Current Issues in Risk Management

Stewart Hodges Cass Business School

Fourth Annual Conference Of The Cass-Capco Institute Paper Series On Risk

Cass Business School, 14th April 2011

Stewart Hodges Issues in Risk Management: 2

Current Issues in Risk Management

Structure of the Presentation:

1. What are we good at?

2. Where may we see improvements?

3. What are we bad at?

4. Where are we most vulnerable?

5. Some open questions.

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What Are We Good At? 1. Modelling short term market risks under “normal”

conditions. includes time varying volatilities and covariances.

VaR Limits and Returns

-2.00%

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

Dec 2009 Mar 2010 Jun 2010 Sep 2010 Dec 2010

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What Are We Good At? 2. Modelling a wide variety of contingent claims

Under increasingly complex assumptions, Aggregation across disparate models, Valuation is understood better than hedging –

which is understood better than residual risk.

3. Return attribution important for understanding the nature of

deficiencies in existing systems through the way risks are mapped.

often underused.

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1. Modelling and managing counterparty risk, including two-way risk.

2. Quantifying liquidity and transactions costs.

Optimising execution, managing liquidity

sources.

Where May We See Improvements?

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Where May We See Improvements? 1. Modelling and managing counterparty risk, including

two-way risk. 2. Quantifying liquidity and

transactions costs. Optimising execution, managing liquidity

sources.

Caveats: ..but liquidity behaves like a “will-o’-the-wisp”, and there is also a tension between exposures to

counterparty risk and to cash flow risk.

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Where May We See Improvements? 3. Coping with other changes in the environment,e.g.

new instruments, e.g. Cocos, inflation linked SPs, multiple curve term structure models

4. Visualisation of risk positions.

Most of our risk management charts haven’t changed much for years,

Visual presentation is important and untapped resources are available.

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What Are We Bad At? 1. Modelling extreme risks:

Stress testing, (what scenarios?) Use of copulas

(empirical issues).

2. Understanding the financial system as a whole: The nature of feedback effects, Measurement of (contribution to) systemic risk.

3. Understanding the full implications of new products and

new technologies.

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Where Are We Most Vulnerable? 1. The world economy, e.g.

Chinese surpluses / trade wars Stagflation / sovereign defaults

2. Market dislocations: Bubbles and crashes, Flash crash, volume of

“piggy-back” electronic trading unconnected to fundamentals of prices,

Cyber terrorism / civil unrest etc.

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Where Are We Most Vulnerable? 3. Other unsolved problems of Basel III, e.g.:

What to do about “too big to fail”, - including can firewalls work?

Making counter-cyclical provisions How many CCPs should there be, and how many

members should each have? Scope of regulation

4. Our reaction to each crisis sows the seeds of the next

one: What sort of crisis is it most likely to be? What would we like it to be?!

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Some Open Questions 1. Do we have too much regulation and micro-

management of risk in place of sensible incentives? Have institutions evolved to be over-adapted to their

environment? 2. Can risk be managed successfully by following a check

list? c.f. safety in aviation etc. 3. Are risk issues yet given sufficient weight at the top

levels of organisations?

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Some Open Questions 4. Lord Adair Turner asks key questions about:

the balance between debt and equity contracts in the economy and the financial system,

the aggregate extent of maturity transformation which the financial system performs, and

the economic functions which finance performs, including its social value.

5. What needs to be done to create a better alignment of

interests?

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Postscript

100 years ago Lilian Bland flew an aeroplane she had designed and built herself.

She may have understood risk management rather

better than we do - she died in 1971 aged 92.

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References Acharya, V and M Richardson (Eds) Restoring Financial Stability: How to Repair a

Failed System, Wiley 2009 Berd, A (Ed), Lessons from the Financial Crisis, Risk Books, 2010. BIS, Basel III: International framework for liquidity risk measurement,

standards and monitoring, December 2010. From: www.bis.org/publ/bcbs188.pdf

BIS, “Basel III: A global regulatory framework for more resilient banks and banking systems”, December 2010. From: http://www.bis.org/publ/bcbs189.pdf

Demos: Lessons from the global financial crisis, Nov 2008, From: www.demos.co.uk/files/Apocalypse%20-%20%20web%202.pdf

Gatheral, J, “Optimal Order Execution”, WP 2010 Turner, A, ”Leverage, Maturity Transformation And Financial Stability:

Challenges Beyond Basel III”, Speech presented at Cass Business School, 16th March 2011, Downloadable from: http://www.fsa.gov.uk/pubs/speeches/031611_at.pdf