Too much confidence is attributed to the development if scientific platform of risk management. Securitization was also used to manage risks. Evidently, new risk management platforms led to new forms of hedging.
New order of financial risk
There was little evident that the tool to manage financial risk would work. Subprime mortgages seem to be falling, but the banking system are expected to take writedowns on credit cards, auto loans, commercial mortgages, corporate debt, and credit cards. The government supports the largest banks so that it does not fail. Better management ensures that the financial institutions continue to operate. Disclosure measure tends to be in place to prevent volatility in the marketplace. Financial institution operates differently by taking bigger risks for larger yields.
Implications for nonfinancial companies
Nonfinancial firms are facing recession and demand for credit also decreasing. It is the best opportunity to focus on new banks relationship. Companies have to focus on doing business with a minimum credit. Few companies would want to raise their money by issuing shares. Few changes are expected in the financial systems, but the new regulations tend to develop healthier and transparent financial systems. Businesses need advanced risk management models and diversified funding techniques so as to eliminate adverse impacts.
Future
Evidently, risk cannot be wangled out of the system. The business cycles from 1982 to 2007 are part of changes in economic systems. Companies are expected to manage the cash flow and investment accordingly.
The last temptation of risk
The great credit crisis tends to create most doubt on various economic issues. Much of what was alleged to be true seem not to be true. These are because the Great Moderation was illusions. On the same note, the monetary policies that were meant to decrease inflation seem to cause more vulnerabilities in the economy. The misguided beliefs were based on interpretations of flawed information. The information on risks has been reduced to mere numbers and equations. The models should have been stated to be no more than starting points. The reduction of risk could not be mastered in any way, but it was taken to take literal meaning. The 1987 crash was vied to be part of Great Moderation, and it led to long-term failure of hedge and mortgage industry.
