What can we expect from Risk Management

1
What can we expect from Risk Management?

• -- at financial firms?
• -- from supervisors?

2

• Identifying which risks are sufficiently
  compensated is a difficult task.

VERY difficult.
Likewise, identifying risks that threaten a
firms survival.
3
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
4
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 SL crisis.

Yet firms kept making loans and retaining them in
their own portfolios.
5

• 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)

6
The Risk Managers 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???

7
The Risk Managers 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?
8
The Risk Managers Problem (concluded)

• Theorem Within a firm, power flows toward the
  people who are making money.

Corollary Risk managers dont earn conspicuous
profits.
Consider the case of Joseph W. St. Denis, who
once worked at AIG Financial Products (June 2006
September 30, 2007)
9
The Supervisors 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.
10
The Supervisors Problem (conted)

• Regulation in terms of book values is much too
  slow.
• Supervisors have a hard time saying stop when
  they arent 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?

11
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?
12
Solution Lots of Capital

• Requiring equity capital is a long-standing
  battle.
• New instrument contingent capital certificates
  (CCC)
• Issued as sub-debt
• Converts if banks capital falls
• (MARKET value equity ratio)
• Might dilute shareholders, but protects taxpayers.

Requiring lots of CCC at optimistic banks should
not meet tremendous resistance.
13

• 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.