Risks of Risk Management

IAmEric · Post by **IAmEric** » Fri Mar 17, 2006 1:52 am

Hi everyone,

Since I suspect we have a ton of NPers who work in risk and, in particular, Aaron has finally obtained the critical 4 posts, I thought I'd ask a question, which is probably old news and has been discussed to death in a million places, but is on my mind.

When I look out at the world, one of the major risks to the markets that I see is, ironically, risk management. I suspect that one of the primary employers of junior quants in the last 5 years has been in risk analytics (HHs, please correct me if I'm wrong). If there is any truth to that, it means there is literally an army of quants who have not lived through a business cycle building risk systems on markets that no one really understands, e.g. CDS/CDOs.

From what I've seen, the actual "risk managers" are typically high level management who actually have very little clue about what is going on (except Nonius and Aaron of course Smiley ). For example, at my previous employer, one of the risk managers got his break because he would perform magic tricks at the company parties Party

If things are at all like what I have seen, then we've got a bunch of fairly clueless risk managers out there with an army of fairly green quants developing sophisticated risk models that are probably pretty useless in a crisis. Nonetheless, there seems to be this completely ludicrous false sense of security.

Across the boards, vols seem to be historically low which would mean that most VaR engines are saying "smooth sailing". What happens if vol increases? Everyone's VaR model is going to start sending out little red flags. Assets are going to start getting reallocated. Since everyone has almost identical VaR models, the signals will be pretty much identical at all firms. I know it is not an original argument, but this could easily lead to a negative feedback. A small red flag due to increased VaR could signal everyone to make very similar reallocations. If everyone does it at the same time, the market will obviously be affected. In essence, the impact of risk management could actually increase systemic risk in the markets and amplify vol movements.

I'm very curious to hear what others think. Is this a totally bogus line of thinking?

Any pointers to literature discussing this kind of thing would obviously be appreciated. Here is an article I found interesting on the subject

The impact of risk regulation on price dynamics

Jon Danielsson, Department of Accounting and Finance, London School of Economics, July 2002

Cheers Beer

Eric

apine · Post by **apine** » Fri Mar 17, 2006 2:27 am

it is not a totally bogus line of thinking. you also forgot some other things, too. like tight credit spreads which is another way to be short volatility and short liquidity. but anyway, from an academic standpoint, your thinking is good. from a trading standpoint, timing is everything. people have been killed going long vol, which is another way of saying purchasing liquidity from the market.

this is the age old cycle of markets, nothing more and nothing less. in the meantime, things could be great for years. hopefully, skillful risk managers will be looking at far more than the var numbers. the impression i get from people is that they do. i say this without being a risk manager and not working for a large bank, so i could be totally wrong. they look at worst case scenarios, etc. i think that people learned from 1998 and 1987. it will be a slightly different twist to the story for the next time. but there still is some risk, particularly as central banks have been tightening liquidity which is the usual suspect.

IAmEric · Post by **IAmEric** » Fri Mar 17, 2006 3:01 am

Speaking of the devil. Here is a great article (found on eRaiders.com)

Value-at-Risk: The Next 10 VaR Disasters

rowdyroddypiper · Post by **rowdyroddypiper** » Fri Mar 17, 2006 3:17 am

Apine, you are correct, at least in my tiny bit of the world people are more focused on scenario analysis than they are on statistical measures of risk. I kind of view it as crisis rather than risk management. They have something along the lines of "what's our strategy if/when, shit hits the fan". Anyone reading this bear in mind that I work in a very illiquid space that has piles of idiosyncratic risk so this is probably the only way to go. I'm not sure how well this would work for someone with a bank type portfolio. I suspect it probably wouldn't but what the hell do I know.

Cheng · Post by **Cheng** » Fri Mar 17, 2006 8:59 am

RowdyRoddyPiper,

also bank type portfolios tend to be quite illiquid. You think you do business only with the big corps and you are fine since everything is perfectly liquid ? It is far from that. Our book here is composed only of big and medium corp names and I would say that at least 50% of it is illiquid as hell. So scenario analysis cannot/should not be ommitted.

rowdyroddypiper · Post by **rowdyroddypiper** » Fri Mar 17, 2006 2:04 pm

See, that "what the hell do I know?" disclaimer is already paying off...big time.

Good point. I tend to forget that what banks do the 99% of the time that I'm not interacting with them.

ballsup · Post by **ballsup** » Fri Mar 17, 2006 2:39 pm

Thanks i am Eric - i am actually planning on doing some research in this area in the coming months, so your links are useful.

I think you might want to seperate out the risk modelling techniques from the regulatory framework.

I think you also have to think about the different players. In theory the big investment banks should be capable of taking a reasonable long term view, and holding their own corner. The minute you start letting life/investment companies sell retail investment products to the public, or large corporates set up pension funds for their employers you have to think really hard about agency issues...

But what the hell do I know?

Nonius · Post by **Nonius** » Fri Mar 17, 2006 2:40 pm

Eric, didn't have time yet to look at your link on the negative feedback. but, here are my 2 cents.

not so sure that everyone is using the same models for VaR, but, even if they were, different institutions have different risk appetites, different current utilizations of risk, and different motivations. furthermore, not everyone is regulated by the same jurisdiction, or even the same regulatory body. the players are institutional investors, banks, hedge funds, insurance companies, etc etc. so, just because VaR limits are breached in one bank, doesn't mean they are simultaneously breached at other places or even within months of each other.

Furthermore, for banks that use historical simulation for VaR, desks can cheat the system pretty easily; I knew a bond trader once who would buy out of the money bond options JUST at the right strike to cover this one bad day in the look-back period. actually, that isn't a cheat...it is fair game, and his strategy was openly discussed with various risk managers and traders.

As for other risk measures, my experience is that for certain types of books, VaR is an ok measure to set a limit by. for example, if done carefully, it works ok for certain simple fixed incomoe strategies. for other strategies, such as merger arb or anythying that requires events to occur, it sucks.

in all cases, as everyone pointed out, a rm needs to perform both historically as well as bespoke (ouch, stop using that word) constructed stress tests...unfortunately, I've seen too many places not really take those stress tests too seriously. In fact, in most places I've seen, it is a number that is computed, talked about in a meeting for a few minutes, and then forgotten. furthermore, I think not enough people in banks, hfs, etc, look far enough back for historical tests. I find it mindboggling that a lot of people don't include Oct 87 in their tests. people either have short memories, are too young, or are fooling themselves into thinking that something like that is so remote as to make it effectively an event with vanishingly small probability. I think the probability is high enough that people should measure a stress using those types of shocks, ESPECIALLY if you are dispersion/correlation dude.

Nonius · Post by **Nonius** » Fri Mar 17, 2006 2:59 pm

oh, again, maybe it is all in the linked literature, but I would suspect that it would be exceedingly difficult to set up a statistical test to show that risk regulation has added risk to the financial system. you'd have to make a lot of inferences about things you absolutely will not be able to observe. and, you will not be able to test the hypothesis in the same markets without the risk regulation.

ballsup · Post by **ballsup** » Fri Mar 17, 2006 3:26 pm

Nonius,

What about if you compare two different countries, with two different takes on regulation - then consider the institutional asset allocations?

But what the hell do I know?