RiskMinds - DB on reforming the financial markets

Hugo Banziger, CRO of Deutsche Bank, gave a presentation on his ideas on how best to reform "The Global Financial Architecture".

He started by emphasing:

• The economic imperative to resolve the current crisis for the benefit of all people, not just the financial markets.
• That the current crisis is very close to the crisis of the 1930s (he did his PhD on the Great Depression, so he should probably know).
• He has been involved in the rescue of 3 banks recently, and said that one major German financial institution was only 6 days away from insolvency before it was saved.
• His opinion that letting Lehman go was a bad decision that has worsened the crisis.
• That without goverment help the financial markets would have gone into meltdown and that this state of affairs is totally unacceptable for the industry.

He proposed action in three areas:

• Monetary Policy - Governments and central banks should pay more attention to the interaction between monetary policy and global capital flows. Central bank policy should also consider targetting how to prevent asset price bubbles as well as more standard measures such as inflation (Comment: maybe my bubble index idea wasn't so stupid?). Emergency liquidity provision also needed a rethink in light of past failures.
• Regulation and Supervision - Capital requirements should be increased and capital calculations need redesigning to reduce pro-cyclical aspects so as to provision in the good times for the bad (Spanish regulator had already done this apparently). Capital calculations should be calculated over longer time periods (30 yrs?) using the worst of events from the past. Scenarios need adding into the capital calculations so they are not just probabilistic in nature. Regulators should insist upon better transparency and disclosure, in particular on valuation methods and the methods of the Credit Rating Agencies. Ultimately, regulation needs be co-ordinated on a global basis given the global nature of the markets.
• Private Insitutions (the Banks) - Appalled by the lack of integrated risk management at many banks, and clear governence of the risk is essential. IT systems should be robust and centralised access to data to calculate exposure is essential. A typical cost of $200m to implement Basel II indicates to him that basic technology infrastructure is not in place and good risk management cannot be being done. Having data in spreadsheets and reporting to regulators with a 3 month timeframe is not good enough and the industry needs to get the infrastructure in place to properly handle and report in a timely manner upon the risks it is taking. He proposes that each bank needs to get a diversified and stable funding base in place - DB issued long term funding recently to reduce dependence on short-term sources and has $65b in reserves, so (maybe at the risk of sounding smug) he believes DB is well positioned.

Interesting talk, Hugo risked coming across as a little smug in the presentation but did admit that DB had faced problems too (but just not as bad as most other institutions though!).

 

 

RiskMinds - insurers on the crisis, risk managers (and suicides...)

Panel debate amongst CROs from some of the big insurers and the FSA. Main points:

• Summarised the current crisis as "A collective failure of imagination over the scenarios of what is possible by risk managers and regulators"
• Insurers are doing better than the banks in the current crisis, and this is due to learning from the bad experience insurers had in 2002 following the collapse of the dot com bubble.
• Quants are not to blame for the current crisis - they are involved but the current liquidity crisis is not a quant issue (Comment: but surely the collapse in asset prices from poor modelling is what led to the collapse in confidence and onwards to the liquidity crisis)

Joachim Oeschlin, CRO of Munich Re said that at a recent panel event he asked a group of risk managers what had been the failings of risk management, was it:

• Risk managers enjoyed the credit party like everyone else?

• Risk managers did not see the bubble coming?

• Risk managers did not have enough power?

The response from the risk managers was the latter (unsurprisingly!) but he favours the first two explanations above. Joachim said that Munich Re had been looking at how their company performed in the Great Depression of the 1930s. It seems that we should be thankful that we have personal bankruptcy laws these days, as one thing he noted was a great increase in suicides in the 1930s as people who owed too much money simply killed themselves...maybe we haven't got it so bad after all. Crisis? What crisis?

RiskMinds - Model Risk and Variable Dependency Assumptions

Professor Paul Embrechts gave the opening talk this morning on quantitative risk management. Main points:

• Paul thinks the largest recent failing is to take VaR for granted - he says that it is only a statistical estimate that has a range of values based upon what assumptions are made.
• Related to the above, whilst improving quantitative risk management is vital he states that risk management is about human judgement.
• He sees "pricing model uncertainty" - the risk that a model for pricing an instrument is badly formed or based on poor assumptions - as a key risk to be addressed going forward (echoing VaR post yesterday)
• On pricing model uncertainty, he pointed out what the regulators are proposing with the recent consultative document from the Basel Committee on fair value calculation practices (click here). This covers things like assessing model sensitivity under periods of market stress, challenging of models, understanding of suitability and appropriateness etc.
• On the incremental risk capital charge guidelines from the Basel Commitee (click here) he raised concerns that a calculation for market risk with a VaR of 99.9% over one year was both very difficult to model and very difficult to backtest (without lots of good data being available, which is not usually the case).
• He ended by spending some time on the re-occuring theme of variable dependency (leading to a lack of expected diversification) and illustrating it with a simple example concerning summations of VaR levels from different business lines at a bank.

Good speaker - main points/concerns were the validity of pricing models and dependency assumptions between variables.

Stress-Testing Consultation by the FSA

The FSA published a consultation paper on stress-testing yesterday (click here to view).

RiskMinds - VaR is not dead at Citi

Very good and refreshingly open presentation given by Alan Smillie of Citi Group on whether Value at Risk (VaR) has been discredited as a risk management tool (see earlier post for Taleb on VaR).

He started by generically describing VaR as being composed of both:

• A statistical model of the market
• Pricing models/sensitivities to translate the market movements to P&L

He said that much of the recent losses/write downs at Citi are in ABS CDOs at levels of 10x/100x larger than those predicted by the VaR models that they use. He summarised by saying that whilst VaR has not performed well, it should not be dismissed since their experience is that their losses (and inaccuracies in VaR calculation) were not (mainly) due to failings in the statistical model of the market, but rather in major failings in the pricing methodology for pricing ABS CDOs.

It seems that the traders and risk managers at Citi regarded ABS (Asset Backed Securities, mainly mortgages) as equivalent to a bond, and so they regarded an ABS CDO as equivalent to a CDO of bonds. In fact the ABS was itself a securitised product, so effectively they were dealing with a CDO of CDOs (CDO^2). This did not offer the diversification of risk to justify the AAA rating given to the ABS CDOs - apparently the ABS prices in each CDO were 90% correlated. Alan clarified that given the problem was in the pricing model, not in the model of the market, better scenario analysis would not have helped Citi to avoid these losses either.

Alan refered back to an article in Risk magazine in 2006, saying that banks were not experiencing any "exceptions" (breaches of the VaR loss level) at the level that should be expected (2 to 3 per year for 99% VaR). The article suggested that banks were therefore being charged too much regulatory capital and this should be reduced. He said that Citi experienced 20 VaR exceptions in 2007, and expected much more in 2008 and as such VaR is not working well given the current market volatility.

He expects that future risk capital calculations required by the regulators will be based upon VaR combined with subjective, non-probabilistic stress testing (apparently something that Deutsche Bank have been doing internally for years according to a later speaker). He didn't seem to address the issue of how to avoid pricing model risk, but it was a good talk with a lot more openness over Citi's losses and problems than I expected.

RiskMinds - Tuesday Panel Debate

Panel debate this morning was interesting, speakers included Riccardo Rebanato of RBS, Bob Scanlon of Standard Chartered, Andreas Gottschling of DB and David Morgan of the UK regulator, the FSA. A few sections from the debate:

• Current Crisis - Scanlon said that the current government guarantees offered to the banking industry will realistically have to be in place for 7 to 10 years, not the 3 years that is officially spoken of. He also said that he was concerned that current government intervention will pervert the market, with the transfer of credit risk from corporates to governments. Put a different way Gottschling said that "nationalising crap does not turn it into strawberry cake". Morgan said the FSA is aiming for tighter liquidity and capital standards since the future risk of something similar to the current bail out is unacceptable to the public. Rebanato criticised the FSA for focussing too much on recapitalisation and too little on liquidity provision. Morgan emphasised that the "discount window" funding from the Bank of England was only there for crisis times and not to be used as "lender of first resort". Morgan seemed forceful on this last point but seemed on the back foot relative to the practioners in the panel.

• MTM Accounting - all seemed united that mark to market accounting should stay and that we should not effectively "shoot the messenger" i.e. the real source of the crisis lies elsewhere, not in MTM accounting.

• Securitisation - Rebanato said that the key to getting securitisation going again was a rethink of how an investor can trust the due diligence done in assessing the risk of a product, in particular a total rethink on the role and practices of the credit ratings agencies. Scanlon added that increased capital requirements combined with no securitisation market would slow economic growth and as such securitisation is a necessary part of the future of the markets and essential for the growth of the global economy.

• Liquidity Risk - Rebanato said that ideas such as "liquidity VaR" were invalid given that a liquidity crisis is such a digital event. Gottschling favoured robust scenario analysis but ultimately management skill and judgement is key. Morgan of the FSA criticised the banks for very poor liquidity management in place now regardless of what new regulatory requirements may come. Rebanato made the point that many private companies would (in the absence of regulation) choose not to deflate balance sheets and reduce profitability in order to be better placed to deal with future (but infrequent) liquidity crises. Morgan again came back to the costs to the tax payer of the current crisis and Scanlon threw in that the FSA and other regulators were going to cause the crises of the future...

At that point the debate ran out of time which was a shame since Scanlon was only just getting warmed up on hitting (verbally!) at the regulators...

RiskMinds - Robert Merton

Robert Merton gave the opening talk this morning on the subject of sovereign wealth funds...and immediately digressed into talking about the current credit crisis. As with Shiller yesterday, he is advocating more and better financial theory that has learnt from recent problems rather than saying the mathematics is invalid. He was heavily critical of the pricing models used for CDOs and the like (more of which in a later post).

An interesting point was that he reminded the audience that vanilla loans and mortgages contained embedded put options on the assets of the issuer, and that as a result the recent dramatic decrease in value of this kind of instrument is not purely due to ten sigma movements in markets, but rather lower movements in market variables but combined with greatly increased sensitivity (delta) to these inputs as markets decline and become more volatile. Put another way, he does not hold with the fashionable premise of the Black Swan of extreme events explaining all that we have been experiencing.

On sovereign wealth funds, he suggested that they should concentrate on their unique advantages as investors/counterparties in the market, such as credit worthiness and access to liquidity, and focus much less on stock picking and timing to allocate investment (he cited recent investments in US investment banks by CIC as an example). He proposed that sovereign wealth funds should sell that which costs them nothing (e.g. liquidity) and that others needs. He ended his talk by suggesting the sovereign wealth funds may (only may) step in to fill the gap left by the dramatic downturn in hedge fund activity in the market, as he classified both types of institution as "lightly regulated" and able to get around the "institutional rigidities" faced by the banks. So maybe the sovereign wealth funds are not the international bogey-men that the press have been making out recently?...

RiskMinds - from Blame to Bubble Indices...

I am attending the RiskMinds Conference in Geneva this week. Given what has happened over the past year, its somewhat intellectual name seems less appropriate than it once did, but I guess not many of us are smelling of roses on that point...

Seems to be very good attendance with the main hall full to overflowing for the first full day of the conference - unsurprisingly I think many people are looking for answers (from "what did I do wrong?" to "who can I blame?"). From a quick survey of the attendees, there seems to be no doubt that regulators and the credit rating agencies seem to be the favoured candidates to blame.

Robert Shiller (author of Irrational Exuberance) gave the openning talk on the current credit crisis and what to do about it. He made the point that behavioural finance (stock market pyschology) is becoming much more integrated with financial markets theory, and put forward the positive point that financial theory needs to be expanded to encompass what we have experienced over the past year, not that all financial theory should be thrown away (a jibe at Taleb on this point?)

Much of Professor Shiller's talk was spent on illustrating various "bubbles" in real asset prices in various markets against long run trends, usually involving a comparison with the data of the Great Depression of the 1930's, and an occaisional mention of his book (I haven't read it (yet) but I would guess it spends a lot of time on bubbles too). He is very keen on the democratisation of finance, more particularly of financial advice (it would seem that the FSA has been listening in the UK, with the recent action against commission-based financial advisors).

He also proposes greater usage of macro economic indices and related derivatives to make risks of house price falls, inflation, economic growth, employment etc more transparent to all and to allow easier hedging of these risks. He raised some eye-brows of many banking staff by proposing mortgages whose payments went down when these factors moved against a house owner (with the originator hedging these risks using futures on the indices he proposes). He was not so clear what should happen when these factors went in favour of the house owner!

One thought struck me though the talk, is that if it is relatively easy to illustrate/calculate these real asset price bubbles illustrated by Professor Shiller, then why not go further than just having indices on direct macro-economic variables and have indices based on these "bubble" calculations? If everyone could see that the "bubble" index for a particular risk factor was high then you could hedge your "irrational exuberance" or at the very least there would be a transparent indicator that a market was moving into dangerous price territory. Stupid idea? Maybe, but if it has legs please remember you heard the nickname"Aero" for the cocoa index here first!...

A couple of rants and a bit of humour...

Busy day on the FT yesterday. First Taleb continues his campaign against VaR and mainstream financial mathematics (see earlier post). Second the CDS market is damned by John Dizard. And on a lighter (but related) note, Jonathan Davis updates us on the behaviour of the fickle "Mr Market family".

Rules of Principles Based Regulation?

I went along to an event a few weeks ago organised by JWG-IT in which they talked about how they are involving 8 of the top banks (it was 11 but these are the times we live in...) in defining what they term as "Sturdy Breakwaters" to help financial institutions turn regulatory principles into template action plans that would (almost) ensure regulatory compliance.

A "Sturdy Breakwater" is a legally recognised term which in the context of industry guidance by FSA is described as offering effectively what amounts to protection against action by the FSA against an institution following such guidance, but not offering protection from other third parties (other institutions and clients maybe). Such industry guidance would need to be explicitly made public by the regulator but once done so it would be possible for institutions to adopt this approach and benefit from its protection (and prescription). For those of you interested in finding out more please take a look at a background document "FSA confirmation of Industry Guidance"

The debate on the pros and cons of rules-based or principles-based regulation have raged on and on in the industry. Basically most regulators dislike the rules based approach since firstly it promotes a "tick box" approach to achieving regulatory compliance (without necessarily delivering on the underlying problem being regulated) and secondly the bright people at the banks invariably find a way round any given set of fixed rules.

The banks would prefer a rules based approach since it is easier to turn a set of rules into a set of actions, rather than trying to figure out what a broad principle means - anyone fully certain what achieving "best execution" from MiFID entails doing yet for example?

Institutions understandably do not like it when regulators use the best part of a compliance implementation at one organisation to say to another "and why aren't you doing this too?" but sometimes the flip side of this is that the institutions sometimes do nothing for a particular regulation, watch what other organisations do and which organisations are fined and why.

Put another way it seems like the regulators and the institutions are both sometimes guilty of trying to arbitrage each other through a deliberate policy of either saying or doing very little.

This Sturdy Breakwater/Industry Guidance approach seems to be a sensible approach to bridging the gap between principles and rules, I guess the only question is if this is such a good idea then why are there only four pieces of confirmed Industry Guidance in place so far? Any answers appreciated!