Risk Homeostasis and the Hamster

Homeostasis refers to some regulating process that keeps an outcome close to a target by compensating for external disturbances; core bodily temperature is an example of being homeostatically maintained within narrow limits despite major variations in the external temperature.

In essence, risk homeostasis theory deals with the notion that every individual has a tolerable amount of risk that he/she finds bearable. Should the perception of risk in some aspect of that individual’s life change, the individual would compensate by either reducing or increasing the amount and severity of risks taken – all in order to maintain an equilibrium of perceived risk.

Individuals therefore have a perception of the expected benefits/costs of risky behaviour that they weigh against the expected benefits/costs of safe behaviour.

In a celebrated example of the theory, its originator, Gerald J.S. Wilde studied the behaviour of a taxi fleet. Some cabs in the fleet were fitted with anti-lock brakes (ABS), while the remainder had conventional brake systems. Over a period of three years the study showed higher accident rates for the ABS-fitted cabs; drivers were taking more risks based on the perception, at least, of a safer vehicle.

Is the theory applicable in a finance or treasury environment?

We have seen different waves of financial innovation over the last four decades. Markets have, in general, become more liquid and accessible. A variety of different products, such as basic futures, options, so-called exotic derivatives, and exchange traded funds are now traded commonplace. 

We have also had a significant number of financial debacles – the most notable being the global financial crisis (GFC) in 2007/2008 – each leading to various changes in regulations and different restrictions in an attempt to prevent future losses/debacles. 

I would argue that the GFC presents one of the most striking examples of financial homeostasis, on a large scale, possible. When the GFC hit us, we observed a scramble of market participants, debt holders, shareholders, regulators, and central banks trying to organise bail-ins, bail-outs, mergers, etc. in order to prevent the financial system from collapsing. The story of the last decade has been a re-build, with massive financial stimulus, and the concomitant removal of such stimulus as well as stricter regulatory actions to ‘avoid’ future crises. 

The build-up to the GFC is a clear example of risk homeostasis theory at work; financial innovation (in the form of derivatives and increased lending) led to regulatory action and requirements (Basel I/II requirements, for example), which in turn created opportunities for innovation and regulatory arbitrage (think about credit default swaps and collateralised default obligations), which planted the seeds of the GFC. In essence, by trying to create a safety net, we created the platform for a crisis. 

It is fair to say that most professional market participants have adapted to the changes and challenges brought by the new environment. In general, the derivatives markets have created an environment that allows market participants to price more accurately for risks. In our own organisations, we are required to assess the level of risk we are taking, at all times – we also need to be cognisant of how such risks are changing and whether our approach has become stoic.

We are led to consider two questions. Firstly, what constitutes a sound risk management programme and secondly, have we created some complacency? 

What constitutes a risk management programme?

A risk management programme or process will typically consider the following steps:

Have we created the basis for complacency?

It is time to discuss the hamster … Risk management could seem like an endless task where we, like the hamster, run on a wheel without end. The purpose of risk management, however, is the homeostatic risk control of an organisation – this means that we should maintain the risk management process described above rigorously and ensure that we have the ability to adapt to changes and challenges posed by the external environment.

The last decade has seen relentless efforts to stabilise markets – this includes new regulations (Basel 3.5, Solvency 11, MiFID II, etc.) as well as so-called Quantitative Easing involving balance sheet expansion implemented by various central banks - the US Federal Reserve, the  European Central Bank, the Bank of England and the Bank of Japan. It would be easy to think that we are in a safer place from a risk perspective. Let’s not be complacent – the theory of risk homeostasis demonstrates clearly that participants in the markets adjust their behaviour accordingly; overall, we might be fooled by a false sense of security. Risk vigilance remains key (or follow the hamster!).