Banks Could Only Dream Of Being Like Casinos

 

I happened upon this article in The Banker, which expressed concerns that the government’s attempt to enable more competitive banking to boost London’s growth might lead us towards the dangers of ‘casino capitalism’.

The casino metaphor is flawed, because it misunderstands both how banks work and how casinos work (see my blog tab ‘Banking/Financial Risk’ on the side bar for more on this subject). Both deal with probabilities, but in different ways. Probability theory tells us that in n number of incidences, we expect certain values as a result. The more incidences of n, the closer we expect to get to our predicted value. So, for example, in coin tossing, the greater the number of trials, the closer we expect the heads-tails ratio to be 50-50. 

Casinos operate in this way – they cannot predict the precise outcome of every gambling event, but they predict stability in the long term, which means a high probability of turning a profit. Your big win at the casino one Saturday night will be cancelled out by the broader probability landscape, where net losses for the totality of customers secure the solvency of the casino.

To see why banks are not like casinos, we have to understand the distinction between risk and uncertainty. A risk involves an incident where we are not sure of the outcome, but we know the probability. Uncertainly means we don’t even know the probability. Gambling £100 on a coin toss is risky, because there is a 50% chance you could win and a 50% chance you could lose. Whether your mortgage will increase after your next fixed-term ends, and if so, by how much, is a matter of uncertainty. 

Casinos operate under a risk model where the known probabilities guarantee a stable income; banks operate under a model that is a small mix of probability and a larger mix of uncertainty. Government guarantees aside, it would be much harder for a casino to go bust than a bank. If the banking sector had operated like casinos in the past 15 years, an awful lot more would need to have gone wrong to have brought about a similar crash to the ones the banking sector endured.

The reference to banks being in danger of ‘casino capitalism’ was a quite unfortunate and misjudged comparison. If banks had the same long term model as casinos, their risk portfolio would be a lot healthier. But then they wouldn’t be banks in the way we know them – just as oranges would no longer be oranges if they were yellow, bent and grew on banana trees.