Perhaps the very act of declaring something a RISK FREE ASSET guarantees that it will not be such.
Underneath that declaration of RISK FREE is a presumption that the RISK FREE entity can absorb an unlimited amount of debt. When in fact, the thing that we are seeing over and over again is that it is the debt itself that causes the risk!
In insurance, if insurers allowed someone to insure a building that they own for five times its value in the event of a fire, we all understand that a fire becomes highly likely.
In banking, it is also a basic tenet of lending that if you lend someone much, much more than they could ever possibly repay, that they will not repay. But in banking, we have let the concept of RISK FREE creep into our heads and let that overcome the basic tenet about lending and repayment. Banks are actually encouraged to put more of their money into RISK FREE securities to make them more secure. But in the case of both the sub prime and the sovereign crises, the problem comes from assets that were improperly designated RISK FREE.
But what if it is the designation of RISK FREE itself that leads to the problems?
In the US Life insurance sector, the regulators provide a Risk Based Capital (RBC) regime. It assigns a level of capital based upon the regulators understanding of the risk of various activities. Most life insurance products at the time of the creation of the RBC regime in the early 1990’s involved a guarantee from the general account of the insurer to the beneficiaries of the insureds. Life insurers traditionally took large amounts of credit risk to support those guarantees. The RBC originally was focused first on the largest risk of the life insurers, credit.
Variable Annuities did not involve a guarantee from the general account and were therefore considered RISK FREE. Many insurers wrote that business and did not attribute any capital because the products were RISK FREE. From the start, insurers paid a fixed commission to brokers who wrote the business. Insurers did not directly charge the customers for those commissions, but instead recovered those payments from the accounts over time. Later, life insurers started to also add guarantees from the general account of the benefits from the variable annuities. The variable annuities were still considered to be RISK FREE so there was still no RBC charge.
It was not a surprise that valuable risk protection that was highly underpriced was attractive to buyers and these products became very heavy sellers for a dozen or more companies. So much so that attempts to later change the RBC to require proper capital amounts for the product were potentially critically damaging to some of those firms. Eventually, when the financial crisis hit, some of those dozen insurers that wrote large amounts of these products were looking for help from the TARP program
So perhaps we should be rethinking this concept of RISK FREE. When the activity deemed as RISK FREE starts to become risky, it starts (or in the case of the sub prime backed CDOs always) pays a higher return than the lowest risk activities. When the denominator for RISK FREE is zero or very near zero, very tiny amounts of excess returns from growing risk of the activity which is now designated RISK FREE in error will look to be fantastically profitable. A firm that is trying to optimize its return on capital will shift as much activity as possible into the improperly designated assets class.
As long as there is a RISK FREE class, there will be an incentive to shift as much activity as possible into any security in that class that is misclassified.
And because the capital requirements for risk free are zero, there is no limit to how much banks can move into that class. They actually look good if they leverage up to increase activity in RISK FREE.
We need to stop even saying that any class of investments is RISK FREE. As we see where that idea has led us, we need to leave it in the universities where it belongs and keep it out of the business world. They can keep it on a shelf right next to their bottles of perfect vacuum and along side their frictionless surfaces. That is where it belongs.
In the real world, there are no RISK FREE assets. The capital requirements need to be floored with a positive number and graded up with the level of returns. The market really is telling us something about risk when returns are higher, not about the brilliance of the companies that are able to find the misclassified RISK FREE investments.