no class of trades and investments with a higher failure rate than those pre- sented as ‘intuitive’ – for instance, committing to an unplanned position because somebody just recommended it. In contrast to a hit-and-run approach, the right homework in risk management means following clear enough guidelines:
● Assess and reassess one’s risk tolerance. The assessment of one’s own risk appetite and risk tolerance must be accurate not precise, since it is not pos- sible to kill two birds with one well-placed stone, and it must be properly documented. While the market is going north, it is easy to think one can handle riskier investments. But little by little the assumed level of expos- ure may be more than the investor wants to take, or actually needs, and much more than he or she knows how to handle.
● Lower short-term expectations to meet market reality. During the go-go 1990s, and similar periods in the past, many investors became accustomed to annual returns of 15–20% or higher. Not only is this well above the S&P 500’s historical average of 11% (from 1926 through to 2000), but it also translates into huge risk – hence future cost.
● Focus on the longer term and put a level of confidence on your projections.
This closely relates to choice of an investment horizon. It is always wise to keep an investment period, and the market uncertainty associated with it, in perspective. Volatility may be unpleasant, but it is not unnatural.
Investors who have the time, patience and discipline to do their homework with their investment programme and the positions they have taken, are rewarded in the longer run.
OBS merged with on-balance sheet exposure, with off-balance sheet instruments now accounting for $300–400 trillion in notional principal.
● This means more than $60 trillion in real money at a time of major crisis,5 and
● A sword of Damocles as the notional amount is growing by some 30% per year.
The third crucial characteristic of the modern economy, which can hit financial stability like a hammer, is the in-transit credit risk unloaded on third parties (Chapter 6). Credit risk mitigation was at the level of a few billion dollars in the early 1990s; it stood at $2 trillion on 1 January 2003, and by growing at 30–35%
per year it is estimated to stand in excess of $6 trillion on 1 January 2007.
Is there an economic justification for taking such mega-risks? The theoretical answer usually found in textbooks is return on capital. Standard deviations of return and Sharp ratios (the latter being unstable) are commonly presented as measures of risk-and-reward profile.
However, as applied to some players like hedge funds, these metrics substan- tially understate the true risk assumed by the entity that puts in its block highly leveraged assets. And because there is no structure that cannot be subverted, the practical answer to the ‘mega-risks’ query is: lust and greed.
An issue many hedge funds, banks and investors don’t seem to contemplate is that an ever growing risk appetite is subject to the law of risk of ruin. This is not reflected in the standard deviation of returns, but finds itself in spikes at the very long leg of the risk distribution. The only measure of risk of ruin is provided by stress testing at at least 15 standard deviations. Among the reasons for such an outlier are:
● Complex derivative instruments in which many players trade
● Liquidity characteristics of traded instruments
● Use of derivatives with non-linear sensitivities
● Wrong hypotheses and plain model error
● Non-representative historical data for estimating standard deviations
● Bad judgement or misconduct, creating the possibility of sudden, dramatic unexpected losses.
An error hypothesis most frequently found is that risk and return are almost lin- early related, leading to the equally misplaced assumption that the bigger the risks one assumes, the greater will be the returns. Quite to the contrary, risk and
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return are proportional only up to a point. After that, the greater the risks one takes:
● The less will be the returns
● But the more likely becomes the ruin.
By going beyond the so-called efficiency frontier, the inverted U-curve in Figure 8.2 dramatizes what was stated in the preceding paragraph. Among the reasons for this inverted U-curve are: over-optimistic calculations of expected profits; biased interpretations of value-based tests; misjudgement of risks; use of too many volatil- ity smiles in pricing; growing risk concentrations (sections 2 and 3); wrong dis- tributions of risk-based capital; and ineffective supervision by the board and CEO.
Precisely for these reasons, there is plenty of scope for rethinking and revamp- ing exposure control, and for emphasizing detail. A senior Barclays executive put it this way: ‘If you take value management to transaction level rather than whole entity, you may increase deliverables from value-based management by 25%.’
There is much more to be gained from risk control at a high level of detail, because risk of ruin is a material exposure that does not respond to classical tests, and for which companies are not ready to proceed with stress tests. The September 2006 loss by Amaranth Advisors, a hedge fund, of 65% of its capital (a cool $6 billion, by speculating on volatile gas prices) is an example of risk of ruin.
Optimists say that as long as overall financial stability is not affected, the risk of ruin can be seen as part of creative destruction and rebirth, as happens in elec- tronics and among internet companies. This particular concept is borrowed from Silicon Valley, where the organizational secret of stress is:
● Intentional creative destruction, and
● Rebirth, through imagination and innovation, as Apple Computer has shown.
Pragmatists answer that Silicon Valley is of interest to financial institutions as the birthplace of brilliant investment opportunities, but not as a model of corporate governance, because banks and financial institutions are not only operating entities, but also guardians of other people’s wealth.6(Research done by Nasdaq in the 1990s has shown that, to survive, a Silicon Valley company has to reinvent itself every two and a half years. In that innovation-intense environment, old companies die and new ones emerge, allowing ideas, people and capital to be recycled.)
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In banking, air transport, utilities and energy, new business vistas have been opened with deregulation, which started in the late 1970s. But in case some people hadn’t noticed, a new wave of re-regulation has started – particularly in banking and insurance. Examples are:
● Basel II in 1987
● Market Risk Amendment in 1996
● Basel II in 1999–2007, and
● Solvency 1, Solvency 2 in the insurance industry.
GAAP and IFRS (including IAS 39) are also part of re-regulation – and for good reason. Enron tells us why. In 1986, Kenneth Lay became the head of a company just formed by the merger of two natural gas pipelines. In a manner characteristic of Silicon Valley thinking, the new CEO figured that there was plenty of business opportunity in changing the entire way gas pipelining was done.
Soon, however, by promoting deregulation as a way to bypass government controls, Enron became an energy hedge fund with a gas pipeline on the side. By merging risk in finance with risk in energy, the firm rode on the wave of deriva- tives and of high leverage. There has been no evidence of limits to this policy of risk of ruin.
One thing that distinguished Kenneth Lay from other gas company executives in a positive way is that he viewed the national map of gas pipelines differently than everybody else. He also recognized that by pushing deregulation, Enron
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Return (just note difference)
Risk (just note difference) Low
Low High
Figure 8.2 Risk and return are non-linear and are often negatively correlated
could leverage itself. Another mark of distinction, this one most negative, has been that risk factors and their impact were ill-studied, and there were no limits to risk taking. Eventually, this proved to be Enron’s and Lay’s undoing.
Notes
1 Basel Committee on Banking Supervision, Working Paper No. 15, ‘Studies on Credit Risk Con- centration’. BIS, Basel, November 2006.
2 This is a real-life case, though some minor details have been changed.
3 Business Week, 13 February 2006.
4 International Herald Tribune, 8/9 May 2004.
5 D.N. Chorafas, Wealth Management: Private Banking, Investment Decisions and Structured Financial Products. Butterworth-Heinemann, London, 2005.
6 D.N. Chorafas, Alternative Investments and the Mismanagement of Risk. Macmillan/Palgrave, London, 2003.
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