ERM Symposium Day 2: Panel 2

Colin Lawrence is back (Bank of England, PhD Economics University of Chicago, also paratrooper in Israel), representing the regulatory perspective. Dan Rodriguez (Credit Suisse CRO, PhD Economics MIT, BS West Point). Michelle McCarthy, Nuveen.

Colin: [KR: already said "et cetera" twice thrice.] Themes to think about for the conference overall: shift toward financial stability regime, almost zero-tolerance for "fat-tailed" failure, stress testing of capital and liquidity, business model sustainability, dynamic capital and liquidity buffers, (bail-in) contingent capital, and recovery and resolution regime. Mentions Frank H. Knight's 1921 book "Risk, Uncertainty, and Profit." Not actually objecting to risk and losses, as long as the Board is made aware of the risks undertaken. [KR: in general, he's showing the same slides as yesterday.] Encourages debate with regulators.

Dan: Credit Suisse has a practice of cashing out toxic assets and paying the proceeds out as employee bonuses. Spent a lot of time going over things that Credit Suisse has done to make it a safer bank. Goes through evidence that perception of safety is manifesting (CDS spread tracking with non-banking, volatility decreasing.)

Michelle: Discussing risk management in asset management firms. Mostly concerned with middle-of-the-distribution/market risk since asset managers have less exposure to extreme outcomes. Key thing is disclosures, because of how investors use these funds (part of a larger portfolio.) Also portfolio managers personally bear the risk of screwing up their portfolio, as in they could go to jail (unlike banks.) Needed a way to aggregate the risk of each portfolio manager (since each one measures risk in his own way.)

Exposure to market and credit risk, but biggest by far is operational risk. Are risk managers responsible for strategic risk? Not really, it's the Board's failure. Doesn't blame VaR; it's not stupid to ask "how much will we lose if history repeats itself?" The blame lies with the Board who only asked to see VaR. Also doesn't consider reputational risk part of the job.

Q&A:

How many stress tests do you (Colin) run?

Colin: Depends on goal. He ran one stress test for every institution in the UK. Had the institution run it and also ran it himself and compared the results. Facilitates constructive dialog. The institution itself should be running as many as possible. Point is to find where you're vulnerable then decide whether that risk is acceptable. You don't have to necessarily change anything in response to a vulnerability.

What is recent regulation doing to financial institutions? Is it becoming a utility?

Dan: There's a huge change. People are leaving the field. Not necessarily a bad thing. Average hedge fund leverage has gone down significantly. Not a lot of risk capacity. Banks that remain are getting a larger share of a smaller pie.

Michelle's reaction?

Michelle: Certainly less capital available. Ability to match duration using swaps is limited, increasing exposure to interest rate risk.

Audience question: comment on results compared to some matrix estimates.

Michelle: Any time you mine data, you're assuming that history will repeat itself.

Model wrong or the application of the model? What's the future of mathematical modeling?

Michelle: Business model will always move to the edge of what's allowed in an effort to optimize. When a new product arrives, you haven't the data to build a reliable model, but we still go to the edge. The solution isn't to throw out the model but to have the discipline not to apply models to things to which they were never meant to apply.

Colin: When you have concentrate, large positions and no liquidity, hedging is very different. References a "dog and frisbee" paper about regulation and modeling. Trust is models is too high.

Panel 2.