The issues that have already been analysed could give the impression that risk management is a discipline which is independent of the object to which it is applied, that is, that the principles of risk management can be applied to industrial companies, savings banks and individual investors in the same way. However, as the following explanation indicates, this is not the case.
1.2.1 Individual Risk Management
In the same way as a business, an individual’s economic activity (work, investments, etc.) is also subject to risk and susceptible to management.
Many of the issues that have been discussed in relation to companies can also be applied to individuals. However, there are two important (inter- related) differences between individual investors andfirms: limited liabil- ity and risk aversion.
Most countries have laws which state that when a company goes bank- rupt it has limited liability, which means that the owners, the managers and the employees don’t pay the debts, and only the assets of the company respond. This is essential for an economy’s business development, as demonstrated by John Ford’s companies, which went bankrupt several times before Ford came to“invent”mass production.
Conversely, an individual responds to any contracted debts using their assets, and it is false that if an individual fails to pay the fees on a bank loan, for example a mortgage, the bank seizes the collateral and the payment obligation is cancelled. It is increasingly evident nowadays that in the case of default, the collateral goes to public auction and if what is made at auction does not manage to fully recover the debt, the individual retains the remaining debt with the bank. In this case, the bank may take, and indeed does take, legal action against the individual to demand that the remaining debt is paid and if this occurs, the individual’s assets are used to respond to this demand (accounts, wages, property, etc. can be seized.) These legal actions usually take a lot longer than it takes to execute a mortgage, and because lawyers, trials and so on are expensive for both parties, in many cases agreements are reached. On this basis, the individual cannot be considered to have limited liability in any way, but this is not entirely true.
Besides the fact that individuals do not have limited liability and compa- nies do, another difference is that an individual’s risk aversion is usually greater than that of a company. There are many reasons for this, one of which is that without limited liability, greater risk aversion is needed.
“Bankruptcy costs”and“financial distress”are other reasons for individuals’
greater risk aversion compared to companies, as these costs are much higher for the former. “Losing your home and sleeping on the street”is not the same as“losing your office and ceasing economic activity”, and“not having money to buy food” is not the same as“not having money to pay employees, suppliers and so on.” Similarly, on reaching a certain level of income, an additional monetary unit creates much greater “utility” in the company’s case than in the individual’s, because the individual reaches a stage at which this factor improves living standards very little, whereas the company distributes dividends to many shareholders.
For all the reasons previously outlined, it is perfectly legitimate for a business manager to manage company risk differently than their own individual risk. In other words, the “utility function” of an individual is less linear—it is more concave than that of a company. Limited liability and risk aversion means that an individual’s risk management is performed in a much more conservative way than a company’s, and therefore a manager cannot be criticised in any way for taking many more risks when managing the company than when managing their own assets.
However, there are other factors that cause risk management in a company to be different from that of an individual. It is clear that the individual does not have the“accounting problems”or agency problems that exist in a company. Similarly, in many cases the individual does not have the same resources as a company. These considerations, together with the aforementioned cases of risk aversion and limited liability, further support the argument that a manager not only can but must manage the company assets in a different way to their own personal assets.
1.2.2 Risk Management in Savings Banks
Savings banks arefirms in which the main activity is to take the depos- itors’ money and lend it to individuals and businesses. The risk related to this mainly arises from the default risk and credit risk of the borrowers.
For this reason, the majority of what has been demonstrated previously in the case of industrial companies can also be applied in this case. However, there is one significant difference that has important consequences: the liability of a savings bank is mainly made up of demand deposits and/or term deposits, usually around 90 %, while the remaining liability is made up of capital and other savings bank or central bank loans.
In order to protect the depositors’ money and the stability of the financial system, savings banks are subject to specific regulations and close supervision by the central bank, which in theory should prevent savings banks from facing bankruptcy or even financial distress. The concept of protecting depositors stems from the fact that the liability, which does not come from business capital, lies mainly in the hands of banks and institutional investors, both of whom are assumed to have the
ability to analyse and understand the risks they are taking. Conversely, it is not usually possible for the depositor to ascertain the bankruptcy risk of a savings bank, and thus logically it should be the government that protects their interests. In addition, depositors generally do not receive any remu- neration for their investment and if they do, it is usually at much lower rates than those in the market. For the economy to function properly, as a rule, it is necessary for the public to deposit their savings in a savings bank or use them to make investments, but due to risk aversion the public always demands safe investments. Thus, for normal economic develop- ment it is desirable to protect the depositors’ money.
On the other hand, as previously noted, the stability of the financial system must be protected as the liability of savings banks is usually made up of“demand deposits”, money that the depositor may withdraw at any time, while its assets are usually made up of much larger instalment loans.
In fact, mortgage loans represent a high percentage within the loan portfolio, usually about 50 %, and have a payback period of around 30 years. For this reason, if the depositor is not absolutely certain that their money is completely safe, there could be a huge number of requests for deposit withdrawals that could not be realised, which would cause
“panic”. If panic is widespread, the government and the central bank can do very little to avoid the bankruptcy of thefinancial system.
Given the above, savings banks have specific regulations and are subject to close supervision, meaning they do not have the freedom to take the same risks as industrial companies and may have to accept many restric- tions depending on the risks being taken. In other words, their utility function is“less linear”, and therefore their behaviour is more conservative than that of an industrial company.
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Risk Quanti fi cation