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”in whose opinion? “Relevant”

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.

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? The Supervisor’s Problem (cont’ed)

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.