Financial Risk, Bacteria, Antibiotics and Hand Sanitizers

 

“We cannot solve our problems with the same thinking we used when we created them”  – Albert Einstein

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To what extent is financial market risk similar to bacteria? What can the financial markets learn from medical science about how to (and not to) cope with risk?

Understanding what risk is, how it grows and evolves and how we deal with it is  crucial not only for the longevity of the financial markets but all things dependent upon them.

Like risk in the financial markets, bacteria (and other microbes) are pervasive and take many forms. Some bacteria are necessary for life (helping to digest food for instance) some are downright nasty and can be life threatening. Knowing which are which and how to properly deal with each type is crucial to our success.

Antibiotics and other antimicrobial medicinal drugs are broadly used to treat a range of illnesses. Have a cough, runny nose or earache?  Doctors often will prescribe an antibiotic upon the first sign of a sniffle hoping to knock out these pesky creatures causing discomfort. “Sanitizing” one’s hands with an alcohol or other chemical cleanser is becoming an all too common practice as a “preventative” measure

Medical science is quickly learning that the tools for dealing with potentially dangerous bacteria can create more problems than they solve. In many cases, antibiotics are misapplied to conditions in which they in fact provide no assistance in fighting a particular type of illness because its cause is something other than bacteria (a virus for instance). Hand sanitizers can kill the “good” germs while leaving the bad ones to evolve into potentially worse ones.

Though unpleasant, occasional (moderate) illness is part of the human condition. As more and more antibiotics are applied to individual cases of illness, an interesting and frightful thing is happening: microbes (particularly bacteria) are developing resistance to the antibiotic drugs and other compounds used to kill them. Further, the necessary strength of a given drug must be greater to reach the same result as the bacteria “learn” how to sidestep the impact of the chemical compounds. In turn, new and more powerful medicines are developed and the bacteria continue to evolve.

Whether or not you use antibiotics or hand sanitizers is not the question – the decisions of many individual doctors and their patients to overuse antibiotics impacts the systemic risks for us all.

Unlike bacteria, most financial risks are created by the intertwined and interdependent relations and interactions of market participants. But the way these risks react to our efforts to contain and control them are remarkably similar in their outcome.

The movement of one player in adjusting for idiosyncratic risks (through diversification and hedging) impacts the overall risk to the entire system. What one player does to protect her own position may in fact be adding risk to the overall levels of risk in the system.

For instance, securitization “spreads” risk over a broader group – eliminating the concentrated risk to a single participant. Yet, over the longer term, doing so can create co-dependent relationships from seemingly unrelated entities. (Take for example, real estate mortgages). Risk cannot be controlled or eliminated entirely; more often, through manipulation, it is shifted from one house (mine) to another’s (the other guy’s) morphing along the way.

There is a way in which the more those risks which have the potential for systemic proportions are tried to be controlled using the same methodology, the greater the overall risk(s) become(s). The effectiveness in the risk control tool (whether it be antibiotics, hand sanitizers, faulty notions of diversification, hedging, VAR modeling, etc.) decreases while confidence increases. We think we have things under control and then take on more risk of different types. This is a dangerous mix – over the long term, this may be our biggest risk of all.

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For a thorough synopsis of antimicrobial resistance,  see the World Health Organizations site:

http://www.who.int/mediacentre/factsheets/fs194/en/