What can we expect from Risk
Management?
-- at financial firms?
-- from supervisors?
Identifying which risks are sufficiently
compensated is a difficult task.
VERY difficult.
Likewise, identifying risks that threaten
a firm’s survival.
Perspective is everything
Good risk management includes such things as
• Appropriately pricing risks
• Sound underwriting practices
• Relevant stress tests or VARs.
“Appropriate”
“Sound”
“Relevant”
in whose opinion?
Whose risk assessments?
Risk assessments differ across investors at any point
in time.
We had warning signals:
– Jim Wilcox in fall 2005 re: house prices
– CNN.com, 9/17/04: FBI warned of “Rampant fraud in
the mortgage industry [which] has increased so
sharply that the FBI warned Friday of an ‘epidemic’ of
financial crimes which, if not curtailed, could become
‘the next S&L crisis.’”
Yet firms kept making loans and retaining them in
their own portfolios.
Richard A. Posner Why the Economic Crisis Was
Not Anticipated
“The warnings were disregarded because of
preconceptions …, the cost and difficulty of
taking effective defensive measures against an
uncertain danger, and the absence of a
mechanism for aggregating, sifting, and
analyzing warning information flowing in from
many sources and for pushing it up to the
decision-making level … .”
The Chronicle of Higher Education (4/14/09)
The Risk Manager’s Problem
Risk managers identify things that are unlikely to
happen.
Hence, s/he can be wrong many times before
s/he is right.
How confident can a risk manager really be of
his assessments???
The Risk Manager’s Problem (continued)
• Risk models have two key components
– Historical data regularities.
– Assessments of how/whether history applies at
the present time
The data results are more tangible.
Whose “assessment”?
The Risk Manager’s Problem (concluded)
Theorem: Within a firm, power flows toward the
people who are making money.
Corollary: Risk managers don’t earn
conspicuous profits.
Consider the case of Joseph W. St. Denis,
who once worked at AIG Financial Products
(June 2006 – September 30, 2007)
The Supervisor’s Problem
All the same challenges faced by a risk manger,
plus:
Government regulation that limits apparent
profit-making is subject to strong political
forces.
Greenspan re: subprime lending in 2005.
The Supervisor’s Problem (cont’ed)
• Regulation in terms of book values is much
too slow.
• Supervisors have a hard time saying “stop“
when they aren’t sure.
• Market prices – including counterparty
assessments of financial condition – could
help, but
• Now there are stronger conjectural guarantees
• Systemically important firms(!)
• Stop 10 out of every 5 possible problems?
Conclusion
To protect the Treasury, we need financial firms
(and their employees) to bear the cost of bad
outcomes.
– Compensation contracts
– Capital
How much capital is enough?
Whose opinion?
Solution: Lots of Capital
• Requiring equity capital is a long-standing
battle.
• New instrument: contingent capital
certificates (CCC)
– Issued as sub-debt
– Converts if bank’s capital falls
(MARKET value equity ratio)
– Might dilute shareholders, but protects taxpayers.
Requiring lots of CCC at optimistic banks should
not meet tremendous resistance.
Planning for “improved” risk management to
protect the financial system will give us a false
sense of secuity.
Capital protection is the ultimate defense
against risk management systems that are
intrinsically prone to failure.