For the 14th time, the Center of Competence Finance in Zurich organized the ETH Risk Day. More than 100 experts from both academia and industry met on Friday, September 9th, 2011 at the ETH Zurich. Seven high quality presentations covered both theoretical as well as hands-on topics related to risk management in banks.
A strong focus in most presentations was on capital adequacy and managing balance sheet risks of banks. Prof. Embrechts, in his talk called Up the devil’s staircase, down the financial abyss, illustrated the steps that, according to his view, lead to the recent crisis in the financial system. The first step of the devil’s staircase is leverage, followed by the application of the Black-Scholes model introducing the abstract concept of implied volatility and its pricing. The staircase became even more devilish with the introduction of cash and synthetic CDOs, instruments being dynamite for the financial system. Wall Street banking can be seen as the mathematical problem of gain maximization under the constraint of ethical boundaries. According to Prof Embrechts, the role of mathematics should be to support quantitative risk management focussing both on the frequency as well as the severity of loss giving events. He concluded his talk giving he following recommendations for risk management in practice:
- If you don’t understand it, don’t buy/sell it.
- Speak to “the guys in the boiler room”.
- Beware of “new” paradigms, like the “New Economy”, the “New Risk Management”. “New” usually means that tried and trusted measures of the past are being ignored.
- Always understand your gains and beware of volume, especially with AAA rated instruments.
- Concerning the Basel II+ or III standards, do not try to reinvent the wheel, check countries and institutions that came through the crisis less harmed, understand why!
Philipp Rickert and Dr. Dominik Lambrigger of KPMG presented in their talk an auditor’s perspective on the challenges associated with the new Basel II.5 and III frameworks. They showed how Basel II.5 introduces the concept of incremental risk charge, stressed VaR, securitization and re-securitization risk modeling, and focuses on comprehensive risk measures. In the Basel III framework, the speakers focused on the introduction of a comprehensive measure of the market value of counterparty risk.
Thomas Ivell from Oliver Wymann presented in his talk some aspects about the traditional wealth management industry showing why managing client money is not an as risk free business as expected. Indeed, during the crisis many wealth management participants took on their balance sheet liquidity risk by allowing clients to redeem products, for example, money market funds, that had become illiquid. Other examples were the repurchase of defaulted capital protected certificates issued by Lehman or the compensation of clients who lost money while being invested in so-called absolute return products. Interestingly, the lombard loan product was shown not to have been of major concern to wealth managers during the crisis.
In a very interesting and entertaining talk Dr. Martin Bardenhewer from the Zurich Kantonalbank (ZKB) presented some thoughts on the impact of regulations. He pointed out that bank risk management needs to consider the two dimensions i) capital and ii) liquidity. The capital dimension on one side can be adequately measured through the notion of risk weighted assets and leverage ratio. Liquidity exposure is best characterized by the asset-liability gap and the available liquidity buffer to avoid insolvency in stress situations. In addition it is very important to focus risk management also on operational aspects, mainly payment services and collateral trading, to assure that in a crisis scenario the bank can still be operational and adjust its risk positions. Dr. Bardenhewer concluded his talk by illustrating the key decision traps that have to dealt with as being
- the problem of anchoring,
- relying mainly on confirming evidence,
- focusing on the status quo rather than the future,
- trying to be prepared in the future based on recent experiences, and
- the lack of focus on forecasting structural changed.
In addition, he mentioned three major modeling traps that need to be addressed,
- assuming mean reversion and thus ignoring structural changes,
- the stability of preferences, and
- no market saturation.
Dr. Karl Rappl from the supervising authority FINMA presented lessons learned from the 2008 financial crisis. The main focus of his talk was on communication between the different market participants and how these have and will be addressed going forward. The focus was on more detailed supervision and better defining the unique role of the independent auditor as the right hand of the supervisory authority in the Swiss banking system.
Dr. Louis Scott from UBS Investment Bank focused in his talk on risk, valuation, and the cost of funding. The two main dimensions to be addressed are i) managing the counterparty credit risk and ii) assuring sound terms in the collateral management agreement. For interest rate swap derivatives, these dimensions are addressed through clearing them through the London Clearing House requiring collateral to cover the market value of the swaps.
In the last talk of the day by Prof. Dr. René Carmona from Princeton University, the focus was on risk management in commodity markets. Different ways how to gain exposure to the commodity market were presented in the first part of the talk. In the second part, Prof. Carmona focused on pricing issues including the difficulties introduced by the existence of forward curves and changing correlations. The third part of his rather technical talk focused on new markets, like the emission markets, illustrating challenges associated with them especially with respect to pricing the instruments.