Investment Risk and Interest Rates

 (This is a current extract from the Patterns of Power Repository.  An archived copy of this page is held at http://www.patternsofpower.org/edition02/3341.htm)

Banks, money-lenders, savers and investors are all lenders of money.  They want to be repaid, but they have to take account of the risk that the borrower might default (i.e. not repay the loan).  They mostly charge an interest rate, or ‘yield’, which is affected by the risk of default and by competition for the money available in the financial system.

Savers and investors should take account of the robustness of the financial products (bonds, shares, savings accounts etc.) that they use.  Provided that the risk in the product is clearly visible, they can choose to incur more risk in exchange for a higher rate of interest.  If they knowingly take a high risk and they then lose money, they have no grounds for complaint against the seller.  If the risks are misrepresented, as allegedly happened in the period leading up to the 2008 financial crash,[1] then savers and investors have a legitimate grievance – and might lose confidence in the financial markets.

Lenders were able to insure themselves against credit-default risks, and traders started to bet on these risks by making ‘credit-default swaps’ (CDSs), which played a role in the 2007-8 financial crisis.[2]

Credit-rating agencies are responsible for assessing the risk of financial products and the risk-worthiness of individuals, companies and governments as borrowers; the credit ratings are used to determine the interest rates available to savers, investors and borrowers.  Financial products are becoming increasingly complex, though, and some are so complex that they cannot be rated reliably – so neither buyers nor sellers can properly assess risk.  There has also been a problem of ratings agencies having a conflict of interest when they are paid by clients who want favourable ratings.[3]

Some financial products increase the ‘leverage’ of investments,[4] so that the potential returns are greater than would otherwise be achievable with the sum invested in the product – and the losses can also be much greater:

“Most banks have gross assets [i.e. exposure to risk] of up to 50-100 times their equity capital. Consequently a bank that lost 5 per cent of its assets would see its equity wiped out and would, without government support, face closure.”[5]

Barings bank collapsed in 1995 as a result of reckless trading.[6]

© PatternsofPower.org, 2014

[1] On 24 October 2012, a Manhattan Federal Court brought an action against Bank of America for fraud, as reported in a Department of Justice press release:

“Countrywide and Bank of America allegedly engaged in fraudulent behavior that contributed to the financial crisis, which ultimately falls on the shoulders of taxpayers.” 

That press release was available in April 2014 at http://www.justice.gov/usao/nys/pressreleases/October12/BankofAmericanSuit.php.  The BBC report was at http://www.bbc.co.uk/news/business-20072217.

[2] On 6 November 2008 The Economist produced a report entitled Credit derivatives, which commented on the role of CDSs in the 2008 financial crisis; it was available in April 2014 at http://www.economist.com/node/12552204.

[3] On 11 February 2013 Russ Roberts, in an EconTalk interview entitled Cathy O'Neil on Wall St and Occupy Wall Street, commented that:

One of the strangest aspects of the financial crisis is the people who argue that it's the rating agencies' fault because they rated junk highly. That was what they were paid to do. Why would you expect them to do otherwise?”

This comment appeared about 20 mins into the interview; a transcript was available in April 2014 at http://www.econtalk.org/archives/2013/02/cathy_oneil_on.html.

[4] Anat Admati and Martin Hellwig explain the concept of leverage in their book The Bankers’ New Clothes, in chapter 2: How Borrowing Magnifies Risk.  The example given is of Kate, who borrows money to buy a house.  She has a $30,000 deposit and borrows $270,000 to buy a $300,000 house.  If house prices go up by 5% and she sells the house, she will have $45,000: a 50% return on her investment.  If she wants to sell the house after house prices have gone down by 5%, though, she will have lost half her investment.  By borrowing 90% of the cost of the house she has magnified, by a factor of 10, the potential of both the risk and the reward of fluctuations in house prices.  Clearly, a fall in prices of more than 10% leaves her with debts – which is equivalent to what happened to the banking industry when it made leveraged investments.

A World Bank paper, entitled The Leverage Ratio, identified three different types of leverage and made a proposal to regulate it because:

“Excessive leverage by banks is widely believed to have contributed to the global financial crisis… ”

The paper was available in April 2014 at http://www.worldbank.org/financialcrisis/pdf/levrage-ratio-web.pdf.

[5] Prospect published an article by John Kay, entitled Making banks boring again, on 17 January 2009.  It highlighted the risks taken by banks and was available in April 2014 at http://www.prospectmagazine.co.uk/magazine/makingbanksboringagain/.

[6] On 22 June 1999 the BBC published a brief retrospective report on the Barings collapse, entitled How Leeson broke the bank, which was available in April 2014 at http://news.bbc.co.uk/1/hi/business/375259.stm.