Financial Institutions: Problems and Applications Richard Bookstaber Presentation for “Risk Management Strategies in an Uncertain World” April 13 th, 2002

2 Objective How financial markets can: Create risk Magnify existing risks Mitigate risks

3 How Financial Markets Create Crises Liquidity – Nurtures a demand for immediacy Leverage – Magnifies the damage if liquidity is lost Innovation – Creates complex, vulnerable products

4 An Engineering View Liquidity + Leverage => “Tight Coupling” Innovation => “Complexity”

5 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

6 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.

7 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.

8 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

9 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”

10 What is Required for Financial Markets to Help? 1.A well-defined distribution 2.No “gaming” 3.Securities Standardized Fungible Liquid Securitization – and hence solutions from the financial markets – must be proceeded by having a market that can be securitized.