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Defining Financial Risk

Atul K. Shah, Suffolk Business School

C. Richard Baker, Adelphi University Presented at the BAFA annual conference, University of Manchester, March 2015.

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Defining Financial Risk

ABSTRACT

Risk is central to Finance Theory and Research. However, instead of getting to the bottom of

its fundamental meaning and understanding, the academy has consistently skirted around the

subject. Its focus has been operational and utilitarian, rather than determined by relevance,

accuracy or reliability. Drawing from the work of sociologists and anthropologists like Beck,

Douglas and Wildavsky, this paper explores the fundamental nature and characteristics of risk

and compares them to our present-day knowledge in Finance. In reality, risk is highly

subjective, requiring knowledge of alternative values and beliefs – it is primarily a social and

cultural phenomenon. Finance’s determination to ‘objectify’ it and ‘measure’ selective

aspects of risk is shown to be biased and driven by hidden operational imperatives rather than

fundamental scientific goals. It seems to be ideologically motivated by a desire to protect a

particular academic hegemony in finance. This paper exposes the dimensions of financial risk

which are under-explored and under-researched, and uncovers large gaps in our knowledge

and consciousness. The role of experts in defining and measuring risk is questioned and

shown to be biased, adding to the risk to society. The findings open up new possibilities for a

holistic approach to risk research in finance.

Key words: Financial risk, Culture, Beck, Douglas, Wildavsky

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Defining Financial Risk

1. Introduction

Financial risk is a very real problem and a significant issue in modern society. The loss

of a pension could mean hunger, illness and misery for an old-aged pensioner. The loss of

savings through the collapse of a bank could have a devastating effect on individuals. Inability

to service a mortgage or other debts could mean repossession of the home and could break up

or destabilise the entire family. In extreme cases, it has led to mental health breakdown and

even suicide. For corporations, financial risk can affect the value of business investments and

financial assets. At a societal level, the decline in value of a currency could have a dramatic

impact on the entire economy. Similarly, the widespread failure of banks could lead to a

worldwide financial crisis as happened recently from 2008 to the present in Europe and the

United States. As money comes to play an increasingly important role in our lives, we are

concomitantly becoming a 'risk society'. As was shown in the recent financial crisis, large

financial institutions can fail thus necessitating government interventions to stabilize the

economic system (Tyrie et al, 2013; Permanent Committee on Investigations, 2011).

If we examine the existing knowledge about risk in finance, we discover a technical

field rich with sophisticated mathematics and statistics, where risks are reduced to numbers

and measurements (Mackenzie 2006, Power, 2007). The assumptions made to facilitate these

calculations are rarely discussed at length or empirically validated. The principal focus is on

rational individuals who maximise their utilities through maximising wealth. There is also an

assumption that individuals are risk averse. Such behaviour accords much more closely to a

trade or business practice rather than a science, where experts stand to profit from their

calculations (McGoun, 1995). Considerable evidence exists of the domination and

exploitation of risk evaluations by experts, both in the physical and the social sciences

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(Douglas and Wildavsky, 1982; Beck, 1992). Mackenzie (2006) has demonstrated that

finance theory and models led to the creation of new financial products and markets –

consequently, the finance experts have been party to the active creation of financial risk – not

just its measurement and evaluation. Hitherto mainstream finance teaching and research has

avoided the questioning of its own claims to expertise. It has grown significantly as a

discipline in terms of student numbers and research output, and it has been successful in

propagating its scientific and objective basis, despite fundamental flaws (Frankfurter and

McGoun, (2002).

A large number of books written post-crash by authors such as Michael Lewis (Lewis

2009; Lewis, 2011; Lewis 2014), and on subjects like the collapse of Lehman Brothers

(McDonald and Robinson, 2009) and the near collapse of the elite financial institution

Goldman Sachs (Cohan, 2011) have exposed in detail the culture and politics which influence

the risk-taking behaviour of large financial institutions. The irrationality and illiteracy about

risk at the top of many institutions is meticulously explained by Das (2011). None of these

authors are finance academics, yet they reveal a significant vacuum in the public’s knowledge

about risk, complexity and political bias in finance. This illiteracy was deliberately promoted,

exploited and used to maximise private gain at public expense. The greed levels and bonuses

and incentives were beyond human reason and comprehension. By ignoring these facets in

the empirical evaluation of risk in finance, it is shown that the academy has been complicit in

the financial crash and its related consequences for millions of ordinary people and

unsophisticated investors.

The principal contribution of this paper lies in the introduction of an alternative

literature to the study of financial risk, which has the potential to illuminate its understanding

in a significant way. Although there have been extensive discussions on risks in the physical

sciences, such debates in the field of finance and economics are less common. This is primarily

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because there are certain core assumptions made in finance and economics which are not

subject to debate. McGoun (1995) demonstrates how the technical limits of risk measurement

in economics were first identified in the 1930's, but somehow, the attractiveness of measuring

risk was so strong, that these limitations were avoided from the 1950's onwards. There has,

however, been a growing critique of some of these basic assumptions in finance and

economics. For example, McGoun (1997) makes a case for a better understanding of the

cultural role of modern financial markets and transactions arguing convincingly that they

resemble a 'hyperreal game'. It is argued here that society needs to recognise the nature and

problems created by financial risk, and actively try to address these problems instead of

ignoring or denying them. Although finance texts are generally silent about the culture and

politics of risk, more general textbooks on risk management do discuss risk culture as a key

part of risk management (see e.g. Hopkin, 2012).

This paper adopts an inter-disciplinary approach to the study of financial risk. Two key

sociological/anthropological works regarding risk are used as a basis for the argument: Risk

and Culture, by Douglas and Wildavsky, 1982; and Risk Society, by Ulrich Beck, 1992. Both

are widely acknowledged as major works in the social analysis of risk, and there is a common

theme underlying these books. Risk is argued to be a subjective construct, and as such it is

difficult to assess from an objective standpoint. However, risk has a real impact on people and

society, so it has to be studied rigorously and hidden dangers need to be exposed – there is a

strong normative emphasis in the writings. It is argued that great care must be exercised when

society decides to rely on experts for the evaluation of risk, because experts are rarely free from

bias. Our paper seeks to expose the complexity of risk, and suggest ways of analysing risk

which have hitherto been ignored in the mainstream finance literature. Far more attention

needs to be paid to culture and values in risk evaluation and measurement. Fundamentally,

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society needs to understand the bias of experts in financial risk calculation and management.

Much more research is needed around the ethics and values of finance professionals and

academics, the institutional structure of the finance academy, and therelated impact on

markets, society and the planetary ecosystem.

The paper is organised into eight sub-sections, each of which discusses various facets

of financial risk. Section 2 introduces certain basic features of risk and its possibilities and

limitations and outlines some of the existing knowledge about risk as discussed in the prior

literature. This is followed in Section 3 by a discussion of the definitional weaknesses of

financial risk. Section 4 reviews the obsession with objectivity in the finance literature. After

that, Section 5 analyses assumptions in the finance literature about individual preferences and

attitudes towards risk. Section 6 discusses the efforts by members of the academic finance

discipline to refer to the rigor and objectivity of their work in order to justify their conclusions;

while at the same time making an effort to protect and preserve carefully accumulated

knowledge from outside criticisms. Section 7 exposes the role of the finance academy in the

creation of financial risk, exposing further the lack of objectivity in matters concerning

financial risk. The concluding section summarises and extends the main arguments of the

paper.

2. The Nature of Risk

The Oxford Dictionary defines risk as a 'chance of hazard or of bad consequences, loss,

etc.' Thus risk carries a wide range of significations, mostly premised on the impact of future

events on human beings or communities. Risk is a concern for the future, expressed in the

present. Its modern definition and discussion is focused primarily on the downside or negative

aspects, and primarily on the impact of risks for human life on this planet. However in order to

decide whether or not a particular risk has a potentially adverse impact, we need to have a clear

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view of what is considered to be positive and worthwhile, and what is negative and must be

reduced, managed or eliminated. Thus we cannot discuss risk without discussing values and

ethics. Hence any attempt at calculating or discussing risk objectively is doomed to partiality

and incompleteness. This also explains why, if experts claim their risk calculations to be

objective, their motives should be treated with suspicion. In truth, 'substantial disagreement

remains about what is risky, how risky it is, and what to do about it' (Douglas and Wildavsky,

1982, p. 1).

Risk should be seen as a joint product of knowledge about the future and consensus

about the relative importance of certain outcomes (Douglas and Wildavsky, 1982). When

knowledge about the future is certain and the consensus about outcomes is complete, then the

problem of risk becomes technical, and its resolution is a mere matter of calculation.

However, when knowledge is uncertain and a consensus about outcomes is lacking, the

assessment of risk becomes particularly problematic, because the measurement and

evaluation of risk is no longer feasible. Thus risk calculations may be appropriate for

situations where there is certain level of specific knowledge about the future and common

agreement about the potential impact of future events, but not where there is uncertain

knowledge about the future and/or disagreement about the outcomes. It is rare that we have

certain knowledge about the future and at the same time, common agreement about potential

outcomes. The need for consensus about outcomes reveals the critical importance of politics

in the assessment and evaluation of risk. In reality, most risks comprise uncertain knowledge

about the future and a lack of consensus about outcomes.

In addition, risks can either be voluntary or involuntary. In a liberal society, we may

be less concerned about voluntary risks, but involuntary risks, especially when they affect

vulnerable groups of people, are a cause for public concern. Systemic risk is a classic

example of a major involuntary risk which was ignored by both experts and regulatory

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institutions prior to the 2008 crash. Paradoxically, the very people who did not participate in

the risks were forced to bail out the financial markets and institutions. Similarly, not all risks

can be visible or discernible by ordinary people. For example, most people would not be able

to distinguish between a normal glass of water and a polluted one, and it is only under the

microscope operated by a trained scientist that such risks become visible. Thus experts play a

vital role in the acknowledgement of certain risks and in deciding levels of acceptability. For

example, it would be impossible to find perfectly pure water, and there would be degrees of

impurities which would be harmless to human beings, so the water would be certified by

experts as relatively pure.

Certain risks are irreversible: 'once set in motion, they continue inexorably until they

cascade out of control' (Douglas and Wildavsky, 1982, p. 21). There is a fundamental need

for social and political concern about such risks. In order to identify irreversible risks, and

their potentially damaging consequences, there is a need for some kind of unbiased

knowledge and acceptance about the likely outcomes. In the study of pollution, there is a

shifting of the conventional domain of risk calculation, with many scientists claiming that the

natural environment should be protected from damage not simply for human welfare, but for

animal and environmental welfare too. Thus irreversibility seen from a wider perspective is

even more complex, and its analysis requires a more detailed understanding of the natural

environment.

Risk relates to likely future events, and concern for risk requires that we anticipate the

future in the present. Beck explains (p.34):

'The centre of risk consciousness lies not in the present but in the future. In the risk

society, the past loses the power to determine the present. Its place is taken by the

future, thus something non-existent, invented, fictive as the 'cause' of current

experience and action. We become active today in order to prevent, alleviate or take

precautions against the problems and crises of tomorrow and the day after tomorrow -

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or not to do so.' (emphasis in original)

Risk analysis often requires a break from the past, yet most of the conventional methods of

risk analysis are based on using past trends as the basis of predicting the future. This problem

becomes especially acute when there are fundamental changes in types of risks. Beck uses the

example of chemical and industrial pollution in which there may be an introduction of

unknown and even 'unknowable' risks into the environment. In such cases, not only do past

approaches utterly fail, they can also create a misleading sense of comfort and security. A

good example of this scenario in the case of financial risk is the whole issue of evaluating

systemic risk in banking (Shah, 1996a; 1997).

Consequently, even though risks are real and worthy of careful study, in practice it is

very difficult to study risk in a completely objective manner. The very nature of risk is

diverse and subjective. This is why objective approaches are needed and at the same time

limiting. Beck's major critique is that modern methods of analysis are unable to fully deal

with risks because they get trapped in their own language, institutionalisation and politics.

Rigorous methods of analysis may attempt to avoid 'subjectivity', primarily out of fear of

being insufficiently 'scientific'. Beck argues that there is very little dialogue among scientists

and experts, and when they do talk, they talk past each other. However, in order to study risk,

multiple disciplines need to be inter-twined and directly connected with one another. Beck

explains (1992, p.59):

'My thesis is that the origin of the critique of science and technology lies not in the

'irrationality' of the critics, but in the failure of techno-scientific rationality in the face of

growing risks and threats to civilisation. This failure is not mere past, but acute present

and threatening future. In fact it is only gradually becoming visible to its full extent. Nor

is it the failure of individual scientists or disciplines; instead it is systematically

grounded in the institutional and methodological approach of the sciences.toward risks.

As they are constituted - with their overspecialised division of labour, their

concentration on methodology and theory, their externally determined abstinence from

practice - the sciences are entirely incapable of reacting adequately to civilizational

risks, since they are prominently involved in the origin and growth of those very risks.'

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Thus according to Beck, not only is modern science incapable of unravelling complex risks,

it is also party to their creation and promulgation. After the 2008 crash, there has been a

growing critique of the ideological impact on regulatory policies and practices during the

decade leading up to the crisis. The belief in free and efficient markets, where institutions

monitor their own risks because it is in their self-interest to do so, prevailed, and regulation

and laws were changed in order to liberalize regulation (Watson, 2013; Peston, 2010;

Reinhard and Rogoff, 2011) – allowing a free rein to financial institutions and markets in key

high risk areas like derivatives.

This ideology prevailed in spite of significant recent experiences of stock and financial

market crashes like the 1987 crash, the US Savings & Loans Crisis, the Asian currency and

markets crisis of 1998. The US Federal Reserve Chairman Alan Greenspan was an exponent

of this faith in markets, even though after the crash, he was ready to use public money to bail

out failing institutions. In hindsight, this evidence sounds surprising, but it is possible that

this ideological influence prevailed because of the reasons cited above by Beck. Scientists

and experts are fundamentally incapable of reacting to risks because they are party to their

very creation. Their ideology was used to support financial institutions in removing the

private costs of regulation and oversight and the pain of compliance – it served powerful

interests at a time when they wanted to expand the risks and their own short-term rewards

(Ferguson, 2010). Stark evidence about a housing bubble and poor lending practices in North

America were ignored for years.

In the next section, we will examine the definition of financial risk.

3. Defining Financial Risk – An operational over-ride

A precise definition of financial risk is often avoided in major student texts like

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Brealey, Myers and Allen (2014) and Copeland, Weston and Shastri (2005). The discussion

plunges straight into the measurement and management of risk, as if the concept of risk itself

was unproblematic. Ross, Westerfield and Jordan (2012) writing on fundamentals of

corporate finance, explain in Chapter 12 the need to define risk, and then jump to the

statement that it can be measured by variance – the calculation overwhelms the definition.

Eeckhoudt and Gollier (1995), authors of a significant text on financial risk, state a

fundamental assumption (p.3) - 'that the individual or corporation - or more generally the

decision maker - is only interested in one thing: the level of final wealth .... We do not intend

to engage in a debate that tends towards the theological.' In a World Scientific Series

post-financial crisis book on risk measurement and management (Roggi and Altman, 2013),

a whole chapter is devoted to the history of risk, but it is rambling and comes to no

conclusion about the definition of risk except that in the present day, it is a measurable

phenomenon. Subjective probability and operationalism have been the key sources of risk

measurement, argues Holton (2004).

Even operational definitions of financial risk are suspect, argues Holton (2004, p.24):

‘At best, we can operationally define our perception of risk. There is no true risk.’ Even

though risk metrics are used in financial applications, their usefulness involves several

limiting assumptions. It is possible that the commercial desire to operationalise risk

overwhelms its reliability and fundamental nature (Power: 2007, 2009)

There is no reference in finance to advances in risk knowledge and understanding in

other fields like sociology, psychology and anthropology. Thus a fundamental subject is

analysed without any clear definition, and this is justified because it is commonly accepted in

the literature. In most finance texts, it is as if everyone knows what risk is so there is no need

to define it – let's go ahead and measure it, and even more importantly, demonstrate ways of

managing it. In his detailed survey of the history of risk measurement, McGoun (1995)

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demonstrates the significant degree of confusion that exists about the meaning of risk in

economics, and the range of terminology used.

If we wish to summarise the present understanding of financial risk, one way to do so

would be to list various topics in which financial risk is discussed. A representative list might

include:

Individual preferences and attitudes to risk - risk averse, risk neutral, risk seeker;

Portfolio theory - risk as variance of return; risk reduction through diversification; Beta

risk and the Capital Asset Pricing Model;

Option volatility and the risk of derivative securities – Black-Scholes Option Pricing

model;

Measuring risk using probability theory or state-preference theory;

Risk Management - hedging strategies;

Bond Duration and volatility;

Portfolio insurance;

Different types of risk - e.g. interest rate risk, market risk, credit/default risk.

From the above, we see that the subject is sub-divided without any comprehensive analysis of

the whole. Measurement overrules understanding.

Since risk influences asset and securities values, the demand for particular types of risk

measurement in the modern world of finance and capital markets is significant. Variances,

betas and volatility are common buzzwords for finance students and scholars. These measures

are seen to provide guidance on relative risks and asset prices, and their popularity suggests

that people working in the field of finance find them useful for analysis. However, this does

not necessarily indicate that these measures are the best way to understand and measure or

evaluate risk.

The above list of topics demonstrates the partial and disjointed understanding of risk in

finance. In fact, it shows that the theory of risk in finance is not a theory at all, but instead a set

of operational assumptions and definitions. It supports McGoun's (1995) argument that the

need to understand risks which have been bypassed since the 1950's, is much greater than any

difficulties with measurement even though earlier debates clearly demonstrated the difficulties

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of both understanding and measurement. One of the central concerns of finance research is the

valuation of securities, and risk is only really examined and explored to the extent that it

influences securities valuation. The importance attached to securities valuation is directly tied

to the belief in efficient markets and the focus on individual investors or investment portfolios.

It is generally assumed that if markets are sufficiently competitive then securities will be

properly priced by the market. This belief often leads to misleading ideas about the efficiency

of markets in general and the potential implications of market efficiency or lack thereof for

social welfare (see for example: Simmel, 1978; Strange, 1986).

Another fundamental flaw in modern risk measurement is that it ignores the human

paradox of distinguishing between is and ought. Past trends are used to project future

expectations, without any consideration of the likelihood of the past being repeated in a

changing environment. Relative frequency probability, the most common method of risk

measurement, suffers from the 'reference-class problem'. 'There is no simple way to determine

which historical conditions, if any, are sufficiently similar to current conditions to use the

relative frequencies of an event under those conditions as an appropriate "measure" of the

"rational" probability with which to expect the event to occur under these conditions’.

(McGoun, 1995, p. 512).

There is also a time dimension in risk measurement which is often ignored in financial

analysis. For example, if an average return is calculated over a number of years, it might be

assumed (erroneously) that the return will continue in the absence of major changes in the

environment, provided that the investor holds the security for a similarly long term and ignores

intermediate fluctuations.

In addition, finance theory requires some assumptions relating to personal attitudes

towards risk. This is dealt with using a two dimensional axis - risk and return. Usually, a

description is given of different types of risk positions adopted - risk averse, risk neutral and

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risk seeker. A statement is then made that risk and return follow a pattern – high returns come

with high risk. Individuals are risk averse if they are willing to accept a smaller return in

exchange for a small amount of risk. Risk neutral individuals are indifferent towards risk,

while risk seekers are those who willingly take on risk, in the expectation of high returns. The

analysis then goes on to assume that most individuals are risk averse, and this is the basis for

the subsequent measurement of risk. There is an implicit assumption in this descriptive

model that risks may be acceptable provided there are high potential rewards. However, it is

possible those individuals may have a combination of risk aversion and risk-seeking behaviour

in different circumstances, and that there are other dimensions besides return which influence

their personal attitudes towards risk.

One aspect totally ignored in contemporary finance is the whole area of ‘people risk’.

As people are critical to the operation of financial markets and institutions, their judgements,

sub-cultures and actions have a direct influence on the measurement, impact and evaluation of

risk. Examining the 2008 crash, McConnell and Blacker (2011) show how people-related risk

had a major contribution to the securitisation industry. The writings of Michael Lewis (Lewis

2008, 2011), Mackenzie (2006) and Tett (2010) echo this thesis. The fact that this is ignored in

the literature is yet more evidence of the partial, biased and incomplete understanding of risk in

finance.

In terms of risk measurement, the breakthrough in finance was made by Markowitz

(1952) when he suggested that risk can be measured by the standard deviation of returns,

assuming that asset returns are normally distributed. This opened up a whole series of

techniques of risk measurement using statistical and mathematical methods. The entire

distribution of returns of an asset could now be described by two statistics - mean and standard

deviation. The question as to whether standard deviation is an adequate or complete measure of

risk, or whether the assumption of normal distribution of asset returns is empirically valid, was

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bypassed. Similarly, the focus on distribution of returns detached the issue of individual or

societal preferences and attitudes towards risk from the measurement of risk. Theoretical and

calculative convenience overtook empirical reality.

It should be noted however, there is a big difference between the measurement of risk

and its management. Contemporary finance literature assumes that as long as risks are

measured, they will be managed and contained. This is a very big jump and ignores the reality

of risk control and the politics of risk management (Das 2011, Shah, 2014). Power (2007,

2009) has shown that a great deal of risk measurement in organisations is done as a ritual, and

that the impact of this activity on management is often marginal – there is a risk management

of nothing or everything. In the burgeoning discipline of Enterprise Risk Management, Hayne

and Free (2014) show how risk management has become a management fad. Often, risk

measurement processes are used as a chimera by management to show that they are doing

something, without actually understanding financial risk or managing it effectively. After the

forensic analysis of the financial crash, a number of writers have exposed the significant

management illiteracy about risk in some of the largest and most significant financial

institutions (Lewis, 2011, Tett, 2010; Das, 2011; Peston, 2010).

The emphasis on risk management and the sub-categorisation of risks into new and

emerging terms like interest rate risk, market risk, regulatory risk, foreign currency risk,

liquidity and credit risk, have led to attempts to assess the reality of specific risks as they affect

firms and individuals. Techniques of evaluating these risks have evolved in finance in order to

provide useful assessments of returns and default. Thus, quite sophisticated methods of risk

analysis have developed in areas where there is commercial benefit from accurate analysis.

However, such approaches do not always enhance the knowledge base of the fundamental

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components of financial risk and how they inter-relate to one another. It can be argued that by

dividing a concept which is not fully understood into sub-categories for pragmatic purposes,

society has been increasingly distanced itself from the fundamental meaning and

consciousness of financial risk.

Collapsing risk and return into monetary values make them useful for comparison

purposes. Cost-benefit analysis is a standard technique of risk evaluation in finance, where

costs or outlays are compared to potential benefits, and if benefits arise in the future, they are

collapsed to the present through a process of discounting. While this is a useful technique, it

has limitations when the monetary value of costs or outcomes cannot be easily ascertained.

The technique gives undue prominence to values that can be calculated, not necessarily the

most significant. Similarly, discounted present value techniques obscure the inherent

uncertainty of future events.

Modern finance theory is obsessed with objectivity and mathematical precision in its

claims to be a recognised science. Thus it is assumed that risk can be measured and discussed if

the procedures of measurement and analysis are rigorous and beyond individual subjective

preferences. Mathematical calculation and precision are ways of giving financial risk the

image of objectivity; although whether or not the risks themselves are objective is

questionable. Haldane (2012) has claimed that this avoidance of uncertainty in the theoretical

models, and assumptions of rational expectations, have been a key flaw in the understanding

and effective measurement and management of risk. McGoun (1995) concludes in his analysis

of the history of risk measurement in economics and finance (p. 530):

'The acceptance of a probabilistic measure of risk was an act of faith. The persistence of it

in the face of its lack of success, and the heroic strategies that are invoked to immunise

cherished theories are acts of faith as well. There is more than scientific method involved.

One can only guess whether the rejection of a probabilistic measure of risk would lead to

a loss in status of the profession, a severe depreciation of painfully acquired human

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capital, a horror at the absence of any apparent alternative, or some or all of the above. It

might certainly lead to better theory.'

Complex mathematics can also be used to protect the experts and to convey scientific

precision. It can be a fence which carves out a territory and demonstrates control and

understanding when these are at best imperfect. Douglas and Wildavsky (1982) and Beck

(1992) have expressed significant reservations about these ‘objective’ approaches, and they

claim that in the past there have been deliberate attempts by experts to protect their expertise,

and justify it as being scientific. The following section discusses this issue at length.

4. Objectivity and risk

Douglas and Wildavsky (1982) note (p.7l):

'Objectivity means preventing subjective values from interfering with the analysis. Put

the figures in, work out the probabilities, crank the handle, and the answers will come

out. ... Something has gone badly wrong with the idea of objectivity. It is taken out of

context and turned into an objective value for all discourse. The rules that produce

objectivity rule out someone's subjectivity. In a context of justice, an objective

judgement is disinterested (but not necessarily right). In a context of social enquiry, an

objective report is honest, free of personal bias (but not necessarily right). In a context of

scientific enquiry, an objective statement is arrived at by standardised techniques: the

inquiry can be replicated and under the same standardised conditions will reproduce the

same answers. However objective the processes, the interpretation is not guaranteed to be

right by objectivity in the research design.'

Thus the fact that conventional approaches to evaluating financial risk assume a world

where individuals are primarily concerned with financial wealth, and this is an 'objective'

assumption, raises questions about why scientists make such huge leaps of faith and deny them

at the same time. This premise is quite clearly materialistic and not all individuals, cultures or

societies are so driven by material priorities. When others try to discuss the validity of the

standard assumptions, their approaches are seen to be biased, subjective and leading to

imprecise results (Das, 2011). Both Douglas and Wildavsky (1982) and Beck (1992) argue that

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what is really suspect in these claims of objectivity is the desire to shield scientists own value

judgements from public scrutiny. Beck is also wary of the multitude of risk definitions and

categories, suggesting that these are attempts at capturing and politicising risk. He notes

(p.31):

'Every interested party attempts to defend itself with risk definitions, and in this way to

ward off risks which could affect its pocketbook .... This pluralism is evident in the

scope of risks; the urgency and existence of risks fluctuate with the variety of values

and interests. That this has an effect on the substantive element of risks is less obvious.'

Thus when there is an expansion in the number of categories of risk measurement, such

as interest rate risk, exchange rate risk, market risk, credit risk, this does not necessarily lead to

a better understanding of risk. Such definitions divert our attention from dealing with some of

the more lasting and damaging financial risks, and discourage us from taking preventative

action – a type of divide and rule. Multiple definitions may be deliberately designed to confuse

rather than illuminate. Beck is particularly critical of the quantification of risk, an aspect in

which he echoes Perrow (1984). Beck writes (1992, p. 29/30):

'The studies of reactor safety restrict themselves to the estimation of certain quantifiable

risks on the basis of probable accidents. The dimensions of the hazard are limited from

the very beginning to technical manageability. In some circles it is said that risks which

are not yet technically manageable do not exist - at least not in scientific calculation or

jurisdictional judgement. ... But the quantifiable concepts of risk concentrate on the

probable occurrence of an accident and deny the difference, let us say, between a limited

aircraft crash and the explosion of an atomic plant, improbable as it might be, which

affects nations and generations not yet born.'

There is a very real gap between technical rationality and social or cultural rationality, which

may raise questions that are not answered by the risk technicians.

There is very little distinction in finance between personal and societal risks. Societal

risks, like the systemic risk of collapse in banking or financial markets, have until only recently

been fleetingly discussed perhaps because they are incapable of being mathematically

modelled (Shah, 1997a). These kinds of risks are often ignored and at times even denied or

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deemphasised (Group of Thirty, 1993; Reinhard and Rogoff, 2011). In truth, there is an

unstated ideology in finance that there is no such thing as society - merely collections of

individuals. Fundamentally, there is no belief or ethical concern about society and its

well-being. The insurance industry is a commercial enterprise and aims to profit from

individual and societal risks, and in pricing its risk products, performs statistical analysis of

past experiences of these risks (Skipper and Kwon, 2007). The industry avoids insuring

high-risk technologies like nuclear power and in many cases, civil unrest is also excluded from

cover. The insurance industry is primarily a commercial business whose goal is to profit from

risky situations and not to help reduce societal risks. At best, the insurance industry helps to

distribute the impact of these risks. Insurance provides some opportunities for reducing or

managing risk, which are in themselves useful, but this can create a false consciousness of

being in control of financial risk or of always having the ability to manage it. For a long time,

the finance academy has succeeded in detaching risk from human experience, without caring

for the consequences of this detachment. It is strongly positivist in its orientation, thereby

avoiding genuine and highly significant normative concerns.

5. Individual preferences and attitudes towards risk

One of the oldest and most accepted generalisations in decision theory is that people are

generally risk averse. Individuals are also assumed to prefer certainty to uncertainty, and

rational and well informed. In reality, there is considerable financial illiteracy of the most

basic kind, like understanding interest rates, budgeting and loan repayments (Shah, 2014).

This handicaps individuals severely in managing their finances. In addition,'against

established theory, people are not risk averse for negative prospects, only for positive ones ...

so we actually are creatures who habitually tolerate risks' (Douglas and Wildavsky, 1982,

p.79). For example, when faced with a certain loss of one thousand and a 5% chance of losing

20

two thousand, individuals are likely to choose the latter alternative, even though it involves

risk. They note further (p.72):

'When we look closely at how private individuals make choices, we will see that they

choose not be aware of every danger. The institutions in which they live screen some

disasters from their ken. Their social environment sorts and clips the prospects before

them. If they did not so edit their universe, they would be liable to the same stultification

and freeze on resources as would afflict an imaginary government that might try to

institute total protection and' zero risk. Refusing to take all dangers into account is not

behaving irrationally,'

It is also important to see the difference between individual preferences free from societal

influences, and preferences which cannot be detached from wider influences. Conventional

risk analysis assumes that individuals are free to express their will and that there is no such

thing as society. This thinking is misleading and potentially harmful, as Douglas and

Wildavsky point out (1982, p.80):

'In risk perception, humans act less as individuals and more as social beings who have

internalised social pressures and delegated their decision-making processes to

institutions. They manage as well as they do, without knowing the risks they face, by

following social rules on what to ignore: institutions are their problem-simplifying

devices.'

Thus to assume individual preferences as being rational and consistent also ignores the degree

of socialisation of individual attitudes toward risk and the role institutions play in managing or

simplifying these risks.

There is a perception among scientists that (Beck 1992: p.58) 'if the public only knew

what the technical people know, they would be put at ease - otherwise they are just hopelessly

irrational.' Beck goes on to argue:

'This perception is wrong. Even in their highly mathematical or technical garb,

statements on risks contain statements of the type that is how we want to live -

statements, that is, to which the natural and engineering sciences alone can provide

answers only by over-stepping the bounds of their disciplines. .... The technical risk

experts are mistaken in the empirical accuracy of their implicit value premises,

specifically in their assumptions of what appears acceptable to the population.'

Thus individual preferences cannot be divorced from ethical beliefs and value judgements, and

21

if financial risk is to be properly understood, the experts need to go beyond the boundaries of

their disciplines. Thus the positivism of finance theory is a charade – it makes fundamental

normative assumptions but refuses to acknowledge them as such.

Somehow, the finance academy has for a long time analysed risk by detaching it from

human experience, in spite of the fact that for millions, it has had catastrophic consequences

for their livelihoods. Whether this was done consciously or sub-consciously we do not know,

but the outcome of this has been significant human suffering and pain – through homelessness,

unemployment, personal bankruptcy, marriage and family break-ups, depression and mental

health breakdowns. It is possible that this served their own academic careers and claims to

scientific rigour but the public and social cost of this detachment has been enormous. The

evidence supports Beck in showing that risk measurement and calculation says more about

who has power, than about fundamental truth and human experience.

Beck is particularly critical of the isolation of ordinary people from risk evaluation and

the influence of scientists in calculations of acceptable levels. He writes (1992:p.69)

'The effect on people can only be studied reliably with people. Society is becoming a

laboratory... (The experiment on people) fails to take place in the sense that the reactions

in people are not systematically surveyed and recorded.... The experiment on people

does take place, but invisibly, without scientific checking, without surveys, without

statistics, without correlation analysis, under the condition that the victims are not

informed - and with an inverted burden of proof, if they should happen to detect

something.'

Thus for Beck many real and significant risks are experimented live on people. It is possible

that even for financial products, greed and commercialisation lead to live experimentation

rather than careful prior analysis.

For Beck, many of the risks taken by modern society are unknown - they are forays in

the dark. For example, individual chemical compounds may be non-toxic but if combined, the

22

same compounds may be lethal. Similarly, some people have warned of the dangers of modern

financial instruments (General Accounting Office, 1994; Shah, 1996a) as being high risk

transactions whose future impact is often unknown, yet there is little global 'worrying' about

these risks (Shah, 1996b). Beck argues that the fact of globalisation has led to an increase in

the spread of many social and ecological risks. The globalisation of financial markets has led

to the proliferation and export of financial risk. The next section examines the role of

regulatory institutions and policy in the public protection of financial risk. .

6. Expert Bias in Risk Definition

One of the crucial areas of public concern relates to acceptable levels of risk. To what

extent should society permit certain risks, and beyond what levels should the risks be

eliminated? This is a major area where society has little choice but to rely on scientists for

deciding levels of acceptability, especially in complex areas like derivatives. It is also the arena

where there is much disagreement, and evidence of polarisation and bias among the scientific

community. For individuals and societies to understand, recognise and manage financial risks,

they need to be conscious of the nature and extent of the risks they face. As we have already

seen from our analysis of the existing risk measurement techniques in finance, science does a

poor job of this. Thus people are forced to act on what Beck calls 'second-hand

non-experience'. He writes (p.72):

'One no longer ascends merely from personal experience to general judgements, but

rather general knowledge devoid of personal experience becomes the central

determinant of personal experience.... ultimately, no-one can know about risks, so long

as to know means to have consciously experienced.'

Thus when insurance companies evaluate personal health risks, and draw up elaborate

contracts of what is covered and what is not, there is a reliance on health experts who operate as

a business for commercial gain. The risk analysis is not directed fully toward individual benefit

23

or health improvement but toward more abstract concerns with the financial profitability of a

series of risks. When an insured person contracts a particular illness not covered in the contract,

this would be the first time the person experiences the reality of the risk and its impact could be

potentially devastating as it is uninsured. Douglas (1992) writes about her long experience of

dialogue with risk experts (p. 11):

'When I tried to engage established risk analysts in conversation I soon gathered that to

emphasise these dubious uses of risk is perverse, a dirty way of talking about a clean

scientific subject. Though they recognise that the grime and heat of politics are

involved in the subject of risk, they sedulously bracket them off. Their professional

objective is to get at the real essence of risk perception before it is polluted by interests

and ideology. The risk analysts have a good reason for seeking objectivity. Like all

professionals, rightly and properly, they do not wish to be politically biased: this is

important for their clientele. To avoid the charge of bias, they exclude the whole subject

of politics and morals. To see them studying risk-taking and risk-aversion in some

imaginary pure state is disappointing to anyone who has been attracted to the dirty side

of the subject.'

Thus experts make a strong pretence about being apolitical, without acknowledging that by

trying to promote objectivity in spite of their biases, they are being political.

Beck is also very critical of the proliferation of 'acceptable levels' of risk, as if there

are tolerable limits, which are measurable and controllable. In finance, a parallel can be

drawn with the rise of derivative markets, which have grown exponentially in a very short

time, and experts who are constantly reassuring us of the great advantages of these securities

and the manageability of the risks they generate. Beck writes (p.64):

'A central term for 'I don't know either' is 'acceptable level'..... In connection with risk

distribution, acceptable levels for 'permissible' traces of pollutants and toxins in air,

water and food have a meaning similar to that of the principle of efficiency for the

distribution of wealth: they permit the emission of toxins and legitimate it to just that

limited degree. Whoever limits pollution has also concurred in it.'

Thus acceptable financial risks have to be taken with scepticism because they are likely to be

determined by analysts who profit from determining their acceptability, rather than analysts

who are responsible for any adverse consequences. Beck talks of a subtle conspiracy which

24

pronounces 'maximum concentration decrees' (p.66):

'Whatever does not fit into the conceptual order, because the phenomena are not yet

registered clearly enough or are too complex, whatever lies across the lines of the

conceptual plan - all this is covered by the definition-making claims of the order, and

absolved of the suspicion of toxicity by going unmentioned. The maximum

concentration decree is based, then, on a most dubious and dangerous technocratic

fallacy: that what has not (yet) been covered or cannot be covered is not toxic. Put

somewhat differently, in case of doubt please protect toxins from the dangerous

interference of human beings.'

The ideology of efficient markets and rational expectations can be seen as a deliberate

attempt to deny more serious risks like systemic risk or failures of credit-rating agencies to

accurately evaluate credit. Through denial of market failure, finance endorsed risk creation

and mis-management. One of the reasons for the recent worldwide financial crisis was

warped incentive structures for risk taking - management of these institutions were rewarded

for high risks, but not directly penalised if these gambles turned sour (Permanent

Subcommittee on Investigations, 2011). In fact, this is a very real and fundamental problem

facing large financial institutions - depositors are protected by central banks, but management

are encouraged to take on risk through risk-inducing incentive structures. However,

mainstream research in finance does not even permit the questioning of .the impact of these

incentive structures, and instead endorses the need for these incentives to influence wealth

creation through agency theory. In the meantime, society is forced to bear large and real

financial risk, with potentially devastating consequences.

Douglas and Wildavsky (1982) are also very cynical about the notion of acceptable risks

and the biased role of experts in determining acceptability. They note (p. 49/50):

'Experts are used to disagreement. But they are not used to failing to understand why

they disagree. So to find more evidence they take their analyses down to deeper levels.

If no dangerous contaminant can be detected by an analysis that goes to the one hundred

thousandth part, perhaps it may be found if we go down to the millionth part, or the

trillionth? But expanding measurement only increases the area of ignorance. The

frustration of scientists over disputes about technology is a characteristic feature of our

time.'

25

Thus in risk analysis, there is a need for the debate to move beyond establishing facts to

decisions about acceptability, from 'objective' science to political consensus-making. It is in

this arena that conflicts surface, biases emerge, and where there is a genuine need for experts

who are free from political and economic corruption. Not only is it difficult to find such

experts, but the process of determining acceptability is also heavily politicised, as the stakes

are often very large. This is where a re-examination of the structure of society, which permits

individuals and institutions driven primarily by an economic profit motive, rather than one of

responsible citizenship, is inescapable if we wish to unravel and reduce certain financial

risks.

Scientists also place a strong emphasis on proving causality before they pass

judgement - to the extent they cannot prove that A causes B, they would not admit that A may

generate unacceptable risks. One of the most serious risks in modern finance is commonly

known as systemic risk, but once again, rarely defined in finance texts (Shah, 1997). The

general understanding ascribed to it is that due to inter-linkages in the financial markets, there

is a real risk that the collapse of one financial institution can trigger the collapse of others

(even though they may not individually be insolvent), leading to a chain reaction which can

have serious consequences for a developed money-based economy in the modern world. This

cannot only lead to an economic depression, but also the related social damage of poverty and

hopelessness. The recent financial crisis was preceded by a collapse of the housing market in

the United States. There have in the past been experiences of such systemic accidents, both in

North America and in Europe (Galbraith, 1972; Kaufman, 1994; Reinhard and Rogoff,

2011). This can be seen as an example of the denial of risks by influential people, not because

they do not exist, but because they cannot be dealt with in a commonly acceptable language.

The emphasis on proof of causality is also a deviation from the reality of risk, and can be seen

26

as a subtle form of denial. Beck argues (p.62):

'Scientists insist on the 'rigour' of their work and keep their theoretical and

methodological standards high in order to assure their careers and material success ....

The insistence that connections are not established may look good for a scientist and be

praiseworthy in general.' When dealing with risks, the contrary is the case for the

victims; they multiply the risks. One is concerned here with dangers to be avoided,

which even at low probability have a threatening effect. If the recognition of a risk is

denied on the basis of an 'unclear' state of information, this means that the necessary

counteractions are neglected and the danger grows.... What results then is a covert

coalition between strict scientific practice and the threats to life encouraged or tolerated

by it.'

Insisting on strict causality which is difficult to prove in practice, leads to a deflection from

the analysis and management of significant financial risks. Systemic risk is a real financial

risk, with potentially serious social and economic consequences. Its investigation and

management therefore deserves the highest social priorities and should not be entrusted in the

hands of 'pure' scientists. Beck goes even further and states that (P. 75):

'The possibility of denying and trivialising the danger grows with its extent. ... Risks

originate after all in knowledge and norms, and they can thus be enlarged or reduced

in knowledge and norms, or simply displaced from the screen of consciousness. What

food is for hunger, eliminating risks, or interpreting them away, is for the

consciousness of risks. The importance of the latter increases to the extent that the

former is (personally) impossible.'

In assuming that firms are best placed to manage their own risks as it is in their

self-interest to do so, there is a huge ideological leap of faith which is unexplained. Lack of

evidence of causality may be used by scientists to ignore or deny the risks, as they are not in

their academic self-interest. In fact, there is a risk that this can also lead to the identification

and isolation of scapegoats, who society now sees as psychotic scaremongers and social

outcasts. Until of course, there is a real financial crisis.

The way businesses talk about acceptable risk is commonly called ‘risk appetite’

(Hopkin, 2012). The phrase itself shows how risk is often so misunderstood that rhetoric is

used to disguise its real impact – it is not something one can have for lunch! Financial

27

institutions have for many years used this language in the boardroom, even though there has

often been very poor understanding of risk in the boardrooms, and incomplete and inaccurate

ways of measuring and monitoring risk appetite (Tett, 2010). Some have suggested that risk

appetite is a way in which business leaders can show their concern for risk, and the fact that

they are measuring and discussing it, without actually doing anything substantive to mitigate

risk (Power, 2009). The evidence of the 2008 global financial crash showed how wrong the

risk appetites and measures were of so many large and significant financial institutions (Das,

2011). It echoes what Beck and Douglas and Wildavsky have been postulating – risk appetite

is a deliberate chimera of acceptable risk.

At the systemic level, Beck identifies a deep-rooted sense of irresponsibility which

encourages the creation and maintenance of large and growing risks. Beck writes (p.33):

'... corresponding to the highly differentiated division of labour, there is a general

complicity, and the complicity is matched by a general lack of responsibility.

Everyone is cause and effect, and thus non-cause..... This reveals in exemplary fashion

the ethical significance of the system concept: one can do something and continue

doing it without having to take personal responsibility for it.'

Thus there is a strong social temptation to divide risks and create new categories which are

local and solvable than to examine larger more fundamental risks whose resolution would

require a more responsible attitude and a determination towards the betterment of society as a

whole rather than the individual. Systemic risk in finance was systemically denied. This

denial prevailed because of the systemic free market ideology in finance which did not care at

all about human experience and suffering in the face of growing risks. The next section looks

at how risks are created and managed remotely.

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7. Remote control risk creation and management

One of the biggest growth areas of financial risk in modernity has been the rise in

borrowing – whole generations have been raised seeing debt as a normal almost riskless part of

life (Coogan, 2012). Countries have also gotten used to borrowing themselves out of recession.

This whole cycle has led to an increase in financialisation and the growth of attendant financial

risks. Somehow the fundamental risks of debt – that it is borrowing which will need to be

repaid – have become sub-conscious or even unconscious. Finance theory has been party to

this encouragement of debt and borrowing, and the finance industry has benefited hugely from

the growth in debt and the culture of borrowing as Coogan has demonstrated. Debt has

facilitated the postponement of problems and the advance enjoyment of assets one did not own

(like homes on mortgages). In the case of homes, the myth that house prices will always rise,

encouraged reckless buying and reckless lending. Somehow, this whole culture of debt has

removed people and whole countries from feeling the risk and experiencing it, often until is too

late to do anything.

One of the claimed advantages of financial instruments and markets is that they enable

individuals and corporations to manage different types of risk without necessarily 'getting their

hands dirty' – hedging is the jargon that is used. Individuals are able to reduce risks through a

type of remote control. . However, in reality the complexity of financial markets and products

is such that only well-informed investors or corporations are able to benefit from this

advantage. In addition, even for those individuals who succeed in managing financial risks,

there is a certain surrealness about it, making it very difficult for them to directly perceive and

experience financial risks. A society which cushions real risks can be sweeping under the

carpet a deeper consciousness towards risks, with the result that the risks may change form and

come back later with a real vengeance.

29

Certain individuals and groups are better able to manage their financial risks than

others. Through diversification of investments, they are able to cushion the impact of certain

risks, and even profit from them. However, as a society, we should understand the false

consciousness generated by financial risk management through financial markets, as it may

potentially lead to larger more serious risks being ignored. In fact, Beck strongly argues that

scientists are responsible for the creation of risks, therefore how can we expect them to teach

us how to control or manage them? Beck writes (p.60):

'The first priority of techno-scientific curiosity is utility for productivity, and the hazards

connected with it are considered only later and often not at all. ... Hence it is also

stricken with a systematically conditioned blindness to risk. The very people who

predict, develop, test and explore possibilities of economic utility with all the tricks of

the trade, always fight shy of risks and are then deeply shocked and surprised at their

'unforeseen' or even 'unforeseeable' arrival. The alternative idea that advantages for

productivity might be noticed 'unseen' and 'undesired' as 'latent side-effects' of a

conscious monitoring of hazards only subsequently and against the wishes of

risk-oriented natural science, seems totally absurd.'

As financial experts are party to risk creation in finance (Mackenzie, 2006), then from

Beck's thesis we can see how as a result, there would be a 'systematically conditioned

blindness to risk'. One area already discussed is the subject of 'systemic contagion' where

there is a persistent denial of the existence of risk, evidenced through its lack of definition and

measurement. When events with systemic ramifications do arise, the response is to blame the

operator rather than the system as happened so vividly in the financial crisis (Permanent

Sub-committee on Investigations, 2011). The creation of futures and options markets, which

emerged from virtual non-existence to daily trading of billions of dollars, is another case in

point. Derivatives markets are a classic example of products which distance risk

consciousness as they often deal in instruments which do not require any delivery and

encourage market speculation. Products like stock-index futures, interest rate derivatives, or

collateralised mortgage obligations, are derivatives of abstractions like stock-indices or

LIBOR interest rates. One of the big triggers of the 2008 crash were CDO derivatives, which

30

were linked to the housing market, but securitised and derived in such a way as to remove

themselves from the risk of a collapse in house prices (Permanent Sub-committee on

Investigations, 2011). It also subsequently transpired that the risk and valuation models for

CDO derivatives were deeply flawed.

Financial experts justify these markets as a useful way of providing individuals and

firms with a hedging capability, but there is significant evidence of the use of these markets for

speculation, such that we are creating a 'Casino Society' (Strange, 1986; Lewis, 2011; Das,

2011). The trading volumes and transactions in these instruments generate huge profits for

expert traders, advisers and financial institutions. This latent 'side-effect' of the creation of

futures markets is not seen to be serious, and on the contrary oils the engine of financial

markets. Beck explains the wider socio-political ramifications of such an increase in risk

(p.78):

'Where danger becomes normalcy, it assumes permanent institutional form. In that

respect, modernisation risks prepare the field for a partial redistribution of power -

partially retaining the old formal responsibilities, partially expressly altering them. The

accustomed structure of (ir)responsibilities in the relationship between business,

politics and the public is increasingly shaken; the more emphatically the dangers in the

modernisation process increase, the more obviously central values of the public are

threatened in this, and the more clearly it enters everyone's consciousness. It is also that

much more likely that under the influence of the threatening danger, responsibilities

will be redefined, authorities centralised, and all the details of the modernisation

process encrusted with the bureaucratic controls and planning. In their effect, with the

recognition of modernisation risks and the increase of the dangers they contain, some

changes to the system occur. This of course, happens in the form not of an open but of a

silent revolution, as a consequence of everyone's change in consciousness, as an

upheaval without a subject, without an exchange of elites and while the old order is

maintained. '

If we examine recent developments in the regulation of financial markets and institutions, then

we notice a period of significant change, precipitated primarily by scandal, the crystallisation

of risk. However, there is little change in the old order, where market interests and sentiments

prevail. Haldane (2012), a senior executive at the Bank of England, laments about the

31

effectiveness of the hugely increased new rule books and laws as a result of the crash. More

rules do not mean more protection against risk.

For a long time, regulators did not question the system or the domination of the markets –

they saw their role as to follow and adapt, rather than to lead. Society needs to learn to adapt to

risks, rather than to question them or control them, so it is argued by the economists and

regulators. Beck's hypotheses about the wider implications of risk appear to be supported by

recent evidence relating to financial risk.

8. Discussion

The analysis in this paper demonstrates that fundamentally, risk is a social construct,

and subjective in nature. It exposes the critical importance of ethics and values in determining

the measurement and control of risk. Given how fundamental risk is to finance theory, the

denial of this subjectivity is evidence of a profound ethical and moral failure. The emphasis on

mathematical calculation is used to make risk appear to be objective and measurable, and

apolitical and culturally neutral. At best, risk is defined and constructed operationally, and

even then finance is partial and selective in the choice of risks that matter and the methods

used to measure and evaluate. The truth is far from the assumptions. And the unrealistic

assumptions matter – often these assumptions are made but not even expressed.

Quantifying risk is very attractive. It permits standardised calculation and can help

develop a commonly understandable language for discussing and evaluating risk for a narrow

band of experts. It may even be motivated by a desire to ‘appear’ scientific and close off public

discussion and questioning. However, ease and elegance of calculation should also be matched

by a degree of conscience, consciousness, realism and reliability. If attention is focused on

those risks which are measurable, and even for these, the measurement techniques are

themselves weak and imprecise, then we need to look for alternative ways of risk evaluation. It

32

may be that the alternatives are not so elegant and do not easily fit into existing theories and

models – but they should definitely not be ignored because of this. This paper has drawn on

sociological and anthropological literature on risk to illuminate our knowledge on financial

risk.

Beck's Risk Society is cynical about the science of risk measurement and valuation. Its

primary thesis is that the institutionalisation of modern science makes it incapable of

evaluating social and systemic risks, because it is party to their creation and profits from it.

Thus we should be sceptical about accepting science-based solutions to the problem of risk. He

also unravels many of the complexities of risk, especially its individual, ethical and social

dimensions. Beck is particularly critical of the school of risk management which assumes that

all risks are manageable - all we need do is to call on the experts to guide us in the right

direction and help us decide 'acceptable' levels of risk. At the same time, whilst there are

growing numbers and definitions of risk, we lose sight of the impact of risk, especially to

society as a whole. The consciousness of risk helps us to deny such risks rather than to admit

them and deal with them. Beck sanctions against such denial, and is critical of the growing

irresponsibility of modern forms of analysis. The insistence on proven causality is also a major

handicap, especially for newer and unique risks. Thus we need to exercise great care when we

use past experiences to identify and evaluate risks, and to be open to newer dimensions and

inter-connections between risks. It is precisely these unanticipated· interconnections that can

have disastrous consequences in the event of an accident (Perrow, 1984).

Similarly, Douglas and Wildavsky (1982) emphasise the inherent subjectivity of risk,

and the limitations of technical calculations of risk which detract from more fundamental

dilemmas and concerns about risks. They expose the huge difference between risk and

33

uncertainty – only in very limited circumstances is risk a purely technical phenomenon.

Analysts' claims to objectivity are based on significant subjective assumptions about

individual preferences and risk attitudes. Risk evaluation requires explicit elaboration and

discussion of ethics. When experts refuse to engage in such debates, this suggests bias and

insecurity among them. Risk analysis requires a combination of knowledge about the future

and consensus about the desired prospects. When either of the components is unknown, the

analysis becomes very difficult if not impossible. This paper has emphasised the need to

understand the ethical components of financial risk. Some risks have greater impact than

others - e.g. security price risks are less relevant to the masses, who do not understand the

stock markets anyway, than the risks of a house mortgage or personal debt and savings.

Changes in inflation and interest rates outside the control of individuals nevertheless have real

impacts on their livelihoods. There is a need to help individuals become more aware of these

risks and ways of dealing with them, which need not include the purchase of financial

products. The consequences of financial risk for individuals, especially in terms of family

stability, also need to be analysed and disseminated. Basic financial literacy can be a huge

asset to protect individuals from financial risk, and this ought to be an important concern of

finance academics – the fact that it isn’t exposes their own bias and subjectivity in choosing

research topics.

The finance academy has developed its own methods of analysis and evaluation, and

research and publications are controlled by peers from within the field. There is an internal

policing of experts by experts. It is therefore not surprising that the analysis of risk has come to

this. It is a closed technical field, and the sophisticated mathematics is used to keep it out of the

public domain. The most serious outcome of this process is that public and systemic risks have

been virtually ignored for a long time, resulting in a significant social and economic cost of the

34

failure or risk measurement and management. Somehow, the finance academy has shielded

itself from a public conscience and consciousness of financial risk, and gotten away with it for

a long time. The institutional structures of the academy need urgent reform if society wishes to

understand, manage and control financial risk. The normative questions are very important

and really matter and should be the concerns of science.

More research needs to be done to explore how this behaviour can be rectified and

corrected. Is it possible that the academy’s own attitude toward risk of knowledge

breakthroughs is very conservative, and there is a fear of going outside the narrow paradigms?

Is finance culturally biased towards its own theories and highly protective of them? Is the

political power of the academy such that it continues to protect itself from any public critique,

and manages to get away with it? How good is the finance academy at managing its own risk,

let alone advising others how to do it? Is this bias of finance influenced by research funders

and corporate elites? These are subjects which need further research and investigation.

Society needs to be careful about when and the extent to which it relies on experts for

risk interpretation, especially where they are not entirely independent of the risk creation

process. Beck (1992) writes (p. 155/6):

'Science is one of the causes, the medium of definition and the source of solutions to

risks, and by virtue of that very fact it opens new markets of scientisation for itself…In

this way, a process of demystification of the science is started, in the course of which

the structures of science, practice and the public sphere will be subjected to a

fundamental transformation. As a consequence, a momentous demonopolisation of

scientific knowledge claims comes about: science becomes more and more necessary,

but at the same time, less and less sufficient for the socially binding definition of truth.'

From the above, not only has finance been incapable of adequate and reliable risk

evaluation, analysis and management, it has been party to the creation of new risks. Using the

rhetoric of hedging, risk appetite and more recently, enterprise risk management, there have

been repeated attempts to show that risk is understood and controllable. Following from the

work of Power, this rhetoric needs much more serious evaluation and challenge. The politics

35

of risk measurement and management are largely ignored in the literature, but worthy of

serious scientific research. It seems clear that the lack of consciousness about the public

impact of risk stems from a distinct lack of ethical conscience in the finance discipline.

The above evidence about risk turns the discipline of finance on its head – it shows

how arrogant, ignorant and seriously biased it has become. Its self-policing is a cause of

significant worry, and whilst post-crisis, most of the attention has been focussed on bankers

and their greed and character, the finance academy has survived intact without serious public

critique. Films like Inside Job (Ferguson, 2010) have exposed some of the corruption of

finance academics prior to the crisis – especially in their role in the denial of systemic risk.

Their consultancy roles have been shown to have conflicted directly with risk measurement

and denial. This paper also questions the a-cultural approach to finance – it highlights the

importance of culture and cultural difference to attitudes toward risk and its evaluation and

measurement. It also focuses attention on the culture of the finance academy itself and its

influence on risk. More research needs to be done to reveal this ‘expert’ culture and its

implications for societal risk. How good is its own corporate social responsibility and

accountability?

Future research needs to examine the role of cultural diversity in financial models, risk

assessment and valuation. Instead of assuming rational behaviour and wealth and profit

maximisation, it needs to consider different values and beliefs, and their impact on risk

attitudes and management. More effort needs to be devoted to support and encourage

scholarship from other disciplines like sociology and anthropology in the study of finance.

Finance academics need to diversify their sources of theory and their fundamental paradigms

about corporate and human motives and conduct. In particular, there is an urgent need to

36

cultivate a public conscience and to express public concern about the theories and knowledge

claims of finance experts and professionals.

The holistic understanding of risk requires experts to understand financial and

economic history, and various human experiences with financial products, institutions and

markets. The contemporary teaching of finance in the business schools tends to be abstract

and ahistorical, and this is a major problem as it significantly reduces risk consciousness and

memory. This needs to change so that students and scholars develop a sense of context and

social consequences and impact in their work. It will sharpen the understanding of risk,

ensuring that the past is much more than a set of numbers or statistics about price trends or

returns out of context from their human environment.

Despite such an extensive and insightful analysis of risk, Beck (1992) comes short of

providing any solutions. He demonstrates that modem scientists can no longer continue to

hide behind their traditional power bases and disciplinary boundaries, because the reality of

risks is beginning to knock on their door. The significant rise in environmental and financial

protest movements across the globe is evidence of this. Beck suggests the application of the

democratic process to science, and the setting up of 'modernisation parliaments', 'in which

interdisciplinary groups of experts would look through, evaluate and approve plans, all the

way to the inclusion of citizens' groups in technological planning and the decision-making

processes in research policy' (Beck 1992, p.229). Thus some kind of advance screening of

new financial risks by a democratic process is suggested. Beck also suggests the

'institutionalisation of self-criticism'. He concludes (1992, p. 234):

'What kinds of regulations and protections this will require in individual cases cannot yet

be foreseen in detail. Much would be gained, however, if the regulations that make

people the opinion slaves of those who they work for were reduced. Then it would also

be possible for engineers to report on their experiences in organisations, and on the risks

37

they see and produce, or at least they would not have to forget them once they leave

work. The right to criticism within professions and organisations, like the right to strike,

ought to be fought for and protected in the public interest. This institutionalisation of

self-criticism is so important because in many areas neither the risks nor the alternative

methods to avoid them can be recognised without the proper technical know-how.'

The words of Levi (1980) neatly summarise the dilemma, and point to a possible resolution:

'The moral of the story is that we should learn to suspend judgement ... But although we

should prize precision when we can get it, we should never pretend to precision we

lack: and we should ever be mindful of our ignorance even when it hurts (pp. 441-2) '

When Heffernan (2011) talks about wilful blindness, and the importance of challenging

systems and structures, we are also managing risk when we encourage a ‘Just Culture’. More

specifically, the commercial and corporate bias of financial experts should be viewed as a

public health warning when it comes to financial risks.

38

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