Risk Management in Turbulent Times

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

1
Lessons From Recent
Financial Crises

1.1 THE BASIC GOALS OF RISK MANAGEMENT
The fundamental role of the risk management division of a modern corporation is essentially to assist the top management in making the following decisions:
Decision 1: How much risk to take
Decision 2: How much of this risk to retain and how much to insure or transfer to financial and insurance markets
Decision 3: How much capital to keep as a buffer against losses because of this retained risk
Decision 4: How much liquid reserves to maintain

Decision 1 refers to the size or volume of the different risky activities that the firm undertakes. Decision 2 refers to the fraction of the associated risks that will be transferred to insurers (through insurance contracts) or financial markets (through hedging or securitization), the remaining risks being retained (or selffinanced) by the firm. Decision 3 refers to the maximum amount of net (i.e., after the transfers arranged by Decision 2) losses that the shareholders of the firm are ready to bear themselves: This amount corresponds to the own funds or equity capital1 of the firm. Finally, Decision 4 refers to the level of liquid reserves that the firm keeps for being able to satisfy its future payment needs. If these reserves turn out to be insufficient, then the firm becomes illiquid.2 The managers then have to finance these liquidity needs either by borrowing from a bank, issuing more equity or debt on the market, or selling some of the firm’s assets.

Note that the core of risk management is fundamentally Decision 2 (how much risk to retain and how much to insure or transfer to financial markets). However, this book will show that investment policy (Decision 1), financing policy (Decision 3) and cash management policy (Decision 4) cannot really be separated from risk management policy (Decision 2).


1.2 WHEN RISK MANAGEMENT FAILS

In the last decades, large companies (notably banks and insurers) have elaborated very sophisticated quantitative methods for answering the above questions. These methods have generally proved very successful, but recent crises have also revealed that they can sometimes fail spectacularly. As illustrated by the AIG quasi-failure (see Box 1.1 below) and by other examples described later in this book, it is now commonly viewed that the majority of banks and other financial institutions that participated in the subprime markets (and the securities and derivative markets that were developed in connection with these subprime markets) had it all wrong.3

-7-

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