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Thoughts on how financial risk management and the demands on risk managers may change based on lessons learned from and actions taken as a result of the crisis.
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SPECULATIONS ON THE ROLE OF THE
RISK MANAGER POST-CRISISPresented by Barry Schachter
GARP student chapter European Business School, London
11 November 2010
Crisis is a Catalyst for Change “...life as crisis is a condition in which
man holds only...the lack of feeling certain about anything important...[and is] handed over to the chaos of pure circumstance...”José OrtegaMan and Crisis, New York: W.W. Norton (1958) pp. 87-88.
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Risk Management and the Crisis
Much criticized, both measurement & management of risk
Several examples of failure to cite, e.g.,Mortgage-related losses (e.g., UBS)Lehman BrothersBernie MadoffJerome Kerviel (SocGen)
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Analysis of Failures are Many Senior Supervisors Group, Turner
Report, IMF, IIF, IOSCO, Lehman Examiner’s report, UBS report to shareholders, and many, many research articles (e.g., Stulz, Golub, Jorion)
These include taxonomies of what when wrong and how to fix it
Risk Management Lessons
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UBS Report is Illustrative
Gaps in risk management expertise / experience at the IB Senior Business Management level
Insufficient discussion of or actions upon concerns surrounding Subprime
Absence of Front-desk limit structure
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UBS on Risk Management Failure [Independent] Risk Control framework
was insufficiently robust (see next slide) historical data used for VaR and Stress
“did not attribute adequate weight to the significant growth...” “...hindsight suggests...”
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UBS Risk Control Failures
No loss limits tuned to risk of US housing market
Over-reliance on VaR, Stress, Ratings Insufficient granularity on positions /
risks reported to senior management
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What is Risk Management? My evolutionary view:
It is an adaptation for enhancing individual firm survival
My muddied evolutionary view: It is a proxy tool for supervisory control of systemic risk and protection against moral hazard of public guarantees (e.g., deposit insurance and too-big-to-fail)
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How does this Adaptation Function? Enterprise-wide risk appetite Executive level decisions on risk
allocation Risk taking culture Risk information (measurement) Distribution of authority over risk taking
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What Role Does Risk Manager Play?
In general perception, this is the “independent” risk manager
In part evolved from regulatory mandates
Heavily involved in risk informationdelegated authority over risk taking
Risk Information: Forecasting or Fortune-telling?
Science, Scientism, or Mysticism?
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Analogy to Weather Forecasts
What does “40% chance of rain” mean? Prob. of Precip. = C x A,
where "C" = confidence that precipitation will occur somewhere area, and "A" = percent of area that will receive measureable precipitation, if it occurs at all.Source: US National Weather Servicehttp://www.srh.noaa.gov/ffc/?n=pop
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Historical Note
Hallenbeck first true probability-based precipitation forecasts (for New Mexico, USA) Monthly Weather Review (November 1920)
“Empirical” probabilities similar to method of Historical Simulation VaR
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Statistical Forecasts
Can we forecast low frequency events?ability to modelavailability of data
Relaxing the normality assumption (where it is used)
More fundamental epistemological questions
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Non-Statistical Risk Information
Stress TestingWhat-if scenariosFactor sensitivities
Ideas from network theoryMeasures of connectedness“Latent” correlation identification
Ideas from complexity/game theorypositive feedback & illiquidityconcentration of risk
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After the Crisis: Improving Risk Info
More general VaR models New approaches to stress testing (e.g.,
reverse stress tests) Better data New regulator-required measures New risk metrics Caveat: perfection is unattainable,
but perfection is the benchmark – after the fact
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Authority Over Risk Taking Benefits of Independent Oversight
Second set of eyesMonitoring of potential moral hazard
Risks of Independent OversightRisk assessment is separated from return
assessmentRisk manager as adversary to risk taker
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After the Crisis
Regulatory responseGreater independence from risk takersGreater voice on the board
Market responseFire the old CROs, hire new onesLook for meaningful lessons, don’t confuse
risk management “failures” with “facts of life”
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New Risk Challenges for Risk Managers lower liquidity (e.g., new position limits) greater counterparty risk concentration fewer low correlation trades
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New Opportunities for Risk Managers Increased focus by banks on “asset
management” versus proprietary risk taking
Disintermediation of Funds of Hedge Funds
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In SumNext Generation of Risk Managers
More authority Bigger voice at senior management
level Broader implementation of independent
risk management function (e.g., by institutional investors)
More qualitative requirements New quantitative techniques (more
research)
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In SumRisks to Gen-R Bigger compliance role Less innovation Return to the old normal corporate
culture
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