Ebook The Risks of Financial Risk Management
Episodes of financial instability are a well-documented fact of economic history. This, in combination with the numerous systemic and non-systemic banking crises internationally on record, suggests that financial institutions, and especially banks, operate in a high-risk environment. As may be expected, this situation has not escaped industry and regulatory body attention. Already early on, certain forms of regulation and of organizational techniques of prudence emerged. Then, with the onset of the 1970s, conditions for the international financial services industry began to undergo increasingly rapid changes. Attendant to the end of the post-World War II “golden age of capitalism”, the determining economic arrangements of the period, such as most prominently the Bretton Woods system of pegged exchange rates, disintegrated. Key economic variables including economic growth rates (which tended to decrease markedly in the developed countries), exchange rates, inflation rates, and interest rates started to exhibit significantly higher volatility.
In short, (financial) markets were becoming increasingly complex, uncertain, and risky. In response, new, derivative, financial instruments (futures, options, swaps, etc.) were introduced to better facilitate risk trading and management. By now, derivatives market sizes are enormous as is their role in both risk management and as a source of risk. In effect, both the broader institutional and economic changes and the financial industry’s reaction to them greatly added complexity and opacity to the financial system. New derivative instruments with non-linear pay-off profiles created blow-up risks while complicating risk supervision by top management and regulatory authorities. A number of ensuing high-profile blow-ups in the 1990s brought the issue of financial risk management firmly to the forefront of both top management and regulatory body attention.
This paper looks at the new risk management practices that have evolved since and highlights how the practice of risk management itself creates new risks. These risks that arise through attempts to control the first-order risks that are the target of firms’ financial risk management are referred to here as the “risks of financial risk management”. Financial service providers’ models of and processes for rendering identified risks manageable for the individual institution are referred to by the broad designation “financial risk management”. It is suggested that the risks of financial risk management take various shapes. First, and most straightforward, there is model risk; a term which refers to the fact that every model is only an (imperfect) abstraction from reality; in practice this can produce severe problems. Second, the application of identical risk management policies across financial firms, to address risk modelled as exogenous, can inadvertently boost endogenous risk and thereby create systemic risk and liquidity risk. A third risk is behavioural risk, stemming from the possibility that risk management function might encourage certain undesirable cognitive biases. Fourth is incentive risk, since risk management systems are not immune to gaming and may actually increase risk-taking incentives. Fifth is reputational risk.
The paper is structured as follows: Section 2 sets the scene and provides necessary background by giving examples of financial blow-ups and the risks they illustrate. Section 3 then delineates the concept of risk. Section 4 presents the rationale for risk management at the level of individual institutions. Section 5 outlines conventional current financial risk management models and processes. Building on this, Section 6 explores the risks that arise from these modes of risk management. Section 7 applies the previously developed framework in a case study of the 2007/2008 subprime mortgage crisis. Section 8 concludes.
Contents
1. Introduction
2. Financial Blow-Ups
2.1 Banking Crises
2.2 Salient Institutional Blow-Ups
2.2.1 Investment Banks
2.2.1.1 Derivatives and Rogue Trading
2.2.1.2 Derivatives Mis-Selling
2.2.1.3 Credit Derivatives
2.2.2 Hedge Funds
2.2.2.1 LTCM
2.2.2.2 Amaranth Advisors
2.2.2.3 Quant Hedge Funds in August 2007
2.3 Blow-Ups in Context
2.3.1 Banking
2.3.2 Hedge Funds
3. The Concept of Risk
3.1 Economic Sociology
3.2 (Financial) Economics
3.2.1 Knight’s Distinction between Risk and Uncertainty
3.2.2 Modern Portfolio Theory
3.2.2.1 Step One: Markowitz
3.2.2.2 Step Two: CAPM
3.2.3 Multi-Factor Models
3.3 Section Summary
4. The Rationale for Risk Management
4.1 Shareholder Perspective
4.2 Debt Holder Perspective
4.3 Customer Perspective
4.4 Management/Corporate Governance Perspective
4.5 Regulator Perspective
4.6 Enterprise Risk Management
4.7 Section Summary
5. Financial Risk Management
5.1 Classification of Risks
5.1.1 Market Risk
5.1.2 Credit Risk
5.1.3 Liquidity Risk
5.1.4 Operational Risk
5.1.5 Other Categories of Risk
5.2 Risk Measurement Methodologies
5.2.1 Measure What?
5.2.2 Notionals
5.2.3 Factor Sensitivity Measures
5.2.4 Value at Risk
5.2.4.1 The Rise of VaR
5.2.4.2 Definition
5.2.4.3 Deriving VaR
- 5.2.4.3.1 Nonparametric VaR
5.2.4.3.2 Parametric VaR
5.2.4.3.3 Monte Carlo VaR
5.2.4.4 Applying VaR to Different Risk Categories
- 5.2.4.4.1 VaR and Market Risk: RiskMetrics™
5.2.4.4.2 VaR and Credit Risk
5.2.4.4.3 Operational Risk and VaR
5.2.5 Stress Testing and Scenario Analysis
5.2.6 The Rise of ERM and the CRO
5.3 Regulatory Framework
6. The Risks of Financial Risk Management
6.1 Model Risk
6.1.1 Inapplicability of Modelling
6.1.1.1 Epistemological Issues
6.1.2 Incorrect Model
6.1.2.1 General Methodological Issues
6.1.2.2 Problems with Mean-Variance Optimization
6.1.2.3 Problems with VaR
6.1.2.4 Problems with Stress Testing and Scenario Analysis 74
6.1.2.5 Problems with Extreme Value Theory (EVT)
6.1.3 Correct Model, Incorrect Solution
6.1.4 Correct Model, Inappropriate Use
6.1.4.1 Systemic Risk and Liquidity Risk
- 6.1.4.1.1 Endogenous Risk
6.2 Behavioural Risk
6.2.1 Overoptimism/Overconfidence/Illusion of Control
6.2.2 Anchoring
6.2.3 Framing
6.3 Incentive Risk & Regulatory Arbitrage
6.4 Reputational Risk
7. Case Study: The 2007/2008 Subprime Mortgage Crisis
7.1 The Subprime Mortgage Crisis
7.2 Risks of Risk Management
7.2.1 Model Risk
7.2.2 Uncertainty, Complexity, and Tight Coupling
7.2.3 Endogenous Risk
7.2.4 Behavioural Risk
7.2.5 Incentive Risk: Gaming
7.2.6 Reputational Risk
8. Conclusion
Bibliography
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