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Brian Sentance - Xenomorph

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Data Management 101

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The Failure of Risk Models

08 December 2009  |  6474 views  |  0

Avinash Persaud of Intelligence Capital gave the opening talk of the morning at RiskMinds (see first of set of posts from last year here) and put forward a lot of the very good ideas that he has contributed to in the recent Warwick Commission Report. Main points that Avinash made:

  • Regulators were admirably quick in working out where past regulation had gone wrong in focussing too much on micro (individual institution) rather than macro (whole market)/systematic risk.
  • The regulators then came out with promising papers on counter cyclical regulation and other positive ideas.
  • These new ideas do not win votes however and do not satisfy the public's desire to punish someone - Avinash called this the "Bad Apple" policy, with "bad bankers, bad products, bad jurisdictions" being the perceived guilty parties.
  • All past crises have resulted in demands for three things: i) more risk management; ii) more regulation; and iii) more transparency.
  • These are fine as demands but evidently do not prevent financial crises.
  • Avinash recalled his work back at JPMorgan in the early 90's when the 4:15 report was produced for Sam Weill, which eventually led to VAR reporting becoming widespread.
  • He then fast forwarded to the Asian crisis of 97 where he saw the failings of VAR (or rather its widespread use) first hand with all players using VAR which when volatility increased caused an increase in VAR causing JPM (and all) to sell causing markets to fall, increasing vol causing more selling, increasing correlation and leading to what is called the "loss spiral".
  • In light of the recent crisis, Avinash said the public perception is that bankers created a load of toxic bombs (products), through them at an unsuspecting public and ran away...
  • ...and in his opinion the reality is that banks created a load of toxic bombs and ran straight towards them i.e. this was a failure of risk management where bankers did not understand the risks they were buying and selling.
  • He then took us back to the 1950's and the formation of modern portfolio theory with Markowitz and Danzig working at the RAND Corporation.
  • At that time banks and insurers were still separate, with FX and capital controls still in place meaning that not only could the "efficient frontier" of investment portfolios be observed but it could also be acted upon.
  • Now everyone has the same information everyone can observe the efficient frontier of investment opportunities but cannot exploit or act upon it, since usually everyone moves in (the "herd") and the value observed is changed by this crowded participation in the market. Here he seems to be echoing a lot of what Bob Litterman said at QuantInvest last week over the "crowded trade" and that the barriers to market knowledge and our ability to act on this knowledge have been lowered forever.
  • Avinash put forward that many of the models we use today assume the statistical independence of decision making process whereas the reality is that the market is homogenous (everyone is thinking/acting the same) and hence these models are invalid in this "crowded" context.
  • In light of this, the problem of risk management is not about exogenous risk (risks from outside the market, from Black Swan events to normal distributions) but more about endogenous risk i.e. peoples behaviours upon seeing opportunities cause strategic risks. (Interesting given Jean-Phillippe Bouchard at QuantInvest commenting on what makes prices move). Put another way, behaviour is the issue not the financial instruments themselves.
  • Avinash proposes that risk capacity (the ability of an institution to absorb a particular type of risk) shoudl be thought through more fully, with for example insurance and pension institutions with long-term liabilities having a much greater capacity to absorb liquidity risk than banks, and banks with short term funding being a better position to manage a loan book.
  • He pointed out that regulation that uses market prices to protect us against movements in market prices is doomed to failure before it starts.
  • Booms occur due to some perceived "paradigm shift" technolgy leading to dramatically improved risk/return ratios - he cited things such as cars, electricity, rail, dotcom and the mantra from those involved that "This time it is different..." (see "bubble" post from last year)
  • Avinash thinks the regulators are significantly to blame for the last crisis since they themselves said the latest financial innovations in credit derivatives were making us safer through sharing out risk in the system.
  • He said that there is no theory for making a complex system "safe" as a whole and that the regulators did not/do not "get" this idea.
  • Diversity of approach and risks in a large systems (macro financial markets) is our only current defence and regulatory "best practice" has driven conformity not diversity in the market, making systemic risks higher not lower.
  • So the regulators are themselves creating a homogenised market.
  • In terms of solutions, he proposes that risk and audit committees need separating so that risk management does not become a "tick box" exercise.
  • He further proposes that the risk management function is given some capital so that it can place hedges at a macro level for institution (i.e. looking at the resulting risk when divisional risks have been aggregated) - here is proposing moving to risk "management" as opposed to the much more common risk "reporting" found in many institutions.
  • One risk management indicator idea he proposed was to put a portfolio management model together that was linked to VAR in order to see where the "herd" is moving to (e.g. low vol, high return Asian markets of the past etc) and to move or hedge against this.
  • He is concerned that applying Basel II regulation to the Insurance industry with Solvency II will mean that all players will be dancing to same VAR tune which will introduce more risk as more institutions are forced to react in the same way to market movements and volatility.
  • On the same lines, Credit Rating Agency regulation will create barriers to changes in ratings methodology in response to endogenous market risk, again meaning that everyone will be forced to behave and act in the same ways.
  • He summarised that "endogenous risk" (movements in the market caused by the market) and not statistical distributions that are the key issue and diversity is the only solution.

Entertaining speaker with some interesting ideas that fly in the face of much of what is being done by the regulators today, and generally well received by many of the risk managers present. Behavioural finance and the "crowded trade" (i.e. everyone doing the same thing in the market causing movements within the market) seem to be key themes occuring in a lot of what academics and practitioners have said on risk management recently. Now what to do about it? Not sure that less (not more) regulation will find many fans at the moment...answers on a postcard please!

TagsRisk & regulationWholesale banking

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