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3 posts from February 2012

11 February 2012

Risk models and tools at Baruch College

Emanuel Derman gave the last presentation of the day on mathematical models and their role in financial markets. His presentation seemed to build on some of his earlier ideas with Paul Wilmott on the "Modeller's Manifesto".

Emanuel said that there was a "scandal based on models" is wrong; models did (and do) have their faults but they were not a root cause of the crisis. He started his presentation (somewhat "tongue in cheek") by putting forward a "Theory of Deliciousness" to see how one might arrived at the value of something being more or less delicious. This involved discussion of "realised deliciousness" and "expected or implied deliciousness", plus definitions around equally (relatively) delicious things and absolute deliciousness. See post on FT Alphaville for more background, but fundamentally by analogy Emanuel was putting across that there is no "fundamental theory of finance" and that finance is not physics.

He said that economists do not know the difference between theorems and laws. He seemed to be critical of some recent work from Andrew Lo (see recent post) on putting together a "Complete Theory of Human Behaviour" for once again attempting to codify something that it is uncodifiable.

Emanuel described how economists should be more aware of what is and isn't a:

  • Metaphor - using something physical/tangible to represent a less tangible concept or idea. See this link for his interesting example on sleep/life and debt interest
  • Model - extending the behaviour of one thing to another. A model aircraft is a very useful model of a full-size aircraft with know inputs and useful outputs of interest. We can try to model the weather but here the inputs are known (temperature, wind etc) but the model is hard to define. In finance it is hard to really see what both the inputs are and what the outputs are too.
  • Theory - the ultimate non-metaphor. Here he gave the example of Moses asking the burning bush who shall I say sent me to which God replies "I am what I am". Put another way, you can't ask why on a theory, it just is.
  • Intuition - a premise put forward based neither on logical progression nor on experimentation.

Emanuel said that in Finance there is no absolute value theory, and the majority of models are relative value in nature. From a common sense point of view, the world is not a model. Things change dynamically and in this way effectively all models are wrong to some degree. In summary all financial models are short volatility.

He ended his presentation by saying that nature cares more about principles than regulations (prescriptive regulators beware I guess). His parting quote was by Edward Lucas who said "If you believe that capitalism is a system in which money matters more than freedom, you are doomed when people who don’t believe in freedom attack using money."

Panel Debate

Some highlights:

  • Bruno Dupire of Bloomberg said that it was important that a financial product was aligned with the needs of the customer, and cited certain complex products (with triggers) as being more in the interests of the vendor not the customer.
  • Bruno also said that the hedgeability of a product was also key to a more stable financial system (presumably pointing at products like CDO^3 etc). He said that residual risk (that left after hedging with simpler products) should be measured and costed for. Bruno also mention the problems with assessing long term volatility where traders will try to set this input to what best suits their own P&L
  • Leo Tilman said that risk management needs to be a decision-support discipline and not a policing function. He later suggested that risk managers should have to work as consultants for a while to understand that they get paid for serving the needs of the customer, not just stopping all activity/risks (in fairness to risk managers, I guess they might ask who is my customer? the trader? the CEO? the firm?).
  • Dilip Madan added to the models debate by saying "what is not in the assumptions will not show up in the conclusions".
  • Emanuel likes the old GS partner model for banking, and mentioned the example of Brazilian banks where banks/banking staff(?) did not enjoy limited liability. Dilip said he understood the advantage of this but no limited liability would stifle entrepreneurship.
  • Leon Tatevossian said that post-crisis the relationship between risk managers and traders is better than before, and that there was also greater co-operation between empiricists and modelers. Leo add that risk managers and traders need to speak the same language and understand what each other means by "risk".
  • Bruno said that models were much less of a problem than leverage.
  • All seemed to agree that the tools were not invalidated by the crisis, but the framework in which they are used was the important thing.




Regulatory Dis-Harmony at Baruch College

Roberta Romano gave her presentation in the second session of the morning, putting forward her ideas that what was needed was greater regulatory dis-harmony rather than world-wide harmonisation. Fundamentally she argued that this diversity of approaches in different regulatory regimes would minimise the impact of regulatory error (since it would confine the error to less of the system) and it would provide a test bed for ideas so that it could be seen what regulations work and what do not.

Certainly there is some basis for this idea from others in the industry (see post on Pierre Guilleman concern's on the impact of Solvency II) and I first heard the idea of diversity in financial services put forward by Avinish Persaud at Riskminds a few years back (see post).

Roberta spent a good amount of the presentation putting forward how the process of putting this diverse regulation in place would work, with individual regimes applying to the Basel Committee putting forward why they wanted to deviate from Basel III and justify how such a desired deviation would not increase systemic risk. The Basel Committee would then have a short time frame for approval (say 3 months) and the burden of proof would be placed on the Committee to show that the deviation was a detrimental one. She also described how some of the home-host regulatory conflicts would be dealt with under her proposed process.

I thought that the overall aims of her proposal were sound (diversity leading to a more robust financial system) but the implementation process would be difficult to implement I would suggest and very open to regulatory arbitrage (both by banks and by countries seeking to boost their own economies). Roberta did touch on this, but my biggest criticism was that if one of the benefits was that for a while such a diverse system would demonstrate which regulations work and which do not, then logically everyone would eventually converge on the regulations that work, re-harmonising regulations and reducing diversity.This convergence would then introduce its own (potentially new?) risks and you would be back to where you started.

Panel Debate

A few points from the panel debate following the presentation:

  • There was more criticism of how Basel regulations were gamed by the banks, particularly in relation to optimising Risk Weighted Assets
  • One member of the panel pointed out that non-Basel US banks faired better in the crisis than those subject to Basel
  • Rodgin Cohen suggested that RWA should receive more focus rather than the level of the capital charge (echoing the previous panel session).
  • Rodgin was highly critical in the cutbacks in funding for regulators in the US
  • Rodgin also said that London had its standing as the leading world financial centre due to the US Congress (refering to the Eurobond market and the Sarbanes-Oxley)
  • Regulators should never forget that the "Law of Unintended Consequences" rules



Systemic Risk at Baruch College

Baruch College hosted the Capco-sponsored "Institute Paper Series in Applied Finace" on Thursday. I assume this is a further follow-up event to the one they did at NYU Poly last year (see some notes here). I have put some notes together below, my apologies in advance to the speakers for any innaccuracies or ommissions in putting my thoughts together:

Systemic Risk Presentation

First part of the day started with a presentation by Viral V. Acharya of Stern on systemic risk. I have always found systemic risk an interesting topic, given the puzzle of how do you dis-incentivise an organisation from increasing risks in the wider financial system when the organisation itself will not directly (or wholey) face the consequences of this "external" risk increase.

Viral started his presentation with some great jokey graphics, one of a the HQ of a bank going up in flames with fireman hosing the flames with banknotes not water. He mentioned the definition of systemic risk given by Daniel Tarullo, Governor of the Federal Reserve (I couldn't find the definition, but primer paper here). He asked how Lehman was allowed to fail when the likes of Fannie Mae, Freddie Mac, AIG, Merrills, CitiGroup, Morgan Stanley, Goldman Sachs, Washington Mutual and Wachovia were not and offered assistance in one way or another. He said there was not enough capital in the system to stop Lehmans failure but that he saw Lehmans as the catalyst for the recapitalisation of the American banking system, not the cause. He later implied that Europe had so far lacked such a catalyst for action in the European banking system.

Viral said that he wanted to put forward an ex-ante regulation that would force a bank to retain additional capital to account for the systemic risk it produced. He said that the banking system was obviously much safer than it had been a few years back, but suggested that whilst the system could now withstand say the failure of a large organisation such as Citigroup, in his opinion it would struggle to survive the failure of Citigroup and a Euro default happening at the same time. Viral said that the current Dodd-Frank regulation on systemic risk was not a healthy one in that if a large institution fails, banks of capitalisation of over $50B are jointly taxed to assist in the consequences of the failure. Viral viewed this as a big dis-incentive against a healthy bank (say a JPM) from stepping in to purchase the failing institution before the failure, as JPM would know that it would be taxed anyway on the bailout. 

In Viral's model, he defined a crisis as a 40% market correction, and assumed that non-equity liabilities repayed at face value in such a crisis. Given there is not much real data around for a 40% correction, he used data obtained from 2% correction events observed, then extrapolated from the 2% to the 40% level. He said that the question that needed to be asked was whether in such a crisis scenario that a bank like JPM would retain 8% capital. He emphasis that the level of capital chosen was somewhat arbitary but rather more importantly were the assumptions in the model of crisis, since the capital models used in regulation today are based on average losses not crisis-level losses. Using this and related models, Viral showed that the banks exhibiting the most systemic risk were Bank of America, JPM and the Citigroup (for more background and a complete list see Stern's V-Lab ).

Viral said the restructuring of Dexia (exposed heavily to peripheral sovereign debt) was the "Bear Stearns of Europe" (exposed heavily to peripheral MBS), but that is restructuring was not large enough to cause a more widespread re-capitalisation of the European banking system. Dexia was ranked as one of the safest banks in the Europe-wide stress tests of 2011, given that the Basel risk weightings did not apply any haircut to European sovereign debt. This was another critiscism that Viral levelled at Basel in that the risk weightings are static and do not reflect changes in market conditions.

Panel Debate

Viral then joined a panel debate on systemic risk chaird by Linda Allen of Baruch, joined by Jan Cave of FDIC, Sean Culbert of Capco, Gary Gluck of Credit Suisse and Craig Lewis of the SEC.I have tried to bring out some of the main themes/points of the discussions below:

- The Balance Between Risk to the System and Risk to the Economy

There was a lot of debate on the secondary effects of regulating systemic risk and increasing capital charges on banks, and its wider effect on the general economy. Craig put forward the argument that too high capital requirements would stifle lending and in turn stifle the wider economy (arguably the "bigger" systemic risk maybe?). He argued for a balance to be found and that the aim should not be to eliminate risk in the system completely. I guess Craig was taking the banker's view, but the rest of the panel seemed to agree that the point was a valid one.

- Basel III

All agreed that Basel III was an improvement but there was still much more to be done. Gary was critical of Basel III calculation remaining too static, but Jason described how Basel III had removed many debt-like assets from the capital calculation which was good however. Jason also described how Basel I had been a simple framework (and good for that) but was tinkered with with VAR encouraging assets to be moved to trading book to reduce capital charges. Basel II then introduced the Internal Model approach and over ten years capital requirements were continued to be lowered, with CDO's attracting a 56bp capital charge during this time down from 8%. Enforcement of Basel III on both liquidity risk and capital was considered as key for coming years.

- Liquidity Risk

There was general consensus that pre-2007 liquidity risk was not talked about enough and there were no standard ways of calculating its level. Jason said that pre-2007 the regulators had not modelled what happens when the counterparties start running. Gary said that he questioned whether some of the current calibrations of liquidity risk were correct.

- Volcker

Sean raised the point that Volcker was likely to impact market-makers and hence impact liquidity (see earlier post on this).

- Rehypothecation

Sean also mentioned that Rehypothecation of Assets has not been debated enough and had only received scant attention in Dodd-Frank (maybe see recent article on Thomson-Reuters on MF Global)

- Europe (and more Basel)

General consensus that Basel III capital requirements will constrain GDP growth in Europe. Viral seemed to have the strongest views here, saying the Europe needed a bank recapitalisation program just as the US had gone through, and that such a program would be a big boost to economic confidence. Viral remains deeply sceptical on the success of Basel III - for example all of the 2007 failures were supposedly from well capitalised insitutions under Basel I and II. Viral says that the problem is not the level of capital (8% or 12% etc) but the method of modelling the shock. A good point from Gary I thought was his premise that politics in relation to sovereign debt was playing its part in undermining the calculations and approach of Basel III.

- Too Big to Fail?

One audience question was "is too big to fail simply too big?" and should the largest organisations be broken up into more manageable parts. Viral answered that he was not in favour of a size constraint and cited that some large institutions, notably JPM, Rabobank and HSBC had been relatively robust successful during the recent crisis. He did however qualify this response by saying that he was in favour of a size constraint if the large size reached was due to implicit banking guarantees from the government, and that he would like failing large banks to be broken up into smaller pieces.


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