Sunday, October 11, 2009

Risky Assumptions - Lessons on Risk management learnt from the financial crisis

Through this article I highlight some of the assumptions on risk that investors, companies made which has terribly backfired on us/them during the recent financial crisis

Mean reverting characteristic

The first assumption in any standard book on risk management is the mean reverting characteristic of the risk variables..Let me explain this with the help of my favorite variable sigma (standard deviation)

When companies underwrite on securities(even during volatile times) they believe that the volatility(SD) will return to the long run average…Quite a decent assumption as long as the companies are able to stand the test of time..For example some of the companies/traders (who were short) were completely wiped out on a single day when the UPA government was elected because the volatility increased to a life time high of 75(VIX figure – source: NSE)

In the time of crisis the company’s liquidity takes a big beating which gives them no other choice but to wind off their positions at big losses.

Again I’m not completely supporting the mean reverting characteristic. During complete structural changes in the financial market in a country the variables change a lot and it will never come back to its historical mean.

Do we really STRESS the conditions?

The regulators and companies were smart enough to devise a system(even before the crisis) called as stress testing wherein they will simulate extreme scenarios and try to see what would be the impact on their balance sheet/profitability..

But what we/they failed to understand was the behavior of the market when conditions are stressed..So we merely do a scenario analysis of projecting different variable to extreme cases (example: Interest rate moving by 5%, volatility jumping by 100% etc)…Recently my friend gave me a hypothetical scenario – a really stressful situation and asked me how will I behave in that situation …My answer was ‘I don’t know’..He was surprised at the answer and asked me why I myself did not know..Simple because I have not experienced such a situation in my life and I myself can’t predict my behavior under such extreme conditions..So I said since I’m a very kind and nice person during normal circumstance does not mean I’ll be the same forever..Situations can drive a person crazy…Projection of the behavior is not the way out here..
Lot of the assumptions that we have taken during the normal market conditions fail terribly during stressed condition..One such important failure was the increasing asset correlations. Any global manager with significant exposure in various countries would have thought his positions to be safe because of the diversification..But during the financial crisis the asset correlations increased substantially that all their assumptions regarding correlation went for a toss..

United we stand – Says different risks

True to the proverbial statement which says ‘history always repeats itself’, there have been various individual cases of bank failure in the past due to individual risks which triggered the other risks and caused the collapse of the entire bank. For example it was a rogue trader (operational risk) who collapsed the billion dollar organization ‘Barings’ in no time. It was unacceptably higher levels of hedge fund investing (Liquidity risk) which triggered other risks and eventually caused the collapse of LTCM (long term capital management- A very famous hedge fund).It is entirely the banks and the financial institutions to blame who did not give the due respect for such historical incidents and went ahead doing whatever they were aggressively doing. The root cause of these problems lies in the fact that the organization failed to see the risk management from the enterprise perspective. Hence we infer that though there are different names for the risks (market risk, liquidity risk, credit risk, reputational risk) – they generally occur together

We use VAR:(Value At Risk)

VAR – Simple but an effective tool in identifying the pile of risk that you are sitting upon..Many companies were proud about the fact that they were using complicated models of VAR as the risk management tool and they knew exactly their risk..

But the problem with VAR is that it does not focus on extreme events..Regulators for banks say that the banks have adequate capital for their VAR with 99% confidence level…But what if the risk is only after the 99%..What if the magnitude of risk is exponential in nature after that 99%..Go ask any option writer and he’ll be able to explain this better (I luckily/unluckily being one among them)..

So using VAR is just a hygiene level..If companies want to identify the real risks they need to go much beyond what VAR suggests!!

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