Risk Management in Turbulent Times

By Gilles Bénéplanc; Jean-Charles Rochet | Go to book overview

INTRODUCTION
The risk management methods and concepts used by most corporations have been designed for “normal times.” Typically they rely on simple statistical risk measures and assume that financial markets behave smoothly and efficiently. The problem is that we are living in more and more “turbulent times”: large risks materialize much more often than predicted by simple models, and financial markets periodically go through bubbles and crashes.The Subprime Crisis, which started in August 2007, is a good case in point. It must be viewed as an historical event of major importance, with worldwide and durable consequences on the economic life and on the organization of financial and banking activities in many countries over the world. It has completely shattered public confidence in the risk management methods that were used by banks and financial intermediaries. These risk management methods must be adapted to “turbulent times.” The main objective of this book is to dissect these methods, to explain why they have failed, and to propose amendments for the future.Doing this, we are careful not to throw the baby with the bath water. Unlike some commentators, who basically claim that sophisticated financial methods are nothing but uninformed speculative bets and that risk professionals are essentially incompetent crooks, we take the more reasonable view that these methods are potentially useful but have to be used with a lot of caution. Recent crises have shown the dangers of the “exuberant optimism” that was often expressed by many risk professionals and that is well-illustrated by the following statement by former Federal Reserve Chairman Alan Greenspan in 2004: “Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.”1 This optimistic statement was soon to be severely contradicted by the facts.The view we put forward in this book is more of an “informed skepticism”: by dissecting the main risk modeling methods and the (sometimes hidden) assumptions that they rely upon, we are able to clarify the conditions of their validity. We will insist on four fundamental recommendations that were often forgotten by the risk managers of well-established financial institutions (which, as a result, have incurred massive losses during the Subprime Crisis):
Always get a complete picture of your risks: Forgetting just one risk can be fatal, even if all your other risks are precisely modeled. Even if some risks are difficult to assess, they have to be incorporated in some way in the global risk mapping of the corporation, which risk managers should be able to provide to their top management.
Adopt an “informed skepticism” approach to risk modeling: It is fundamental not only to understand your risk models but also to be aware that they can sometimes be plain wrong. This is the case in particular for all

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