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What does it imply to say one thing is dangerous? How would we all know? Would a failure affirm the view {that a} explicit exercise was dangerous?
Think about two folks playing at roulette. Joe places $100 on every quantity from 1 to 35. Jane places $3500 on quantity 36. Each have guess $3500, and each bets have destructive anticipated values (assuming a 36-1 payoff on the successful quantity, and 38 whole numbers.)
To me, Joe’s guess seems to be much less dangerous. There’s greater than a 90% likelihood he’ll win $100, though the anticipated worth of the guess continues to be destructive on account of the truth that he loses $3500 if quantity 36, 0 or 00 comes up. Jane has greater than a 90% likelihood of dropping all $3500, however will win very large if quantity 36 comes up. That appears riskier.
Now let’s assume that each folks make their bets, and the little ball lands on quantity 36. Does that inconceivable consequence imply that Jane’s guess was truly much less dangerous than Joe’s. I’d say no; she simply bought fortunate.
Once I converse with folks, I usually get the impression that they conflate “dangerous” with “failure”. That’s not how I interpret the time period. Think about two banks:
1. Silicon Valley Financial institution (SVB) takes deposits and invests them in Treasury bonds. It’s a quick rising financial institution.
2. Financial institution OZK (previously Ozark) quickly grows from a small Arkansas financial institution to a significant lender for actual property tasks in America’s largest cities.
Which financial institution’s property appear risker? Based mostly on this proof, I’d say that Financial institution OZK was far riskier.
Now assume that SVB goes bankrupt, whereas Financial institution OZK is doing great. Does that influence your view as to which financial institution engaged in a riskier technique? Ought to that truth affect your view as to which financial institution engaged in a riskier technique?
If failure is proof of riskiness, what does that indicate in regards to the roulette instance mentioned above.
In 2018, I did a post on Financial institution OZK, citing it for instance of the kind of risk-taking financial institution inspired by the ethical hazard in our banking regime. On reflection, it seems to be like SVB would have been a greater instance. However is that true? Was SVB truly a riskier financial institution? Or did quantity 36 come up on the roulette wheel?
My failure to identify the financial institution that really failed illustrates an issue confronted by regulators. In 2018, I used to be presumably trying again on the banking crises of the Nineteen Eighties and 2007-10, and noticing that actual property lending usually led to banking misery. At the moment, Treasuries had been in a bull market from nearly 4 many years. We are likely to estimate threat primarily based on previous efficiency, particularly the latest previous. Regulators are unlikely to identify threat that comes from an space that was not beforehand a significant downside. (Recall that in 2006, MBS traders had been lulled by the truth that the US had by no means skilled a big nationwide decline in home costs.)
Lately, actual property has carried out stunning effectively, as inflation tends to spice up the worth of arduous property like land and buildings. Then again, inflation reduces the worth of T-bonds. It’s fairly attainable that, ex ante, SVB’s method was much less dangerous (even perhaps profit-maximizing!), however these unpredictable macro tendencies harm SVB and helped Financial institution OZK. (To be clear, I think that there have been different variations as effectively, maybe Financial institution OZK has superior administration.)
I don’t consider we’ll ever have the ability to repair the banking system by way of regulation. Regulators will at all times be like generals combating the pervious battle. As a substitute, we have to take away the underlying issues—ethical hazard and a scarcity of diversification. Trump likes to speak about “Making America Nice Once more”. How about “Make America’s banking system extra Canada’s”?
PS. David Beckworth has a superb piece in Barron’s discussing how the rise in rates of interest has helped long-term debtors (together with the Treasury) whereas hurting bondholders.
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