Financial Institutions: Problems and Applications
Richard Bookstaber
Presentation for
“Risk Management Strategies in an Uncertain World”
April 13th, 2002
Objective
How financial markets can:
• Create risk
• Magnify existing risks
• Mitigate risks
2
How Financial Markets Create Crises
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•
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Liquidity – Nurtures a demand for immediacy
Leverage – Magnifies the damage if liquidity is lost
Innovation – Creates complex, vulnerable products
3
An Engineering View
Liquidity + Leverage => “Tight Coupling”
Innovation => “Complexity”
4
Result of Market Structure
Crises for no apparent reason…
1. Crash of 1987
Loss: Market value equal to one year’s GDP for Japan
2. LTCM Debacle
Loss: $1 Trillion of market value
5
How Financial Markets Can Magnify Crises
If no apparent event can cause such destruction of
value, think of what can happen if the markets end up
on the wrong side of a real event.
6
Can Financial Markets Mitigate Risk?
Objective of Financial Markets:
1. For non-systematic risks: Diversify risk away.
2. For systematic risks: Spread them out to dampen
effects.
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What is Required for Financial Markets to Help?
1. A well-defined distribution. Necessary but not
sufficient: A well-defined event space.
OK: Flood, Earthquake, Hurricane
OK: Kidnapping
Not OK: “Weather-related”
Not OK: “Terrorist-related”
2.
No “gaming”.
Not OK: Moral Hazard
Not OK: Feedback
8
Looking at the Problem a Different Way
A well-defined event space.
OK: Fire – no matter what the cause
OK: Death – no matter what the cause.
OK: Fire – except for “Force Majeure”
OK: Death – except for “Force Majeure”
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What is Required for Financial Markets to Help?
1. A well-defined distribution
2. No “gaming”
3. Securities
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•
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Standardized
Fungible
Liquid
Securitization – and hence solutions from the
financial markets – must be proceeded by having
a market that can be securitized.
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