September 18, 2008
Uncertainties about Credit Portfolio Models
There is a huge loss of confidence in the financial marketplace. Who would otherwise think that despite the massive US $ 85 billion bailout of AIG by the FED, the markets will continue to slide. The intervention is real, not talking the market up. The faith in the market is completely destroyed, at least for the time being, and the faith is the central bank has dented. The impact of US $ 180 billion is yet to be seen and one hopes that the Central Banks together can overpower this crisis of monster proportion. ( Hooray, the Dow is in the green as I write, so it may be that we still believe our central banks)
One silent casualty has been the Credit portfolio Model that churned out default probabilities and expected loss numbers. Quite clearly, the present group of credit portfolio models will be reassessed and one is hopeful that the soul searching will lead to better modeling in future in arriving at the economic capital.
Once we come out of the current state of the market, and start thinking about the nightmare with some poise ( hopefully, sooner than later)Models that depend upon PD, LGD, EAD and Default correlations will undergo a post mortem. Let's think of a few issues that may come up with credit portfolio modeling.
First, the class of models need to pay more attention to the derivatives snd off balance sheet items that goes in the bucket of the unknown and the risk information destroyed in the process.
Second, the correlations in the credit portfolio models suffer from the generic problems of subjectivity in time horizon, in many cases such correlations are based not on a global dataset, but only on US data, which is far from ideal.
The normality assumption acts as another constraint, that needs to be thoroughly examined, with the need for backtesting capabilities for model validation process.
these constraints are no reason to throw the model away, but to strengthen it for future.
As Rene descates once observed, our reason need not be clouded by blind faith in black box models. The search for better method is as relevant today as it was in the early seventeenth century, when Descartes observed, in his own flowing language:
" observing many things which, however extravagant and ridiculous to our apprehension, are yet by common consent received and approved by other great nations,I learned to entertain too decided a belief in regard to nothing of the truth of which I had been persuaded merely by example and custom; and thus I gradually extricated myself from many errors powerful enough to darken our natural intelligence, and incapacitate us in great measure from listening to reason."
Rene Descartes, Discourse on Method, 1628.
Posted by sunandoroy at 05:26 PM
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September 16, 2008
Risk Management and Economic Development
Development Economics , when it started evolving with a lot of new nations getting out of their colonial mould post World War II, was all about growth. growth was the be all and end all indicatorof development of a nation. It was defined by GDP , both overall and in per capita terms. This view of development remained deep rooted over several decades, before economists such as Amartya Sen and others started expanding the concept of development, to be adopted by the United Nation in due course. Thus were born the alternative indicators of development, including inequality, quality of life and human development. this happened in the late 1980s and early 1990s.
Further challange to the notions of development was provided by Sen in his 1998 classic Development and Freedom and later in his Identity and violence: The Illusions of Destiny. Sen brought forth the new insight that freedom is a critical aspect of progress without which material wealth failed to find any clear meaning.
The journey of development economics thus progressed over time. If you look at it, however, development ignored one critical aspect, that in exercising choices in the process of development , the State ( and market players) were exposed to a variety of risks. Effective handling of risks contributed to robust growth while its neglect thwarted the growth process. Research in development has remained deficient in this area, focussing rather on the outcome of the process. A risk based analysis of development has not taken place in development studies.
However, we would all agree that in many countries, good efforts at alleviating poverty has been constrained by the uncertainities brought out by the corruptdelivery process, volatile rainfall contributed to huge risks in agricultural production and the inability to develop a risk-return framework contributed to ineffective policymaking by the State.
The performance of the State is important for the economy. Understanding the risks embedded in its actions can hugely influence the outcome of State policy decisions. Operational risks time and again renders state policies defunct. Often, State decisions are not based on sound judgements but on the whims of politicians. Given the strong role in development process, Governments in emerging markets must define their risk appetite and strategy formulation must be aligned to the appropriate risks.
An example of State failure due to inadequate risk assessment was on display yesterday. Why on earth, did Fed stay away from bailing out the Lehman Brothers? Is it because its taxpayers money, and ethically the money should not be used to bail out irresponsible financial engineering? Not at all. Did the Fed underestimate its implications at the global level? Can't buy this argument, Fed guys are smart enough! Then what? The answer was given by Joseph Stiglitz yesterday on CNN. He said that in 2001 crisis, the Government had a lot of money. There was a fiscal surplus and the Fed could bail out many in distress. The case is no longer the same in 2008. Fiscal deficits are high and the US treasury is in deep debt. The three trillion dollar war not only took away investible resources from industry and services reducing employement opportunities and thereby repayment capacity ( a factor in the accentuation of the credit crisis), it is now constraining the FED in going all out in fighting the deadly crisis. Money power is crucial for firefighting. Regulatory rehauling can wait. The Wall Street needs cash, not regulation, at least for now.
This brings me back to the question : Did the US Government properly understood the risks of a protracted policy shift towards higher fiscal deficit? Did it raise an alarm at a threshold? Why a limit structure based on fiscal responsibility was absent?
The crux of the matter is that the development processes is not adequately risk sensitive. Risk awareness is low among the policy makers and those who implement policies. A proper risk management framework at an enterprise wide level can indeed raise the policy effectiveness. This has not been done in the past. This is not done now. But to break this inaction, development economics must make inroads into risk based approaches to development, which is conspicuously absent from existing literature. Fredom, HDI, Quality of Life are all outcomes. There must be a realization that better outcomes are possible through improved risk management at the process level. Surely, risk management as a theoritical stream has come a long way to contribute to development process of emerging economies.
Posted by sunandoroy at 02:53 AM
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The Forgotten Tail of Risk Management: lessons from the financial turmoil of 2007-?
it is evident that Risk Management will no longer be the same once the financial markets risk above the debris of the credit crisis of 2007- ?. It also appears that risk regulation will also undergo a major change if not a complete overhaul. the press conference statement by Paulson a few hours ago reflecting weaknesses in regulation reaffirmed the understanding that lot of soul searching is going on in the regulatory community.In this turbulent time, we are faced with many questions. Why were so many brilliant guys sleeping when the problem was piling up day by day? Why did tons of statistics churned out by agencies, literally on a tick-by-tick basis, failed to capture the early warning signals? Or is it that the sane voices got submerged in what Greenspan termed " creative destruction brought about by financial innovation"?
In this milieu, time has come to question or at least reexamine one accepted focus of risk management, the concept of downside risk. The reliance on the left tail showed things to be in great shape, when looked at through the prism of risk models. In reality, they were not. And when risk models deviate from reality, it is time to rethink the core assumptions. Time to dwell upon whether the left tail contains adequate information to control the risks and whether the downside risk numbers tells the story early enough to react in time.
Is it time for financial market participants to view risks from an alternate perspective?
An alternative, to my mind, and a useful one, would be to use information from both the tails of a distribution of a financial variable. A very standard approach to risk management that has cemented its place in risk management is to look at downside risk. Losses matter, profits don't, seems to be the key messege of risk management. The tail on the left hand side of the distribution is far more relevant to the right tail, that is the enveloping idea. Time is ripe to challange this notion.
Although not ex-post, Risk managers raise an alarm one the threshold toward the left tail is breached. Sometimes such an alarm is too weak and too late in the day to save the firm from the brink of disaster. If you notice, the subprime crisis of 2007 was preceded by a heavenly cocktail of low interest rates and low default rates, an ideal situation for unbridled credit expansion. The key point is, the downside risk was low, but some of the numbers clearly breached the upper tail, and went unnoticed. Had an alarm was raised just because of the fact that things look too good to be true, perhaps financial markets could have done some adjustments and restructuring ahead of the adverse shock brought about by erosion of portfolio value. Unfortunately, risk models were ill prepared to pick up the signals of destruction contained in opulence.
One way risk models could have done better was to use both the upper tail and the lower tail to evaluate risks. A foray into the upper tail would have given important information to risk managers about behaviour of the financial indicators of market, credit and other forms of risk. Had the model capacity was well developed, then early signals could have been traced in the upper tail. While we all know about bubbles ( and subsequent tumbles), risk modeling was deficient in factoring the upside risk in.
In retrospect, the information loss arising from ignoring the upper tail is something risk models must look at. The key messege of financial crisis of 2007 is that risk modeling is in need for a level shift. We can feel the need , but can't exactly articulate. My view is the risk models will be more useful once they accept the assumption that the upper tail is no less important that the lower tail. And when they become aware of the fact that the legacy of the good old Mean is as relevant as the heroics of the Standard Deviation!
Posted by sunandoroy at 01:09 AM
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September 05, 2008
Rocky Road to Economic Capital Modeling
Economic capital modeling in financial organisations is aimed at determining the capital requirement for its risk taking activities. With the Banks adopting Basel II standards in emnerging markets, many of them are struggling with quantification of capital to be required under the Internal Capital Adequacy Assessment Process ( ICAAP). With the adoption of ICAAP, economic capital model has gained in complexity. The popular building block approach that adds capital allocated for all significant risks has been supplemented by estimations of business line capital requirement and even disaggregations leasding to calculation of exposure wise capital requirement. In other words, in banks with better economic capital models one can actually look at capital requirements at a granular level.
As these models become more and more refined, many issues come to the forefront posing challanges and at the same time opportunities to ICAAP to a higher qualitative standards. Key issues that are being faced in organisations and less debated in the public space are:
a) deciphering the relationship between overall economic capital and its building blocks, b) consistency, accuracy and stability of the models that are employed to measure the underlying building
blocks ; c) the aggregation framework and sub-additivity d) impact of adverse shocks to the estimates ( a coherent stress testing framework at an enterprise wide as well as granular level and e) the process of validation of economic capital, first by the bank internally and then by the supervisors as part of the Supervisory review process . These apart, another significant challange that the banks face is to consistently project such capital requirement over an elongated timespan, without compromising with the robustness of the underlying models.
As the industry evolves new standards over time, the economic capital modeling at this juncture faces key challanges if such modeling has to satisfy the robustness tests econometric models are routinely subjected to.
Establishing the relationship between the composite capital requirement and its components poses a key challange. Are they being estimated correctly? Can they be just added to arrive at a number and if so what about the joint stresses evidenced recently affecting both credit and market risks. Integration of all components into a meaningful and coherent framework is as much a challange as to convince the senior management its utility in day to day business decision making process. The stress testing of such an enterprise risk capital ( economic capital) poses a huge hurdle considering that regulatory guidence on stress testing is limited and most of the stress tests recommended are stand alone tests for risk silos. Composite stress testing of economic capital needs much research, and we are sure to witness lot of activity in this space in academics, bank research units and at the central bank level. Also, the ability to forecast such capital requirement over an extended time horizon will certainly add value to the finding, enabling banks to plan ahead.
On the whole, this is expected to be an explosive and exciting area of exploration in the coming months. As modeling and forecasting techniques improve, economic capital modeling and forecasting will be taken to the next level. The thought process has started with the BIS publishing a consultative paper on economic capital modeling a week back on their website. Risk associations like PRMIA can and should join this consultative process and be part of the though leadership. There is no dearth of excitement in the domain of risk management, but if you ask me, this is going to be one of the most exciting ventures!
Posted by sunandoroy at 06:30 AM
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