Risk Management in Turbulent Times

Risk Management in Turbulent Times

Risk Management in Turbulent Times

Risk Management in Turbulent Times

Synopsis

The subprime crisis has shown that the sophisticated risk management models used by banks and insurance companies had serious flaws. Some people even suggest that these models are completely useless. Others claim that the crisis was just an unpredictable accident that was largely amplified by the lack of expertise and even naivety of many investors. This book takes the middle view. It shows that these models have been designed for "tranquil times", when financial markets behave smoothly and efficiently. However, we are living in more and more "turbulent times": large risks materialize much more often than predicted by "normal" models, financial models periodically go through bubbles and crashes. Moreover, financial risks result from the decisions of economic actors who can have incentives to take excessive risks, especially when their remunerations are ill designed. The book provides a clear account of the fundamental hypotheses underlying the most popular models of risk management and show that these hypotheses are flawed. However it shows that simple models can still be useful, provided they are well understood and used with caution.

Excerpt

3.1 THE NECESSARY INGREDIENTS

Risk management has a long history. Various techniques have been developed for many years in all areas of human activities. Classical examples are the construction of dams that protect against floods and the organization of fire brigades to fight against fires. It is only recently that a common methodology has emerged. Recent crises have shown that several ingredients of this methodology are crucial: mishandling one of them can be sufficient to provoke the failure of an established company. This section presents a summary of this methodology.

The necessary ingredients of risk management are listed below.

The Identification step consists of identifying the entire spectrum of possible
risks that can hurt the firm.

The Quantification & Modeling step consists of estimating the frequency and
severity of each risk and also, very importantly, the correlations between
them. Ideally, one should be able to build a quantitative model giving the
cumulative distribution function of losses (or gains) conditionally on
external and internal variables.

The Loss Prevention & Protection step consists of the reduction of the
frequency (prevention) and consequences (protection) of the risks. Taking
the example of property risks, good maintenance of electricity systems
improves loss prevention, whereas maintaining a sufficient water pressure
on-site improves loss protection.

Finally, the Risks Financing & Transfer step consists of deciding which risks
have to be financed directly (when the corporation decides to keep them)
and which have to be financed indirectly (when the risk is transferred to
financial markets or an insurance company).

For many years this traditional approach has been applied to each specific family of risks, the oldest examples being property and marine risks. The occurrence of new and larger risks, together with their growing complexity and multiple interdependencies, required some improvements in the risk management methodology and instruments. We now study these improvements by following each step of the risk management approach: risk mapping for the identification and quantitative steps, loss prevention in new areas like fraud or liability, and, finally, the impressive array of new financial tools that have been created in recent years to transfer and finance risks.

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