RISK MANAGEMENT The Need for Risk Management Systems
Topics Introduction Historical Evolution The Regulatory Environment The Academic Background and Technological Change Accounting Systems versus Risk Management System Lesson from Recent Financial Disaster Typology of Risk Exposures Extending Risk Management Systems to Nonfinancial Corporation
1 Introduction The international banking system has experienced many significant structural changes The new legislation will also put brokerage firms and insurers on a par with banks by allowing them to enter into the full range of financial activities and compete globally Customers, on their part, are demanding more sophisticated and complicated ways to finance their activities Banks are, therefore, increasingly engaged in what might be called "risk shifting" activities The change in emphasis from simplistic "profit-oriented" management to risk/return management
2 Historical Evolution The crash of 1929 and the economic crisis The regulators focused on what is termed today "systemic risk," i.e., the risk of a collapse of the banking industry at a regional, national, or international level US: The 1956 Bank Holding Company Act, and the amendments to this act from 1970, limited the nonbanking activities of commercial banks 1982, the CBOT started trading options on Treasury bond futures 1995 the Bank for International Settlements, based in Basle, Switzerland, coordinated the first major survey of derivative markets among 26 central banks of the most developed countries. 2006 The Basle II
3 The Regulatory Environment The global environment became riskier as the financial markets were liberalized Many of the banks exposed to the mismatch between short-and long-term funds failed to hedge this exposure Interestingly, the push to implement risk management systems in banks came, primarily, from the regulators (rather than from inside banking institutions). In the mid-1980s, the banks complained of unfair competition from foreign banks The response of the Bank of England and the Federal Reserve Bank was, first of all, to strengthen the equity base of commercial banks by requiring that they set aside more capital against risky assets Secondly, the regulators attempted to create a "level playing field." The BIS continued the process initiated by the Federal Reserve Bank and the Bank of England by sending drafts of the proposals to the banks and asking for their comments and suggestions
4 The Academic Background and Technological Change Risk management cannot be understood independentl y of the body of academic research published on risk management techniques and derivative valuation that has evolved since the early 1950s The foundations of modern risk analysis are contained in Markowitz' s (1952) paper concerning the principles of portfolio selection Sharpe (1964) and Lintner (1965) take the portfolio approach one step further by adding the assumption that a riskfree asset exists The next important development in the analysis of risk occurred in 1973, with the publication of two seminal papers by Fischer Black and Myron Scholes, and Robert Merton, on the pricing of options In order to complete this brief introduction to the theoretical basis of modern risk management, we must turn to the work Franco Modigliani and Merton Miller published in 1958 Many of the contributor s to the intellectual framework that we have just sketched out were eventually awarded the Nobel Prize.
5 Accounting Systems versus Risk Management System How are risks affect financial reporting? The traditional accounting approach is, in essence, backward looking. Past profits (or losses) are calculated and analyzed, but future uncertainties are not measured at all As the Generally Accepted Accounting Principles (GAAP) could not easily accommodate derivatives, the instruments have largely appeared in the footnotes to the bank balance sheet; i.e., they have largely remained an off-balance-sheet activity Any such risk-sensitive accounting system would have to compromise between accuracy and sophistication, on the one hand, and applicability and aggregation on the other. Major problems arise in any aggregating system when it is applied to factors that are nonlinear, and
6 Lesson from Recent Financial Disaster Since modern banks began to evolve in the seventeenth century, most bank failures have been due to exposure to bad debts. However, some spectacular bank failures over the last 25 years have been due in part to market exposures generated by derivative positions and politicians and the media have suggested that this is because the banking system as a whole is failing to control these new forms of risk. It is only in the late 1990s that the banking industry has begun to appreciate the risks of correlations between credit and market risk, on the one hand, and liquidity risk on the other If "correlation risk" can be identified as one principal source of hidden bank risk, then operational risks are surely the second major source. The downfall of Barings in February 1995 is often depicted as the result of the actions of a single trader
7 Typology of Risk Exposures Market Risk Credit Risk Bank Risks Liquidity Risk Operational Risk Legal &Regulatory Risk Human Factor Risk
The Dimension of Market Risk
The Dimensions of Liquidity Risk
Risk Exposure of a Bank
8 Extending Risk Management Systems to Nonfinancial Corporation Risk management techniques first developed by, and for, banks are now being adopted by firms such as insurance companies, hedge funds, and industrial corporations. The main purpose of risk management systems for nonfinancial institutions is to identify the market risk factors that affect the volatility of their earnings, and to measure the combined effect of these factors. Of course, in a sense nonfinancial corporations have always engaged in activities intended to reduce or control their risks. Corporations are often exposed to interest rate risk. The main risk of nonfinancial institutions is business risk, while market risks and credit risks are secondary in importance
Epilog Banks are increasingly engaged in what might be called "risk shifting" activities. These activities demand better and better expertise and knowhow in controlling and pricing the risks that banks manage in the market. As the banking industry has evolved, the managerial emphasis has shifted away from considerations of profit and maturity intermediation (usually measured in terms of the spread between the interest paid on loans and the cost of funding) toward risk intermediation. Risk intermediation implies a consideration of both the profits and the risks associated with banking activities. It is no longer sufficient to charge a high interest rate on a loan; the relevant question is whether the interest charged compensates the bank appropriately for the risk that it has assumed.