Financial Institutions: Problems and Applications Richard Bookstaber

1
Financial Institutions Problems and
ApplicationsRichard Bookstaber

• Presentation for
• Risk Management Strategies in an Uncertain
  World
• April 13th, 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 gt Tight Coupling
• Innovation gt Complexity

5
Result of Market Structure

• Crises for no apparent reason
• Crash of 1987
• Loss Market value equal to one years GDP for
  Japan
• 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
• For non-systematic risks Diversify risk away.
• For systematic risks Spread them out to dampen
  effects.

8
What is Required for Financial Markets to Help?

• 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
• 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?

• A well-defined distribution
• No gaming
• Securities
• Standardized
• Fungible
• Liquid
• Securitization and hence solutions from the
  financial markets must be proceeded by having a
  market that can be securitized.