Sunday, May 29, 2016

the desperate hunt.........................

     There was, however, a second and less benign reason behind the expansion of bank balance sheets.  With interest rates so low, financial institutions and investors started to take on more and more risk, in an increasingly desperate hunt for higher returns, without adequate compensation.  Investors were slow to adjust and reluctant to accept that, in a world of low interest rates and low inflation, returns on financial assets would also be at historic low levelsGreed and hubris also led them to demand higher returns - such behavior became known as the "search for yield."...
     Banks played their part in meeting this search for yield.  They created a superstructure of ever more complex financial instruments, which were combinations of, and so derived from, more basic contracts such as mortgages and other types of debt - hence their name "derivatives".  To increase their yield, banks created instruments that comprised highly risky and often opaque structures with obscure names such as "collateralized debt obligations."  The average rate of return on a risky asset is higher than that on a safe asset, such as a US or UK government bond, to compensate the investor for the additional risk - the additional return is called risk premium.  Although some of the deals offered to investors were close to being fraudulent, the desire for higher returns meant there were no shortage of willing buyers.  Only an optimist could believe that the risk premium in the market was adequate to compensate for the risk involved.  It was all too close to alchemy.

-Mervyn King,  The End of Alchemy:  Money, Banking, and the Future of the Global Economy

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