Economic Freedom and the Stability of Stock Prices: A Cross-Country Analysis

A common sense result but a valuable one indeed. I quote the highlights and abstracts from this paper.

• ADR volatility is inversely related to the economic freedom of the home country.

• ADR volatility is decreasing in home-country, property-right protection.
• ADR volatility is decreasing in the level of home country free trade agreements.
• ADR volatility is increasing in the level of regulation in the home country.

---

This paper investigates the link between economic freedom and the price stability of individual securities in a unique setting. Using a sample of 327 American Depositary Receipts (ADRs), we find an inverse relation between the economic freedom of a ADRs’ home country and the price volatility of the ADR. This negative correlation is driven primarily by certain components of economic freedom, such as property right protection, the soundness of the money, and the level of free trade in the home country. Further, we find evidence that less regulation and less government control of markets in the home country leads to more stable ADR prices.

If one wants to find out what the broader public and market thinks about your country and the changes its going through, just look at the volatility of your ADRs. A simple way of judging how stable and future proof people think your country is going to be. ADR’s are a way of you and your country’s firms to raise international funds, its a positive cycle, improve your economic freedom, property rights, free trade and regulation and watch the price and risk of your international fund raising efforts improve.

Just what is a 25 Standard Deviation Move?

I had mentioned this level of movement last year at several lectures. Mr. Viniar who was the CFO of Goldman Sachs said in 2007, we are seeing things that were 25 standard deviation moves, several days in a row.

What does a 25 Standard Deviation mean? Does it really mean anything? These chaps actually tried to put some context around this 25 SD move. I am going to quote some extracts:

a 5-sigma event corresponds to an expected occurrence of less than just one day in the entire period since the end of the last Ice Age; a 6-sigma event corresponds to an expected occurrence of less than one day in the entire period since our species, Homo Sapiens, evolved from earlier primates; and a 7-sigma event corresponds to an expected occurrence of just once in a period approximately five times the length of time that has elapsed since multicellular life first evolved on this planet

So we are at 7 sigma and we are already way back into the mists of time on this planet. “ok ok, so get on with it”

These numbers are on truly cosmological scales, and a natural comparison is with the number of particles in the Universe, which is believed to be between 1.0e+73 and 1.0e+85 (Clair, 2001). Thus, a 20-event corresponds to an expected occurrence period measured in years that is 10 times larger than the higher of the estimates of the number of particles in the Universe. For its part, a 25-sigma event corresponds to an expected occurrence period that is equal to the higher of these estimates but with the decimal point moved 52 places to the left! 

They explain this in a different way.

UK  National Lottery is currently was offering a prize of £2.5m for a ticket costing £1. Assuming it to be a fair bet, the probability of winning the lottery on any given attempt is therefore 0.0000004. The probability of winning the lottery  n times in a row is therefore 0.0000004 n , and the probability of a 25 sigma event is comparable to the probability of winning the lottery 21 or 22 times in a row.  
And we should not forget Goldman’s losing streak – Goldman did not just experience a single 25-sigma event, but experienced several in a row – or forget that other institutions also experienced 25-sigma events. If the probability of a single 25-sigma event is low, the odds of two or more such events are truly infinitesimal. For example, the odds of two 25-sigma events on consecutive days are equal to 3.057e-136 squared, which is 9.3450e-272. This is as likely as winning the lottery about 42 times in a row. The corresponding expected occurrence period is the square of 1.309e+135 years – that is, 1.713e+270 years – a number so vast that it dwarves even cosmological figures. As Oscar Wild might have put it: to experience a single 25-sigma event might be regarded as a misfortune, but to experience more than one does look like carelessness

So before you decide to beat up the banks, have a think about what they were faced with. But then again, one can question, just what kind of a business are you running where extremes of this kind are present? How do design contingencies of this nature? Or put in scenario’s of this kind? Scenario Analysis is one of the most common ways of trying to analyse how things might happen in the future, but if you had to have some scenario’s of wildly cosmologically oriented events like this will need several universe sized computers to analyse.

The mind boggles.

The white male effect

I came across this paper, which talks about something very interesting which I had never heard of before. It talks about how white males are generally less risk averse compared to females and non white males (which is the more politically correct way of saying coloured males).



Here’s a graph of how various risks that one could face in life are judged by these four demographic groups. Surprise surprise, one finds that on EVERY risk factor, white males think of the risks on a lower level compared to others. As the paper commented:

they generally possess a higher-than-average level of education and household income, are politically conservative, display hierarchal and individualistic worldviews, are more supportive of technological advances, and tend to place greater trust in authority figures, such as industry and government officials

Now keep in mind that this is research is based on an American population so the particular biases, limitations, etc. etc. apply. But I never thought of this in this manner. Before I go into this a bit more, let me point out that the research paper specifically emphasizes that this research should not be considered a conclusion that the White Males are the root cause of all issues and that the rest of the population is a homogenous lot and are put upon by these white males. No, the research clearly shows that there are statistically significant differences in risk taking in other parts of the population and that the actual risk taking is much more nuanced.

But going back to the white male effect, what grabbed my attention was how important this factor was. Look down history and take just the last century for example,and you will see that white males have generally been at the forefront of most historical turning points. Some photographs will prove my point.

1.  The Treaty of Versailles

2. Yalta
 
3. League of Nations

4. United Nations founding.

5. Breton Woods

6. Kyoto Protocol

7. Celebrating fall of Berlin wall.

Anyway, you get the idea, there is a blaze of white male faces. Yes, yes, I know about Obama and Indira Gandhi and Margaret Thatcher and Angela Merkel and Golda Meir (there is much doubt about these ladies anyway typified by the quote about Margaret Thatcher that she was the only real man in the British cabinet...), but for the vast majority of the recent historical turning points,  the preparation work, the negotiations, the signing, the implementation, the execution of these public policies have all been done by white males. Now think about this. Recent history has largely been driven by white males whose risk perception is statistically significant in being lower compared to other parts of the population.

What does this mean? This means that much of what we are currently living through (whether food standards, security standards, health and safety standards, etc. etc.) are governed by a scale which is lower than what one would have expected if the grand poo bah’s had more non white male members in the decision making and execution areas.

Let's take the first example, cigarette smoking and the eco-system around it. We are talking about the manufacturers, the regulators, the judges, the lawyers, the scientists, the journalists, the analysts, the reporters, the TV reporters, the protestors, by and large, were white males. And they thought that the risk of cigarette smoking was much lower than what other parts of the population thought. Now doing a bit of back testing of this argument, if we had say a race/gender weighted risk understanding of cigarette smoking in the post Berlin Wall fall period, one can make a reasoned argument that restrictions on smoking would have been rolled out considerably earlier than what actually happened.

In each of the risk factors mentioned in the first graph, because of the nature of white males towards risk, one can make a good argument that a more nuanced way could have considerably reduced the risk for humans. Now that we have figured out that belling the cat would be a great idea to save the mice, who will bell the cat? Affirmative Action? Gender equality laws? Or is the prevention worse than the cure? I am not sure I have the answer, but I am sure that the answer is not going to be easy.

Risk Manager role with Afghanistan International Bank

Sometime in the dim and distant past, I had registered myself with an India based job site. This was when my father was ill, and I was considering moving back to India. Anyway, I had forgotten all about it, till today when this email landed in my inbox.

Post Title: Risk Manager
Organization: Afghanistan International Bank
Location: Kabul - Afghanistan
Duration: Permanent
No. of Post: 1
Sex: Any
Nationality Any
Salary: 4000 US $ p.m.+ accommodation + travel+ other benefits.
Background: Afghanistan International Bank (AIB), a commercial bank incorporated in Afghanistan and managed according to international best practices is looking for an experienced Risk Manager for its Head Office in Kabul.
Job Summary: Overall Job Purpose:
Due to rapid expansions of its business and operations the banking is looking for a Risk Manager. The position allows the successful candidate to be part of the senior management team of the bank and play a major role in its continued development.
The successful candidate will be expected to build a risk monitoring systems complying with Basel II requirements thus additional experience in market and operational risk management will be a distinct advantage.
Priority will be placed on credit management and the successful candidate will have had experience in:
1. • Credit Policies & Procedures
a. Credit policy, review and development
b. Acquisition or development of decision support tools for commercial and retail credit
c. Risk rating framework review
d. Underwriting standards development
2. • Risk Asset Review
a. Review of individual credit risk ratings
b. Credit quality assessments
3. • Portfolio Management Unit
a. Profitability and risk analysis
b. Pricing policy
c. Develop predictive dynamic monitoring
Qualification • Master degree
• Minimum 10 years experience directly related to risk management where at least 5 years in senior risk management capacity.
• Fully functional in monitoring of documentation, portfolios & exposure limits of the bank.
• Excellent analytical, creativity and problem solving skills.
• Posses good presentation and organizational skills.
Interested candidates can send their CVs with recent photo to this address:

Few thoughts crossed my mind.

1. The package is way too low for what is a hardship posting, so I am curious to know why would they have selected that compensation level.
2. Its an interesting job all right, but very ambitious. Candidates for this role with the required background and experience will be very few globally.
3. But it is good to read that they are aggressive, and I wish them luck with their hiring.
4. I researched the bank on the net and I was not really that comfortable to see that the address of the bank related to some house. Here is the address: House no. 1608 Behind Amani High School Wazir Akbar Khan, Kabul. Reminded me of the addresses I would see in the tiny lanes old Bhopal. 
5. One of the unsung success stories in Afghanistan is the steady development of the banking system. Considering that the Mullah's had effectively eviscerated the banking system, in a matter of 5 months, they have passed a series of banking laws, have presence of many international and local incorporated banks, got some good governmental backing from the Ministry of Finance.
6. Here is an interesting Afghan review report for the IMF. Gives you hope, no? and no, I am not suffering from the curse of low expectations. Give the country a break, it is starting from near zero.

I further quote some numbers on how Afghanistan has progressed since 2001 from this speech. (even though the verbiage could be a bit optimistic and is after all, coming from a US State Department Employee, the figures, even if adjusted, are noteworthy).

Reconstruction and development work remains on track in most of the country and the Afghan economy continues to grow at impressive rates, with licit Gross Domestic Product more than doubling since 2002. Thanks in large part to our colleagues in the U.S. Government, the lives of millions of Afghans have improved considerably: In 2001, just 8 percent of Afghans had access to some form of healthcare; now, more than 80 percent of the population has access to medical care. Almost 11,000 medical professionals have been trained. More than 680 hospitals and clinics have been built and outfitted. For the first time in 10 years, the grain harvest was sufficient to meet consumption needs inside Afghanistan. In 2001, 900,000 children – mostly boys – were enrolled in school; now, there are more than 5 million and more than 1.5 million of these (34%) are girls and young women. Since 2001, there has been a 22 percent decline in mortality rates for infants and children under 5 years of age – we are saving 85,000 more young lives every year. Two years ago only 35 percent of children were being inoculated against the polio virus. Now more than 70 percent of the population – including 7 million children – are inoculated. In 2001, there was a dysfunctional banking system. Now, Afghanistan has a functioning Central Bank with more than 30 regional branches and an internationally-traded currency. There are now 3 mobile telephone companies serving over 3.5 million subscribers – this is almost 11 percent of the population. In 2001, there were 50 kilometers of paved roadway in the country, now there are more than 4000 kilometers of paved roads.

The main thing which struck me was the sheer banality and normality of this advertisement. A very small thing, but something which gave confidence to me that Afghanistan is improving little by little, despite all the gruesome news coming out of Afghanistan and all the efforts by the Taliban to drag that benighted country back into the medieval ages. Sometimes, its good to see the good side of the story as well. I can only wish the country the best of luck and here's hoping that the Taliban are defeated. And if it keeps on hiring professionals of the type in the advertisement, it can only get better.

PS: then I read something like this and feel very depressed.

Technorati Tags: Afghanistan,Banking,Risk Management

A million messages per second

I have been researching a wee bit on technology and impact on trading and I came across this rather interesting article about the rate of messages on market data. I quote:

Broader institutional participation, increased volatility, advancements in technology, remote market making, and regulatory changes are driving options quote volumes to higher and higher peaks. The six options exchanges in the U.S send their quote data to the Options Price Reporting Authority, which merges it into one feed and pushes it out to the market. During periods of heavy market activity, Opra sends out as many as 300,000 messages per second, far above what was seen just a few years ago.
To stay ahead of the curve, Opra has repeatedly advised the industry to boost its capacity to receive these market data messages. At the beginning of 2007, the required capacity level set by Opra was 359,000 messages per second. At the beginning of 2008, Opra had increased that level to 701,000 messages per second, and it is targeting 907,000 by the middle of 2008.

If you are interested in risk management (market, credit, operational and legal as well), do sign up to this site, very useful indeed.

All this to be taken with a grain of piquant salt!!!

Has the supercharged banking model run out of road?

This was indeed thought provoking, but I would not go as far as to say that it is such a doom and gloom situation. But then I am biased since I am in the industry itself, but the factoids were interesting and I quote them:

McKinsey estimates that in 2006, profits per employee in banking were a staggering 26 times higher than the average of all other industries worldwide.

It emerged last week that one fund, Paulson & Co, made about $15bn (£7.7bn) last year betting against the mortgage market. Most of that will have come out of the banks.

An extreme example is Citigroup, where total shareholder return over the past five years has been slightly less than zero. Its wage bill, meanwhile, has risen 84 per cent.

 

Technorati Tags: Financial Institutions,RIsk management

Volume, liquidity, and liquidity risk

Interesting paper, made me go hmmm.

Timothy C. Johnson, Volume, liquidity, and liquidity risk, Journal of Financial Economics Volume 87, Issue 2, , February 2008, Pages 388-417.

Abstract:
Many classes of microstructure models, as well as intuition, suggest that it should be easier to trade when markets are more active. In the data, however, volume and liquidity seem unrelated over time. This paper offers an explanation for this fact based on a simple frictionless model in which liquidity reflects the average risk-bearing capacity of the economy and volume reflects the changing contribution of individuals to that average. Volume and liquidity are unrelated in the model, but volume is positively related to the variance of liquidity, or liquidity risk. Empirical evidence from the U.S. government bond and stock markets supports this new prediction.

Technorati Tags: market risk,risk management

More links on Risk Management in Islamic Finance

Risk Management:

1. Growth in Islamic Finance Spurs Need for New Risk Management Methodologies

Two globally recognizedorganizations have teamed up to take on this challenge -- the GlobalAssociation of Risk Professionals (GARP: www.garp.org) and the Banque du Liban(www.bdl.gov.lb). They will jointly develop a first-of-its-kind Certificatein Risk Management for Islamic Financial Institutions due to be launched inlate 2008.
The expertise on Islamic finance from the Banque du Liban combined withGARP's proficiency in creating globally accepted standards on risk managementmethodologies, such as their globally recognized FRM program, will result in abenchmark approach to assessing risk around Sharia'a-compliant financialproducts. "There will be much input from experts around the world to make surewe get this right," said Chris Donohue, PhD, Head of GARP's Research Center."We will have a Technical Committee that will work on developing the contentfor the Certificate and an Advisory Group comprised of Islamic banking andderivative product experts to give us feedback throughout the process." The Advisory Committee will be co-chaired by Dr. Ahmed Jachi, ViceGovernor of Banque du Liban and Dr. Anthony Saunders, Professor of Finance atNew York University's Leonard Stern School of Business.

2. Book on financial risk management and Islamic Finance:

Risk management for Islamic banking financial products and services is one of the greatest challenges that many westernized, as well as Islamic Banks, are facing today.As a result of this market growth in Islamic financial products there is a high demand to understand how to assess and manage the risks arising from applying these products and services. Credit, operational, market and liquidity risks together with the risk of non compliance with the Shariah law are becoming very hot issues for financial institutions. This book presents a common framework of how to efficiently manage the risks faced and minimise the overall degree of Islamic financial risks. This book is a valuable guide for those working in both non-Islamic and Islamic finance.

Contents Principles of Islamic FinanceRisk Management Issues in Islamic Financial ContractsBasel II & IFSB for Islamic Financial RiskMarket Risk in Islamic FinanceCredit Risk in Islamic FinanceOperational Risk in Islamic FinanceConcluding Remarks

All this to be taken with a grain of piquant salt!!!

European bank equity risk: 1995-2006

Quite an interesting paper here, which reviews the changes in bank equity risk after the EMU formed. As expected from classical economic theory, the authors find that the bank equity risk has decreased rapidly. Once you have the same currency, remove barries, flatten regulation and increase cross border trade and cooperation, the systemic risk will reduce.

The interesting exception is Germany and I quote from their conclusion:

While equity risk reduction is apparent in most countries in our sample, an important
exception is the German banking industry, where we observe an increase in bank equity risk an average. The German banking industry is dominated by Sparkassen-Finanzgruppe which
includes savings and Landesbanken. This peculiarity of the German banking system is said to
have limited bank consolidation, lowered market concentration, and facilitated continuing
fragmentation in the market and may well explain the risk increases that we observe in this
study.

Mamiza Haq and Richard Heaney, European bank equity risk: 1995-2006, Journal of International Financial Markets, Institutions and MoneyIn Press, Accepted Manuscript, , Available online 9 January 2008.

We examine changes in bank equity risk following the formation of the Economic
Monetary Union (EMU) in 1999. With the exception of Germany, we observe a decline
in bank risk across euro-zone countries. Total risk decreased for 70% of the euro-zone
banks in our sample with a statistically significant decrease in total risk observed for 51%
of the sample. Similar results are found for idiosyncratic risk and systematic risk. These
results are robust to financial crisis effects and test specification. Moreover, we find some
evidence of a decrease in bank equity risk for a sample of neighbouring non-euro-zone
European countries, consistent with the existence of some spill-over effects.

All this to be taken with a grain of piquant salt!!!

Terrorism / Influenza - impact on networks

An interesting column on how an influenza simulation in NY threw up issues with network congestion and management. Firms have to be up to date with their homeworking strategies but also, the attempts by the government to push for super-fast broadband has to be considered within this angle. If something like this happens in the UK, we will be sorely hit.

But I have some comments: network congestion might well happen, but looking at what happened in 9/11, the level of trading falls off dramatically as people look to close out their books and do not take any further customer orders. They might also just go back to relying on their capital and take any pending orders on the firm's books rather than risk taking it to market and find that its lost in the ether or worse, the price formation process has had some eddies and the prices is stuffed.

So the situation is not that much of an issue, but what might be required to think about is the capability of the firm's capital to handle what amount of trading? Also, if that is the case, then the sales trader will be pushing trades away and will need better voice rather than data connectivity, while on the other hand, the market facing trader might as well as take the trades on his own book.

Still read and consider!

Nothing but Net?
For years, the financial services industry has led the way when it comes to business continuity, participating in a number of industry-wide tests. The most recent US test, conducted by the Financial and Banking Information Infrastructure Committee (FBIIC) and the Financial Services Sector Coordinating Council (FSSCC), simulated a global H5N1 influenza pandemic. By Rob Daly


The sponsors are still poring over about 300,000 data points gathered during the three-week test, but the early results are interesting.

The good news is that Wall Street can withstand a pandemic. The industry's performance was unfazed by an absenteeism rate of 25 percent and only saw performance degradation when the absenteeism rate approached 49 percent-a higher rate than estimates by the World Health Organization (WHO) and the US Centers for Disease Control and Prevention.

Most participating firms, 54.5 percent, tackled their business and regulatory obligations by setting up their employees with telecommuting capabilities. The next most popular response, 40.8 percent, was dividing business groups into a number of units and dispersing them geographically.

An interesting aspect of the test was the amount of stress a pandemic would have on other critical infrastructure, such as the Internet. During one portion of the test, residential Internet throughput was reduced by half due to network congestion, which reduced the real-time performance of market data feeds by several minutes and caused intermittent outages of non-real-time applications, such as e-mail.

This level of network performance doesn't bode well for traders. Operating their bandwidth-hungry trading and market data applications over a residential Internet connection would be like sucking a beach ball through a garden hose. Traders would need to come into the office to take advantage of their firms' financial extranets to get low-latency market data.

However, two types of traders could make the work-from-home strategy work: those who operate in the over-the-counter world and rely solely on voice brokerage, where latency isn't as critical as in electronic execution; and algo-based traders, whose systems are co-located within the market centers.

Since their low-latency connection would be a local network hop or less away from the market, their traffic wouldn't compete with other network traffic from the outside world. It would also mean that algo traders would have to turn over more control to the local servers and keep trader-to-algorithm communication to a minimum.

Local fat-client applications would work the best in this environment compared to applications incorporating service-based architecture or relying on Citrix connections that depend on network availability. But how many firms have taken reduced bandwidth availability into consideration in their business continuity plans?

Of course, overcoming the network latency issue is just one hurdle to trading from home. Firms need approval from the proper regulatory bodies and must be willing to pay the additional licensing fees to application and market data providers to set up the necessary remote trading positions.

To keep trading desks up and running, working from home just doesn't seem to be a practical solution. Instead, firms should plan to keep their traders close and be prepared to feed and lodge them for extended periods.

All this to be taken with a grain of piquant salt!!!

The supine Board of Directors!

One thing which I find so strange, even after so many years in the financial markets, is how frankly supine the board of directors usually is. Not that its just there, another target of amazement are the pension trustees but that moan is for another day. We now have lost quite a lot of senior management across the global financial sector. Ok, so everybody makes mistakes and why should CEO's be immune from being human?

But what gets my goat is how bad performance is rewarded by gigantic lump sums of cash and pension benefits being doled out to these guys. What is the downside for these guys? that they are chucked out of their corner offices? God, with multi-million dollar payoffs, i can do with some more chucking out. And yes, pun intended. Some of these chaps have got hundreds of millions of dollars of payoff for driving their stock prices into the ground and raising risk levels several fold!.

And dont give me the guff that they managed to raise the stock price before, they were compensated for that in the previous years. And furthermore, I do not blame the CEO's, they are acting perfectly normally and economically by limiting their downsides and pushing for the maximum possible personal returns. The fault squarely lies on the Board of Directors.

Unfortunately, we keep on seeing that the Board of the big firms are usually supine. Why take action AFTER the event, you dopey's, your job is to make sure you keep an eye out on risk and the firm and take care before problems hide. Ok, so I further excuse that but what is your excuse for giving such a large payoff to the departing CEO? If the excuse was that you didnt want to leave open the option of legal action, then again that reflects badly on you as you did not design a cast iron contract!

Espokhs.

All this to be taken with a grain of piquant salt!!!

Do big banks need more capital?

See this article from Risk Centre. I quote:

With all due respect to the Nout Wellink and the other members of the BCBS, we do not believe that the implementation of the Basel II proposal or anything that looks remotely like it would have alleviated the ongoing collapse of the market for complex structured assets. When an entire asset class literally dies in a matter of weeks, the risk is infinite. To us, measuring the liquidity or market risk of a Structured Investment Vehicle ("SIV"), with or without the Basel II framework, makes about as much sense as using statistics to predict corporate credit defaults.

Remember too that most of Basel II is based upon the very quantitative models and rating agency methods which caused the subprime crisis, thus offers of assistance from Basel II's creators within the BCBS should be viewed with caution. Basel II merely mimics the business processes of the Sell Side investment houses, systems which are intended first to enable new financial transactions and, as a secondary matter, manage the risk.

Without going into too much detail, I agree with the above sentiments. You see, I have a slightly different perspective on this. Based upon my previous research on extreme events, I am firmly of the belief that the relationships between various factors in these extreme events becomes dramatically non-linear in nature.

So a structure such as Basel II which relies on linear modeling to provide an indication of risk capital is ok for stable, linearly correlated markets but fails miserably when it moves into the fat tails. If you just look at the investment banks, they are taking billions of dollars in losses. My question, if you still are quibbling about it, why did the risk management models not pick up this problem?

Now the fact that the risk management models did not pick up the sub-prime mess leads me to wonder whether it makes sense to provide estimates of capital adequacy based upon these very same risk management models? No Sir.

The answer is that the banks need MORE capital, not less capital. More capital has the downside of implied opportunity cost, less capital has the downside of shaking the entire financial system through systemic risk. If I was a central banker, I would take a hard close look at Basel II.

Technorati Tags: corporate Governance , financial institutions , financial markets , market risk , credit risk , operational risk

Managing VaR at a time of liquidity and volatility problems

Value at Risk – the dangers within

The Bank of England warned earlier this year about the propensity of banks to rely on Value at Risk (VaR) models to manage and guide them on risks. We have been here before, for example during the 1990’s Russian Crisis. Almost exactly the same thing happened, at least on the market side. The was a liquidity crunch as everybody rushed to the exit at the same time.

When everybody rushes to the exit at the same time, one side of the bargain (the buy bit) disappears, and therefore the price formation process is seriously out of whack. When that happens, even small movements in price can and do influence volatility and correlations disproportionately.

Now usually, you are ok to measure your VaR at daily intervals and you don’t update your correlation matrices more than weekly (if you are extremely particular, generally, you can go for 3 months without needing to change, market micro-structures do not change that fast). But as we know, markets have fat tails. Extreme events happen at a far greater frequency than what your normal distribution will suggest.

Consequently, what your VaR numbers will be telling you will not be an accurate reflection of the actual situation. In other words, these numbers tell you the risk that you are carrying. But if you decide to act on that risk number, you will find that the market does not support the consequent decision because there is simply nobody out there to offload your risk to. If nobody wants to purchase your debt or paper, then what are you going to do? You simply suck it up. Or you pray to the great gods of the central banks to provide you with some liquidity.

There is another problem and I quote from the FT article:

In the current environment, no bank chief executive who hopes to hang on to that job can afford to give regulators or shareholders the impression that they are being cavalier about risk. And since VAR is often used to define what level of margins – or financial buffers – are set against trades, some banks are doubly keen to cut VAR, to reduce pressure on their own balance sheets.

But as the banks embark on this task, some are finding themselves caught in an unpleasant trap. The easiest way to reduce a risk exposure is to sell risky assets, such as risky loans. In recent weeks, many banks have been trying to do precisely that.

But these sales have been occurring on such a large scale that they have pushed up market volatility. Thus, measured VAR has risen, exactly as the Bank warned all those months ago.

One big investment bank has recently analysed the impact of its own recent asset sales. These suggest that while these sales should have cut VAR by half in recent weeks on constant volatility levels, in practice this gain was more than wiped out by ensuring market price swings.

By scurrying to reduce risk, in other words, the banks may end up simply running to stand still.

The only way to resolve this is by having stringent stress testing or scenario analysis running. But very few banks that I know of have management trip wires or even have management who take action based upon these stress scenario’s. But all I can predict at this moment is that we will again have this issue. See my previous post on Carnegie as an example.

All this to be taken with a grain of piquant salt!!!

Ignore Risk Management at your peril, your entire bank might be at risk

Here we go again, now Carnegie, the Swedish investment bank, is being pummelled by the markets and country, for having completely mucked up its risk management, allowed traders to run amok and ended up with huge losses. 200 years of pristine reputation, clean and transparent firm, all firmly driven into the toilet.

How many times have we seen this? Risk management underinvestment and then traders take wrong posititions or mis vale or mark to model or something like that and then it blows up, usually bringing down the very management who did not pay money or attention to their risk management systems.

After thinking about it for 2 seconds, I came up with some questions arise which I would ask to the CEO

1. Who does the chief risk officer report to? If the CEO with NO dotted lines, then fine. If there are any dotted lines or matrix management, then there is a disaster waiting to happen. This is applicable to market, credit, ops, liquidity risk

2. Are each division's capital allocated based upon risk?

3. Do you match the divisional RoE with their P &L? On a monthly basis?

4. How do you base your bonus pool allocations? On revenue or adjusted risk levels?

5. Who develops your risk scenario's? How often do you do war gaming? Do your head of trading attend? What is your definition of comfort values?

6. Why are you not making your divisional risk and RoE transparent?

7. What is your investment in IT? What is the ratio of risk investments to trading investments? If less than 20 percent, why?

8. When was the last time you had an independent risk and trading systems audit? And seen the results? And acted upon them? And reviewed them? And fired somebody for not following them?

9. Where does product control fit it? Do they report to trading or risk heads?

10. Who is looking after your model risk? Do you know the stress scenario results? Under what circumstances do they fail? Negative interest rates? Liquidity risk? Spreads very wide? Exchange stops trading? A dr death scenario?

But I am afraid this will happen again and again and again, people just do not listen and short term profits will again overwhelm the risk manager's warnings. And then the bank will again drop into the muck!

All this to be taken with a grain of piquant salt!!!

The Old Lady of Threadneedle Street is losing her marbles

The Old Lady of Threadneedle Street, the venerable Central Bank of England, the Bank of England, announced today that it is going to bail out Northern Rock, a big building society in England (a morgage lender), who apparently got into trouble as it could not fund its liabilities.

So all this high faluting lecturing about the fact that the current situation was all just a mispricing of risk, central banks shouldnt bail out bad lenders and this creates moral hazard was just bunk then? Here's what the Independent says and I quote

His letter to the chairman of the Commons Treasury Committee was as lucid an explanation and analysis of the crisis that has engulfed the banking system over the past two months as you are likely to see, but that doesn't necessarily mean his conclusion – which loosely translated into plain English reads, "Sod off, you are not getting a penny" – is the right one.

What happened 2 days afterwards? the Old Lady is busy shovelling out money just to save this mortgage lender who had some very risk investments. And dont give me that guff about markets not lending each other. What rot, they are lending each other but only to people who have managed their risk. Not to risky people.

And if others are refusing to lend to Northern Rock, why is the Old Lady taking MY tax money and giving it to these bad risk managers?

Central Bank's reputations rely on a firm hand on the tiller. The Old Lady, after a series of major incompetent issues, such as the BCCI case, has managed to recover and has established a reputation of good sound macro-economic management. Now look at it, I think the chaps inside there are a bunch of blithering idiots.

Actually, I have a very good idea that this was political pressure, and if that was indeed the case, then they are even more contemptible.

All this to be taken with a grain of piquant salt!!!

Company Boards lack understanding of IT risks

This report, I am afraid, is one of the d'oh variety. The issue of understanding complex information technology is not new and has lasted for a very long period of time. What is complicating the matter is that the understanding of technology and the business impact/usage is becoming more more younger (i.e. technological knowledge becomes obsolete faster and faster), more distributed and diffuse (more offshoring and outsourcing means that the knowledge of applications and technology is being spread far and wide) and more concentrated (the locations where applications and technology developments are being carried out is concentrated heavily in only few locations).

All this leads to a situation where the senior management and boards do not understand what technology is doing to their business, what risks they face, what can they do and what questions to ask. This is the reason why boards are very rarely able to manage reputational risk arising from technology led operational risk. Such as loss of customer data, downtime of customer service technology (such as POS terminals, ATM machines, etc.). very difficult to manage.

I would think a solution would be to have the CIO brief the board regularly along with the CEO if the firm has a large technology component.

I quote from the report

It found that in three-quarters organisations, IT-related risk, in particular the potential for complex projects to fail, has risen higher up the board agenda. Indeed almost nine out of 10 senior management respondents said that it is a major challenge to respond to the pace of change in IT.

The survey also highlights a lack of mutual understanding between the board and IT professionals over how to assess risk. Over a third of senior management respondents and almost half of internal audit heads feel that IT professionals lack the ability to communicate IT risk and its potential business impact in a way that the board understands.

"Assessing risk is a team game," he said. "Boards, in particular most non-executive directors, simply don't have inherent practical experience of IT risk, as one of our internal audit heads reminds us, and this means they are unlikely to understand the full extent of the risks and opportunities that technology presents to their companies."

All this to be taken with a grain of piquant salt!!!

Do Banks Overstate their Value-at-Risk?

The answer seems to be yes, at least when we are talking about Canadian Banks according to this manuscript. And the reason that the researchers give is that the banks are extra cautious in reporting their VaR's. That is totally understandable as nobody wants to play around with extreme events.

But more importantly, what they are reporting is that the banks are not fully measuring their diversification benefits from various products, regions, functions and risk categories. This is not surprising. Aggregating and collecting data across large banks is a gigantic task and for this to happen on a daily basis is incredibly difficult if not time consuming.

Despite increases in IT technology, hard disk and performance, grid computing, usage of bootstrapping, time series and other statistical techniques, we are still not at the age that every transaction can be captured, matrixed (algebra that is), correlations determined, risk factors updated and then overall VaR calculated is way away still. This is why the authors might have gotten better results if they had measured the monthly var rather than a daily var, but there you go!

Christophe Perignon, Zi Yin Deng and Zhi Jun Wang,
Do Banks Overstate their Value-at-Risk?,
Journal of Banking & Finance,
In Press, Accepted Manuscript, Available online 4 September 2007
Abstract:
This paper is the first empirical study of banks’ risk management systems based on nonanonymous daily
Value-at-Risk (VaR) and profit-and-loss data. Using actual data from the six largest Canadian commercial
banks, we uncover evidence that banks exhibit a systematic excess of conservatism in their VaR estimates.
The data used in this paper have been extracted from the banks’ annual reports using an innovative
Matlab-based data extraction method. Out of the 7,354 trading days analyzed in this study, there are only
two exceptions, i.e., days when the actual loss exceeds the disclosed VaR, whereas the expected number
of exceptions with a 99% VaR is 74. For each sample bank, we extract from historical VaRs a risk-overstatement
coefficient, ranging between 19% and 79%. We attribute VaR overstatement to several factors, including extreme
 cautiousness and underestimation of diversification effects when aggregating VaRs across business lines
and/or risk categories. We also discuss the economic and social cost of reporting inflated VaRs.

All this to be taken with a grain of piquant salt!!!