—The Art of the SpreadBookmaking is a name for a class of enterprises in which the entrepreneurattempts to set both the purchase price and sale price for some event or setof events, or for a financial instrument. The entrepreneur, let’s call him the“bookie,” may or may not be able to set absolute buy/sell levels, but will inalmost all cases have near-absolute control over the spread between thebuy and sell prices, and he will earn his profit principally from this spread.There are all sorts of widely different entrepreneurs who use bookmakingas their method of making money with money. They range from the localguy who takes bets on football games, to the absolutely state-of-the-art sportsbooks housed in casinos, to the specialists on the New York Stock Exchange(NYSE), to the market makers on the Chicago Board Options Exchange(CBOE), to every insurance company in the world. There are thousands ofvariations on bookmaking.
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Terminology matters. Specialists, market makers, and insurance companies are in fact bookmakers by any reasonable definition. If you happento be a little bit surprised at this statement, it’s probably due to the unrealistic and negative connotation that the word “bookmaking” has acquired,particularly in America. Consider what the NYSE specialist firms do. Atbottom, they guarantee liquidity to the market. The specialist guarantees tostep up and buy shares when most are selling, and to make shares availablewhen everyone wants to buy. In return for undertaking such a responsibility, specialists are allowed by the rules of the exchange to control the bidask spread for NYSE-traded stocks. Ergo, they are bookies by precisedefinition.The function of the market maker on the option exchange floors issimilar, although the rules under which the market maker operates differconsiderably from those governing the specialist. Both these groups of entrepreneurs earn the bulk of their profit from the spread between the bidprice and the offer price of the markets in which they participate, the marketsthey make. Naturally enough, they do have and will employ other means ofincreasing their earnings, certainly including trading for their own accounts,but we’re concerned here with their primary function and method of making money with money.Insurance companies are bookies also, but their bid-ask spread is muchmore complex and far less immediate than the spread to be found on theexchange floors. Insurers do not ordinarily make the bulk of their profit bybuying policies at $1,000 and selling them at $1,100 in lots of five, a hundred, or ten thousand. Rather, they use what might be called a “deferred”bid-ask spread. An insurance company’s bid is the sum total of all possibleliability to the company as specified in the policies it writes for you, me, andwho knows how many others. Their offer is the sum total of all premiumsthat you, I, and others pay them—but with a twist. While you and I pay thepolicy premiums on a known date, the insurance company, in some enormous majority of cases, pays out their liability for our auto crash or hospital bill or storm damage only much later, if at all. Therefore, in addition tothe bid-ask spread, the company can (and does, you bet your life) also earninvestment return on a tidy chunk of the premium dollars collected.Now, all this is merely ordinary business practice for insurance companies, but this is once again bookmaking, just as sure as sunrise. The onlydifferences here between insurance bookmaking and specialist or sportsbookmaking are the time frame and number of variables involved, and thevery convenient notion of being able to use other peoples’ money to increasetheir profits. Nice work if you can get it, eh? To be sure, specialists are alsohighly leveraged. Specialists use other peoples’ money, too, with the majordifference that the people lending money to specialists will at least be making a market rate of return on the dollars lent.
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Bookmaking Versus GamblingIn comparing bookmaking to gambling, it’s useful to note that the profile ofprofit differs considerably in both amount and frequency. The low-skill gambler usually attempts to make a very infrequent profit well out of proportionto his stake, his capital. The high-skill gambler attempts to earn a profit generally proportionate to his capital over a healthy majority of (usually varied) propositions. The bookmaker, however, attempts and intends to makea small or smallish but consistent profit over a pre-defined set of propositions within a more or less specific time frame. The sports bookie, in particular, should and will usually know his profit on a given proposition verynearly to the exact dollar even before the game begins. The specialist andthe market maker know from long experience how much they are likely toearn from each day’s market activity. The insurance company relies on astatistical expectation of profit over time, which depends generally on reversion to the mean and the law of large numbers.The bookmaker must select his own set of profit possibilities, and it isin doing so that the bookmaker enjoys a sizeable advantage over the gambler. The sports book, simply because of the gigantic number of sports eventsoccurring in a typical week, knows where his profit possibilities are without even breathing hard. Probably he’s known where most of them are forsix months or more, since professional league schedules are published wellin advance, and collegiate schedules years in advance, of the games beingplayed. Sports bookies have no shortage of profit possibilities; they need onlyto attract players. Since total dollar levels of sports gambling have been rising for years worldwide, attracting players seems to be presenting no obstacle to them. They are in the enviable position of turning on the profitspigot by just opening their doors.Specialists and market makers similarly know their profit possibilitiesright down to the nth degree. When the market is open, so also is their opportunity to profit by simply operating their business. Given the great bullmarkets of the 1990s in stocks and a huge expansion in trading in optionsand other derivatives, not to mention the continual media shilling (and theirprattle that passes for commentary about stock markets), trading in thesemarkets has increased fantastically. So have the profits of the specialistsand market makers. With the advent of decimalization of prices and therapid growth of electronic trading, the bid-ask spreads have shrunk considerably, but the exchange bookmakers are hardly taking out third mortgages.Their gains from the huge volume increases appear to have handily outstripped the reduction in per-trade profit.The insurance companies have a more difficult time in selecting profitpossibilities. The decision to begin offering insurance against some typeof risk is immensely complex, time consuming, and expensive. Even if a
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company has the will, the time, and the capital to enter a new market, it maynot be able to do so because state and federal regulations may bar the way.Furthermore, on entering a new market or offering a new type of insurance,the insurance company initially confronts a difficulty similar to that of thehigh-skill gambler: finding players who will take the other side of their proposition, in this case, buy their product. Insurers, of course, prefer to call thesefolks policyholders and are, unlike the gambler, able to advertise in order toattract them.
Not Such Risky BusinessBookmaking, just as all human activity, has its risks. Fortunately for thebookmaker, though, the risks in his enterprise are usually very well knownin advance and can be controlled to a very high degree, even totally in somecases. Counterparty risk exists, but it is not a material factor for a competent bookmaker. The losing gambler might choose not to pay his bookie. Abrokerage might go into receivership, or have several large clients go bankrupt, and be subsequently unable to pay off obligations to the exchange. Theinsurance company might have a disproportionate number of policyholderswho for some reason become unable or unwilling to keep paying the policypremiums. How serious can these risks be?Perhaps curiously, they aren’t serious at all. In fact, these perceived risksare almost entirely a product of appearance, mere chimeras and straw men.Bookmaking, in all its forms, has been going on for thousands of years, andover the course of time each type of bookmaker has developed ways of making most counterparty risk about as bothersome to the bottom line as astubbed toe. The traditional sports book, on having a player welsh on a bet,used to make a practice of introducing the player to groups of large gentlemen who were fond of demonstrating the proposition that wood and steelare much harder than the human kneecap. This approach tended to be veryeffective in getting the bet settled and guaranteeing no future backslidingon the part of the player, but it was costly both in salaries and occasionallyin time . . . as in time served. Modern sports books insist on either prepayment of the player’s bet or immediate settlement at the end of the game(that’s why the chairs are comfortable and the drinks are cold, isn’t it?). Increasingly often, the sports book will require the player to set up a bank-likeaccount with the book, funded in advance of any wagers. Thus, counterparty risk for the modern sports book is at worst a tiny cost of doing business. Those comfortable chairs do have to be cleaned once in a while andthe electric bill must be paid, but this form of risk poses no threat whateverto the sports bookmaker today.The exchange bookmakers have a more elegant means of minimizingcounterparty risk, although it may possibly be less effective in an absolute
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sense. If a member of the exchange defaults on a trade, the exchange itselfwill pursue the miscreant/unfortunate member (choose one), and, additionally, the exchange members self-insure; they contribute to a capital pool forjust such a circumstance. The specialist or market maker will have a relatively easy time of it in getting matters put to rights. If actual fraud is involved (a very rare happenstance for specialists and market makers), theexchange bookmaker has the option, in some cases the duty, to yell for thecops, namely the SEC, the CFTC, or the FBI.Naturally, once the bureaucrats get involved, efficiency goes straightdown the tubes, but sooner or later the exchange bookmaker will either bemade whole, or the fraudster will find himself explaining his actions to assorted authorities, or both. In any case, the exchanges take great pains toprevent fraudsters from plying their nasty little trade against the exchangemembers in the first place, and to sniff them out quickly when they do. Counterparty risk for the exchange bookmaker is, as a consequence, almost always a nuisance factor as opposed to a substantive risk to capital.For insurance companies, counterparty risk operates differently. Thefirst and most important form of this risk is plain fraud. Fraud is, regrettably, an absolute condition of contest for insurers. Part of the reason forthis is, doubtless, human nature. Certain people apparently cannot resist anopportunity to attempt to swindle other people, and large profitable companies seem to be an irresistible target for these lowlifes. Another majorpart of the reason why insurance fraud is so common is the diffuseness andcomplexity of the industry. For example, of the thousands of auto repairshops in the nation, it’s a statistical certainty that some are operated by dishonest individuals. Insurance companies can’t possibly monitor all of themfor occasional fraud, particularly in those instances where the mechanicand the policyholder work in collusion. Counterparty risk in the form offraud runs to untold millions annually, and the insurers have little choicebut to add the estimated costs of fraud into the policy premiums. By doingso, they lay off this risk, or a very large piece of it, onto the customer, thepolicyholder.The second form of counterparty risk is less costly to insurers. If a policyholder does not pay his premiums, the insurer cancels his policy. Ho hum.Everyone knows this, so where’s the risk? In the case of casualty insuranceor term life insurance, the insurer suffers the cost and inconvenience of having to find another such policyholder if profits are to be maintained at thesame level. Fortunately, from the insurer’s standpoint at least, there is usually a very large pool of potential new policyholders for most types of insurance and the replacement of lapsed policyholders becomes just another costof doing business. It would be fascinating to know what the per-unit replacement cost is, but insurers don’t seem to want to talk about that subjectvery much.
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The third and most interesting form is the nominal counterparty risk involved in ongoing types of insurance such as whole life or universal life. Ifa policyholder terminates or otherwise fails to pay the premium on one ofthese policies after several years, the analysis becomes quite intriguing.The company will pay out some funds in the form of benefits to the formerpolicyholder, but, and this is the fun part, will also likely make a profit evendoing so. These policies tend to be heavily backloaded in terms of benefitaccrual; quite a bit of time must pass from the initiation of the policy untilthe policyholder actually has a significant level of payable benefits.Insurers, having the advantage of employing the best actuarial mindson the planet, understand perfectly well that some percentage of their policies will be abandoned every year, and have most assuredly calculated verycarefully the rate of abandonment to benefits due ratio, the better to approach maximum profitability. When the counting is done, counterparty riskfor most insurance bookmakers is next to nothing and might even occasionally contribute, net-net, to a firm’s profits.
The Real-World RisksJust because one specific type of risk, counterparty risk, is rarely a significant factor in professional bookmaking doesn’t for a moment imply thatthere are not very real types of risk involved. Some of these risks are due tothe nature of the game. Let’s face it, insurance companies, specialists, marketmakers, and sports books (the lawful ones, at any rate) are highly regulatedby sundry agencies of various governments. Governments can and do changethe rules of the game from time to time, sometimes arbitrarily and withoutmuch, or any, warning. Event risk, you say? Perhaps, but that’s a stretch. Bydefinition, event risk cannot be prevented, only insured against or transferred. Regulatory risk, contrarily, can be prevented. There’s not a doubt inthe world that the insurance, securities, and gambling industries spendmillions each year on bribes . . . pardon me, campaign contributions in anattempt to forestall or scuttle outright the ever more onerous and costly regulation so dear to the hearts of so many supposed public servants. Occasionally they even succeed.The great majority of the risks faced by bookmakers, though, do fall intothe category of event risk, but the difference between event risk in the worldsof gambling and of bookmaking is breathtaking. The gambler can lose hisstake on a specific wager due to event risk, but the bookmaker can lose, according to the famous dictum of Lloyd’s of London, “everything, down tothe last collar-stud in his shirt.” Unlike the gambler, though, the bookmakeris able to do something about this. He can take positive action against “suffering the slings and arrows.” It is this opportunity, the ability to deflect orinsure against the negative effects of external circumstance, which we as
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traders must seize upon and learn to apply to our machinations in themarkets.Event risk used to be much more important to sports bookmakers thanit is today, and the reason for this lies in the nature of the industry and thechanges that have taken place within it over the last few decades. You see,event risk for a sports bookie is a very simple thing: it consists of having toomuch money wagered on one side of a proposition.If and when this condition occurs, the bookmaker is at risk. If the wrongteam would win, the team on which the bookie holds too many bets, hewould incur a serious loss. As you certainly imagine, the bookie will resistsuch an outcome with every fiber of his being. In years past, the sportsbookie applied several remedies to this situation. In order to put his bettingbook back into closer balance, he either changed the terms of the bet for future players, thereby encouraging players to wager on the other team, or heexchanged excess wagers with another bookie who had too much wageredon the other side of the proposition. In the case of extreme betting imbalances, he persuaded players to allow him to repurchase their previous wagers. For today’s sports book, these remedies have changed very little innature, but, due to modern communications, these can now be implementedmuch more quickly and accurately. A betting imbalance that would havetaken an old-time bookmaker hours or days to correct via telephone andwire can now be rectified by a few clicks of a modern bookie’s mouse.Insurance companies obviously must grapple with event risk. That’swhy they exist in the first place. Suppose that an insurer, as a result of awell-designed product, good market research, and superior salesmanshipand pricing, has managed to insure some very high percentage of all thehomes in some county or group of adjacent counties. Suppose also thatthe company, through assiduous study of weather disasters, earthquakes,arsons—generally all the loss-producing external circumstances that haveoccurred in this area over the past 50 years—has determined that thechances of an unacceptable rate of loss are just 1 in 100 in any given year.The resulting insurance policy has been duly priced to generate underwriting profits, allow for accumulation of loss reserves, and leave enough overto permit generation of good investment returns. Homeowners have decided that the policy represents good value and have bought it enthusiastically. Everyone involved has behaved responsibly, and now the homeownerswill pay their premiums and the company can just sit tight, manage its business carefully, publish glowing earnings reports each quarter, and live happily ever after, right?As George Bernard Shaw used to say, “Not bloody likely.” Given sucha concentration of liability, the company absolutely cannot tolerate a hugedisaster in this insured area. If such a disaster would occur, the companymight very well not survive it. And such disasters do occur. The hypothetical
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situation just described is in essence the situation in Florida immediatelyprior to hurricane Andrew in 1992, except that Andrew’s subsequent wrathbankrupted not one but several insurance companies and damaged numerous others heavily. What happened? How did the bookies lose?The bookies lost, in this case, because they forgot they were bookies;they became players. Inadvertently or complacently so, perhaps, but nonetheless they did. They kept too much risk, had too many eggs in one basket ifyou like. Insurers have always been able to reduce their potential liability,to lay off portions of their risk while still earning a very good profit. For onething, reinsurance, which is insurance for insurance companies againsttheir underwriting risks, has been readily available for decades. Insurershave also historically been very active in lobbying politicians for improvedbuilding codes and standards, which, when adhered to (sadly, not always thecase), directly reduce the possible insurable loss. More recently, insurershave gone directly to the capital markets and securitized, literally sold asfinancial instruments, various parts of their potential exposure, thus transferring some portion of their risk to investors and speculators. Reinsurancecan ordinarily be acquired in a day or two. Securitization takes longer to putin place, due to underwriting rules in the securities industry and the unavoidable red tape of assorted bureaucracies, but it is such an efficient wayto transfer risk that its use by insurers seems almost certain to grow rapidlyhenceforth.Why didn’t the insurers lay off their excess risk, only to end up stabbedin the knee by Andrew? I have no idea. You’ll have to ask them. The obvious point here is that, if event risk can wipe out an insurance company, itcan much more easily wipe out a trader. To avoid this sort of catastropheas traders, we’ll want to be constantly on the lookout both for the existenceof potential high event risk situations, which we will shun like the plague,and for opportunities to lay off risk, event risk particularly, to other parties.Event risk menaces the exchange bookmakers, too, and we have no further to look for a clear example of this danger than Black Monday, October19, 1987. The Dow Jones Industrial Average, astonishingly, lost 508 pointsin a single day, more than 20% of its value at the time. The causes of this debacle were many and varied, and have been the subject of hundreds ofbooks and articles, but these do not concern us just now. What happened tothe bookies, our market making and specialist friends? In words of one syllable, they got creamed. Not all of them, certainly, but enough of them thatMerrill Lynch and other huge investment firms had to open their checkbooksto the tune of hundreds of millions of dollars in order to recapitalize manyspecialists so that the market could open for trading the next day.On the Chicago Board Options Exchange that day, traders were only interested in trying to buy put options or sell call options. With next to zerointerest in the other side of these trades, the market makers’ spreads became
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so wide that trading simply stopped for a while in many stock and index options. At the Chicago Mercantile Exchange (CME) where the S&P 500 Indexfutures contract trades, the arbitrageurs who had sold stocks short and hadpurchased S&P futures contracts against them were utterly destroyed. Theywere clipped for well over a billion dollars when the futures contract movedto a then unheard of forty-point discount to the cash S&P Index itself. Thiswas more of a problem for CME than it would have been for, say, NYSE, because futures trades must be settled up daily, as opposed to stock tradesthat were then allowed five business days for settlement. How did they whistle up a cool billion-plus dollars overnight? The Federal Reserve, no less,had to open the discount window to let many of the people involved borrowthe amounts needed to settle, or else the exchange probably would not havebeen able to open on Tuesday, October 20.Nor were the exchange bookies able to lay off this inordinate event riskto other market participants. How could they? In the week preceding BlackMonday, the stock markets had already been moving sharply lower. Most ofthe larger market participants who might under ordinary circumstanceshave been willing to accept part of the risk were, in fact, either already trading with a downward bias or had stepped away from the markets and, insome considerable number of cases, were cowering under their desks.
The Ultimate Risk—Capacity RiskA curious sidebar to Black Monday is that, unlike the disastrous event riskthat the insurers encountered with hurricane Andrew, the exchange bookies didn’t do anything systemically wrong. They didn’t abandon their rolesas bookmakers, as did the insurers before hurricane Andrew hit. Theyweren’t careless or complacent, merely overwhelmed by the vicious confluence of events. No matter. The results in each case were the same, differing only in the number of dollars lost. This event was an excellent illustrationof yet another type of risk, called capacity risk. Defined bluntly, capacityrisk is the probability that some obnoxious event will occur and, as a result,you (or I, or the gambler, or the bookmaker) will subsequently not haveenough capital remaining to be able to stay in the game.You may be saying to yourself, “Well, if this can happen to people whoare in the markets for their living, whether specialists, market makers, orprofessional arbitrageurs, how the devil can I avoid being chopped to bitsby these whirling swords of risk?” A fair question, and very eloquently asked.The answer to this question provides yet another guidepost toward a methodof developing successful strategies. Specialists and arbitrageurs require aconsiderable degree of leverage to operate their businesses profitably.We traders have an advantage on this very point—we can take leverage orleave it, use a little or a lot, entirely at our discretion. Like money itself,
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leverage is a tool, and, as with almost any tool, if we use it improperly orcarelessly, we may damage ourselves seriously.Capacity risk only exists when leverage is used. If we wanted to avoidcapacity risk completely, we would simply avoid using any leverage at all inour trading, but using zero leverage is a terribly inefficient application ofour capital. Contrarily, using 5,000% leverage might well turn out to be a suicidal application of our capital. The right amount of leverage is, as is true inmost things, somewhere in between.
Banking—The Balancing ActBanking is an enterprise that lends capital to those who have a potential usefor it, and profits by charging for its use over time. The entrepreneur, thebanker, has a wide range of profit possibilities that vary by the type and duration of loans made, and he enjoys certain advantages not always availableto bookmakers, and never to gamblers. One significant advantage is the collateralization of risk; bankers actively tend to insist that the borrower putup collateral security over the term of the loan. In the event of a borrower’sdefault on repayment of a secured loan, the banker will liquidate the asset(s)pledged as security and thereby reclaim his capital, and, if possible, any interest due and other applicable charges. Again, all this is ordinary businesspractice, and the process of collateralization allows the banker to lower hisrisk and thereby also lower the rate of interest he charges the borrower onthe loan.Bankers, like bookmakers, typically select profit possibilities with avery high probability of success and accept in return a known and calculable positive expectation on their selections. But this expectation isn’t necessarily as small as you or I might think. Just on a whim, I called my banker(an old friend) the other day and asked him what he and his bank deem anacceptable rate of default on secured loans, expecting him to say somethingalong the lines of 1 per cent. Surprisingly, he very nonchalantly replied,“Not counting mortgages, 3 to 6 per cent on secured loans; 15 to 19 per centon unsecured loans, sometimes a little higher.”With a bit more conversation, he disabused me of my (evidently!) verystodgy mental image of “conservative bankers.” Of the 3–6% default rate, hepointed out that, in perhaps 85% of the cases, liquidation of collateral wouldmake the bank completely or nearly whole. “What about the other 15%(about 0.67% of all secured loans)?” I asked. “Oh, we’ll reclaim some capital from the collateral, maybe go through replevin (repossession, for instance in the case of automobile loans) or wage garnishment, whatever lookslike the best way to clean up the loan. We have all the options. This isn’t really a headache for us, just a cost of doing business.” That phrase again!
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Sometimes I don’t know when to quit. “All right. What about the unsecured loans?” He actually chuckled. “Come on, Stu, why do you think the interest rate on unsecured loans is so high? We just raise the interest rate toaccommodate the higher default rate, and we still have most of the optionshere. If a borrower skips town or a business declares bankruptcy we canhave some losses, but a 10 to 15 per cent interest rate spread solves a lot ofproblems, wouldn’t you say?” You bet I would.Wait a minute. “Interest rate spread?” Now, this sounds more like bookmaking, doesn’t it? Banking does indeed have similarities to bookmaking.The interest rate spread is comparable to the specialist’s control of the bidask spread for stocks. The banker’s bid is his cost of money; the interestrate the bank pays its depositors or pays to borrow funds from other banksor from the Federal Reserve. On certain types of deposits such as what youand I call checking accounts, the bid can actually be zero and the bank canfind itself in the very enjoyable position of using other peoples’ money forfree, a better deal than even the insurance companies can create. The offeris the interest rate charged the borrower. Ten to fifteen per cent on thisspread? Good grief, bookmakers would kill for a spread like that.We must be careful not to push this bookmaking–banking analogy toofar, however. In the first place, the banker only partially controls the bid sideof the interest spread. He may or may not be able to attract new deposits atany given time, and he surely does not dictate to the Federal Reserve howmuch it can charge him for additional funds. In the second place, bankersprovide capital to various markets. Bookmakers do not; they provide a service, be it the opportunity to back one’s opinion on a sports event, the liquidity to trade easily in the markets, or a guarantee against excessive loss. Moreimportantly still, the risk profile of banking differs from that of bookmaking.
The Banker’s RisksOrdinary counterparty risk, as my banking friend so thoroughly explained,is present but very manageable for the prudent banker. Hard counterpartyrisk for banks, as for insurance companies, consists of deliberate fraud andis not as manageable, although the typical bank is not nearly as exposed tofraud as is the typical insurer. After all, insurance fraud can be engineeredwithout the insurer’s knowledge, but those who would defraud banks almost always will have made the acquaintance of the banker, which fact offers another level of security for the bank.The “five Cs” of moneylending are credit, capacity, cash flow, collateral,and character. Someone bent on fraud is clearly deficient in the character department, but bankers, not being psychic, occasionally do not discover thisdeficiency in time. If the banker happens to misjudge the character of a borrower or the value of the collateral, he will find himself standing hip-deep in
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a very black pool of counterparty risk. If such an error occurs, the banker cancompensate by maintaining a proper loan-loss reserve, but, unless he sellsthe dubious loan to some other party, he can’t completely eliminate the riskto the bank’s capital.The form of risk that bedeviled the exchange bookmakers on BlackMonday, capacity risk, can easily be avoided. Capacity risk presents itselfto the banker when the amount of capital sought by qualified borrowersreaches or exceeds the banker’s available lending capital, and when depositors remove their funds from the bank en masse. The banker who wants tocontrol capacity risk either can acquire more capital by borrowing from theFederal Reserve, borrowing against his loan portfolio, or by other means, orhe can reduce the demands on capital by making his criteria for lending morestringent. Unlike the specialist and the market maker, the banker doesn’thave to play the game every day with all qualified comers.Regulatory risk is present, certainly, but bankers deal with it in the sameway as regulated bookmakers do; they buy off the politicians. The bankinglobby is one of the strongest in the nation, and the banking industry haslearned, over the centuries, that baksheesh is a very effective device fordealing with governments and bureaucracies. Please note that I do not disapprove of this practice, merely call it by its right name as opposed to usingeuphemisms such as “campaign contributions” or “directed lending.” If youand I were bankers, we would employ this tactic, too. We’d be completelymad if we did not.True external event risk, short of an outright collapse of the financialsystem, is not really on the banker’s radar screen very much any more. Itused to be a huge consideration. American history is chock full of famousfinancial panics and runs on banks, sometimes originating from the flimsiest of rumors (and sometimes not!). Numerous writers, scholars, and economists have made a persuasive historical case that many or most panics,and the ensuing bank runs, were at their root due to persistent regional imbalances in the money supply. This analysis seems awfully reasonable to me.If the supply of money in, say, a five-state area somehow becomes insufficient for the conduct of ordinary business, then money will tend to become more valuable to its holder than the utility or value he might otherwisegain from the purchase of goods or services. The holder of money, seeinghow slow business is, may also decide that prices will soon be coming downsomewhat, which will reinforce this notion of relative utility and furthercause him to defer purchases. In such a situation, he and other people willlikely tend to hoard money, or at best spend it very cautiously.From its very nature, banking absolutely depends on economic activityin order to generate the profits, thence the money, necessary for a