What does "risk" really mean?

So what does risk really mean in our economy today? We all know that every investment involves some risk. We are led to believe though, that our system is setup with the proper structures in place to minimize risk for investors, lenders, lendees, and ordinary folks with a pension, insurance or a college fund for their children. The 2008 financial crisis should have thrown all of this into doubt, however, there are still some very maligned mental models of risk operating in our society. I will explain my meaning with an example. 

Amy Cortese has a wonderful article in the New York Times about crowdfunding, or a cutting edge investment mechanism whereby many ordinary people would be able to make small investments in new small businesses or ventures. Cortese says, "To its advocates, crowdfunding is a way for capital-starved entrepreneurs to receive financing that neither big investors nor lenders are willing or able to provide." This idea has been around for a couple of years and was popularized by the success of Kick-starter. The difference is that Kick-starter facilitates crowdfunding through donations, not investments seeking a return; meaning it is currently legal while actual crowdfunding of investments is not.

The JOBS act signed by President Obama in the middle of 2012, contained crowdfunding legislation which is still not in play because the Securities and Exchange Commission (SEC) has not completed the requisite rule writing. The SEC had until the end of 2012 to finish its work on the JOBS act, but failed to meet that deadline. "The JOBS Act contains investor protections. For example, legislators capped the amount that unaccredited investors can invest through crowdfunding in a given year to $2,000, or 5 percent of their income, whichever is greater," Cortese points out. Comment from the SEC on the rule writing process has focussed on the complexity of creating regulation which would provide sufficient protections for investors and mitigate risk. 

The Institute for Local Self Reliance made a recent post about some successful attempts at crowdfunding within the current laws. They write of a California-based company, (Solar) Mosaic, which is working to install community solar electricity projects funded by a broad based group of individual investors. On their latest project, "The combined capacity of 235 kW of solar capacity sold out in just 24 hours to over 400 investors with an average stake of just $700.  The investment uses a common securities law exemption (Rule 506 of Regulation D), and investors will earn a 4.5% annual return (net of fees) over 9 years, greening the economy and their pocketbooks." 

This is where we encounter the skewed concept of risk in our current system. SEC Rule 506 of regulation D is the closest thing to crowdfunding currently available. It allows the investment project to privately solicit investment from an unlimited amount of "accredited" investors, but only up to 35 "unaccredited" investors. The SEC defines accredited investors as those with at least one million dollars in semi-liquid assests not including real-estate, or an annual income of over $200 thousand for at least the last two years. The current rules imply that those meeting the definition of accredited investors automatically understand risk and can invest in projects like the Mosaic community solar arrays at will, while those not meeting the definition of accredited investors do not and must be limited in their activities. 

Somehow the SEC regulations are keeping us all safe by reducing risk, however, they are also severely limiting the ability both of non-rich folks investing in projects they care about and important new ventures receiving the capital they need to be successful. These new kinds of investment projects and "crowdfunding in general, have 'the potential to be disruptive,' Harvard Business School Professor Clayton Christensen says, by opening up financing to companies that have traditionally struggled to raise capital and to investors who have been excluded from the market."

To take this discussion further, I turn to a post by Dr. Norm Becker regarding our system of shadow banking. He points to an article called "Shadow banking: Economics and policy priorities," which points out two important aspects of our current system which drive what it called "shadow banking," or the financing activities which are derived from real assets and investments, but which themselves are not real or tangible. The article explains that, "The first key shadow banking function, securitisation, is a process that repackages cash flows from loans to create assets that are perceived by market participants as almost fully safe and liquid." Securitisation was a major factor in the 2008 financial crisis which put our entire economy into a massive recession. This process is completely legal and permitted by the SEC. 

The second shadow banking function is called "collateral intermediation." The authors of the article say that, "One of the main challenges in using collateral is its scarcity. The shadow banking system deals with the scarcity through an intensive re-use of collateral, so that it can support as large as possible a volume of financial transactions." This process is highly complex, involves risking very large amounts of real assets as collateral for multiple investments of varying types allowing companies and investors to leverage what they really have (or increase their capital multiplier) many times over. This process also can allow multiple entities to point to the same collateral asset for multiple other investments, each one of which then holds a claim to that original asset. This practice again is completely legal and permitted within current SEC regulations. 

Crowdfunding is in some ways new financial territory, and in some ways an old story of many people pooling their money to support a new business they value. However, our current economic system defines risk in such a way as to deem crowdfunding (even when locally constrained) as highly risky and complex, while securitisation and collateral intermediation, which are both enormously and unimaginably larger in scope and complexity, not risky enough to be further regulated and constrained. As I have pointed out before in my blog, power plays a highly important role in shaping our system and its structures. It is in the interest of the highly wealthy beneficiaries of our current system to deem shadow banking practices as low risk, while stifiling and delaying community level investment mechanisms due to their inherantly high "risk."