DOCSLIB.ORG

Model Risk Management

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
Model Risk Management Model Risk Management Nav Vaidhyanathan Director, Head of Model Risk Management Wintrust Financial Corporation Global Association of Risk Professionals August 2014 These materials reflect the views and opinions of the speaker and are not intended to reflect the views, policies or practices of Wintrust Financial or its affiliated companies. They are for informational purposes only. The views expressed in the following material are the author’s and do not necessarily represent the views of the Global Association of Risk Professionals (GARP), its Membership or its Management. 2 Agenda Model Risk Management is a broad, evolving, and an expanding topic. This presentation will cover only select components at a high level. Inherent risk (model tier) and residual risk of model . A framework for model monitoring . Model risk aggregation framework . Model validation for stress test (e.g., DFAST) models .Global Association of Risk Professionals. All rights reserved 2014 © | 3 Model Risk Axioms* The following can potentially be considered as self-evident truths for Model Risk. Given everything else equal, . All models have limitations . Model Risk is related to model limitations . Model Risk increases with more models (this might fall in the grey area) − E.g., two Tier 1 models potentially pose higher risk than 1 Tier 1 model (everything else being the same, i.e., similar limitations, similar validation status, similar materiality, similar findings, etc.) . Model Risk for Tier 1 model > Model Risk for Tier 2 model . Model Risk for validated model ≤ Model Risk for unvalidated model (for the same model) . More findings ⇒ more Model Risk (same category and level of findings) . Certain types of findings will have higher Model Risk than others . Models with deteriorating performance pose higher Model Risk . Model Risk is exhibited by the variance between model output and observed actual (this is just one of the ways that Model Risk exhibits itself) * may not be axioms in the purest sense of the term .Global Association of Risk Professionals. All rights reserved 2014 © | 4 Inherent Risk and Residual Risk of Model Residual Risk Rating could be High driven by: Rating • Model validation findings: Moderate • Category Residual Low • Level Risk • # of Open Findings Low (Tier 3) Moderate High (Tier 1) • Model performance / Inherent Risk Rating (Model Tier) monitoring Inherent Risk Rating could be driven by: Model owners can reduce residual • Materiality risk – by improving models, • Type of model improving controls, and/or • Used for regulatory / financial reporting or critical business remediating findings decisions • Feeds into another Tier 1 model? Model owners cannot (usually) reduce inherent risk .Global Association of Risk Professionals. All rights reserved 2014 © | 5 Residual Risk Rating Framework . Residual Risk Rating (High, Moderate, Low) is based on the Residual Risk Score range . E.g., RRS > 200 ⇒ High, RRS ≤ 100 ⇒ Low . If the model is deemed unfit for use, the RRR is High . The Residual Risk Score Range to Residual Risk Ratings mapping needs to be monitored periodically . The ranges can be determined by typical observations from model validation and model monitoring exercises . If a model is unvalidated, the residual risk rating is HIGH .Global Association of Risk Professionals. All rights reserved 2014 © | 6 Model Monitoring . Model monitoring should evaluate whether changes (including anticipated) in products, exposures, activities, clients, or market conditions necessitate adjustment, redevelopment, or replacement of the model . Ongoing activities include – review of input data and assumptions, outcome analysis, model stability checks, review of overlays and expert judgments, benchmarking, etc. Key considerations − Model performance monitoring › Pros and cons of model performance measures › Model type › Model use › Type of measure − Periodicity of monitoring − Thresholds for model recalibration or rebuild − From performance measure to model performance rating .Global Association of Risk Professionals. All rights reserved 2014 © | 7 A Bottom Up Framework For Model Risk Aggregation Impact of Failure (e.g., on Capital) Tier 1 Tier 2 Tier 3 Validated … … Yes No High Residual Moderate Low Residual As part of an RCSA Risk Residual Risk Risk process, the impact of the model failure is estimated by model owners The end nodes in the For DFAST projection models, for Severely Adverse Scenario, the impact on capital can be assessed decision tree can be using backtesting during Great Recession period for all models (adjust the variance by severity of the used for aggregating scenario compared to the Great Recession) model risk By looking at the distribution, a conservative starting point for capital can be chosen for each model Tier .Global Association of Risk Professionals. All rights reserved 2014 © | 8 Some Considerations in Validation of Stress Test Models . Are estimates conditioned on macroeconomic scenarios? . Do the models produce outcomes that show separation and order between the baseline, adverse, and severely adverse scenarios? . Are the scenario and assumptions consistent across all models? . Are exposures modeled using appropriate levels of segmentation? . Qualitative elements of the model . Relevance of third party vendor models to company specific characteristics, especially when using proxy portfolio . Sensitivity analysis around assumptions . Use of weak models vs. expert judgment . For models not validated, compensating controls and conservativeness . Documentation . Capital buffer for model risk .Global Association of Risk Professionals. All rights reserved 2014 © | 9 Creating a culture of risk awareness ® Global Association of Risk Professionals 111 Town Square Place 14th Floor Jersey City, New Jersey 07310 U.S.A. + 1 201.719.7210 2nd Floor Bengal Wing 9A Devonshire Square London, EC2M 4YN U.K. + 44 (0) 20 7397 9630 www.garp.org About GARP | The Global Association of Risk Professionals (GARP) is a not-for-profit global membership organization dedicated to preparing professionals and organizations to make better informed risk decisions. Membership represents over 150,000 risk management practitioners and researchers from banks, investment management firms, government agencies, academic institutions, and corporations from more than 195 countries and territories. GARP administers the Financial Risk Manager (FRM®) and the Energy Risk Professional (ERP®) Exams; certifications recognized by risk professionals worldwide. GARP also helps advance the role of risk management via comprehensive professional education and training for professionals of all levels. www.garp.org. .Global Association of Risk Professionals. All rights reserved 2014 © | 10 Model Risk Management for Non Banks Michelle McCarthy Managing Director, Risk Management Nuveen Investments Global Association of Risk Professionals August 2014 Disclaimers These materials reflect the views and opinions of the speaker and are not intended to reflect the views, policies or practices of Nuveen Investments or its affiliated companies. They are not intended to provide investment advice and are for informational purposes only. The views expressed in the following material are the author’s and do not necessarily represent the views of the Global Association of Risk Professionals (GARP), its Membership or its Management. 2 Contents . Differences between models and their uses at banks vs. the buy side . What should be in scope for model risk management activity in the asset management business? . Potential tiering of asset management models, and effect on model risk management activities .Global Association of Risk Professionals. All rights reserved 2014 © | 3 Most literature on model risk management has concerned banks . OCC 2000-16 . OCC 2011-12, FRB SR 11-7 . The case of AXA Rosenberg brought the conversation to the buy side, without much guidance on how bank practices can and should differ from asset managers’ practices .Global Association of Risk Professionals. All rights reserved 2014 © | 4 Different uses of models in asset managers vs. banks . Asset managers are not computing regulatory capital Bank-owned asset managers may need to provide operational risk capital calculations, but this is not in service of the asset management business . We rarely use valuation models as the sole source of valuation; we frequently use external sources . Many asset management models are an input to a decision, but not the sole driver of that decision .Global Association of Risk Professionals. All rights reserved 2014 © | 5 Potential scope of model management activity for asset managers . Includes models that are used for investing or hedging Drive investing activity to some extent Value key assets . Does not include calculators; model must provide estimates and involve uncertainty to require model risk management Good change controls always an important operational control, but calibrations and validations should be reserved for models that estimate uncertainty Would not include compliance systems Would not include price-to-yield calculations Would not include simple screens for fundamental stock characteristics Would not include pure index replication models without meaningful uncertainty . Does not include analyses that help develop an investment thesis—only the tools used to execute the thesis, or to value assets once purchased .Global Association of Risk Professionals. All rights reserved 2014 © | 6 6 Tiering for materiality . A potential tiering of asset management models:
Load more

Recommended publications
  • Request for Information and Comment: Financial Institutions' Use of Artificial Intelligence, Including Machine Learning
    Request for Information and Comment: Financial Institutions' Use of Artificial Intelligence, including Machine Learning May 21, 2021 Dr. Peter Quell Dr. Joseph L. Breeden Summary An increasing number of business decisions within the financial industry are made in whole or in part by machine learning applications. Since the application of these approaches in business decisions implies various forms of model risks, the Board of Governors of the Federal Reserve System, the Bureau of Consumer Financial Protection, the Federal Deposit Insurance Corporation, the National the Credit Union Administration, and Office of the Comptroller of the Currency issued an request for information and comment on the use of AI in the financial industry. The Model Risk Managers’ International Association MRMIA welcomes the opportunity to comment on the topics stated in the agencies’ document. Our contact is [email protected] . Request for information and comment on AI 2 TABLE OF CONTENTS Summary ..................................................................................................................... 2 1. Introduction to MRMIA ............................................................................................ 4 2. Explainability ........................................................................................................... 4 3. Risks from Broader or More Intensive Data Processing and Usage ................... 7 4. Overfitting ...............................................................................................................
    [Show full text]
  • What Matters Is Meta-Risks
    spotlight RISK MANAGEMENT WHAT MATTERS IS META-RISKS JACK GRAY OF GMO RECKONS WE CAN ALL LEARN FROM OTHER PEOPLE’S MISTAKES WHEN IT COMES TO EMPLOYING EFFECTIVE MANAGEMENT TECHNIQUES FOR THOSE RISKS BEYOND THE SCORE OF EXPLICIT FINANCIAL RISKS. eta-risks are the qualitative implicit risks that pass The perceived complexity of quant tools exposes some to the beyond the scope of explicit financial risks. Most are meta-risk of failing to capitalise on their potential. The US Congress born from complex interactions between the behaviour rejected statistical sampling in the 2000 census as it is “less patterns of individuals and organisational structures. accurate”, even though it lowers the risk of miscounting. In the same MThe archetypal meta-risk is moral hazard where the very act of spirit are those who override the discipline of quant. As Nick hedging encourages reckless behaviour. The IMF has been accused of Leeson’s performance reached stellar heights, his supervisors creating moral hazard by providing countries with a safety net that expanded his trading limits. None had the wisdom to narrow them. tempts authorities to accept inappropriate risks. Similarly, Consider an investment committee that makes a global bet on Greenspan’s quick response to the sharp market downturn in 1998 commodities. The manager responsible for North America, who had probably contributed to the US equity bubble. previously been rolled, makes a stand: “Not in my portfolio.” The We are all exposed to the quintessentially human meta-risk of committee reduces the North American bet, but retains its overall hubris. We all risk acting like “masters of the universe”, believing we size by squeezing more into ‘ego-free’ regions.
    [Show full text]
  • Model Risk Management: Quantitative and Qualitative Aspects
    Model Risk Management Quantitative and qualitative aspects Financial Institutions www.managementsolutions.com Design and Layout Marketing and Communication Department Management Solutions - Spain Photographs Photographic archive of Management Solutions Fotolia © Management Solutions 2014 All rights reserved. Cannot be reproduced, distributed, publicly disclosed, converted, totally or partially, freely or with a charge, in any way or procedure, without the express written authorisation of Management Solutions. The information contained in this publication is merely to be used as a guideline. Management Solutions shall not be held responsible for the use which could be made of this information by third parties. Nobody is entitled to use this material except by express authorisation of Management Solutions. Content Introduction 4 Executive summary 8 Model risk definition and regulations 12 Elements of an objective MRM framework 18 Model risk quantification 26 Bibliography 36 Glossary 37 4 Model Risk Management - Quantitative and qualitative aspects MANAGEMENT SOLUTIONS I n t r o d u c t i o n In recent years there has been a trend in financial institutions Also, customer onboarding, engagement and marketing towards greater use of models in decision making, driven in campaign models have become more prevalent. These models part by regulation but manifest in all areas of management. are used to automatically establish customer loyalty and engagement actions both in the first stage of the relationship In this regard, a high proportion of bank decisions are with the institution and at any time in the customer life cycle. automated through decision models (whether statistical Actions include the cross-selling of products and services that algorithms or sets of rules) 1.
    [Show full text]
  • Best's Enterprise Risk Model: a Value-At-Risk Approach
    Best's Enterprise Risk Model: A Value-at-Risk Approach By Seabury Insurance Capital April, 2001 Tim Freestone, Seabury Insurance Capital, 540 Madison Ave, 17th Floor, New York, NY 10022 (212) 284-1141 William Lui, Seabury Insurance Capital, 540 Madison Ave, 17th Floor, New York, NY 10022 (212) 284-1142 1 SEABURY CAPITAL Table of Contents 1. A.M. Best’s Enterprise Risk Model 2. A.M. Best’s Enterprise Risk Model Example 3. Applications of Best’s Enterprise Risk Model 4. Shareholder Value Perspectives 5. Appendix 2 SEABURY CAPITAL Best's Enterprise Risk Model Based on Value-at-Risk methodology, A.M. Best and Seabury jointly created A.M. Best’s Enterprise Risk Model (ERM) which should assess insurance companies’ risks more accurately. Our objectives for ERM are: • Consistent with state of art risk management concepts - Value at Risk (VaR). • Simple and transparent methodology. • Risk parameters are based on current market data. • Risk parameters can be easily updated annually. • Minimum burden imposed on insurance companies to produce inputs. • Explicitly models country risk. • Explicitly calculates the covariance between all of a company’s assets and liabilities globally. • Aggregates all of an insurance company’s risks into a composite risk measure for the whole insurance company. 3 SEABURY CAPITAL Best's Enterprise Risk Model will improve the rating process, but it will also generate some additional costs Advantages: ■ Based on historical market data ■ Most data are publicly available ■ Data is easily updated ■ The model can be easily expanded to include more risk factors Disadvantages: ■ Extra information request for the companies ■ Rating analysts need to verify that the companies understand the information specifications ■ Yearly update of the Variance-Covariance matrix 4 SEABURY CAPITAL Definition of Risk ■ Risk is measured in standard deviations.
    [Show full text]
  • 2018-09 Interest Rate Risk Management
    FEDERAL HOUSING FINANCE AGENCY ADVISORY BULLETIN AB 2018-09: INTEREST RATE RISK MANAGEMENT Purpose This advisory bulletin (AB) provides Federal Housing Finance Agency (FHFA) guidance for interest rate risk management at the Federal Home Loan Banks (Banks), Fannie Mae, and Freddie Mac (the Enterprises), collectively known as the regulated entities. This guidance supersedes the Federal Housing Finance Board’s advisory bulletin, Interest Rate Risk Management (AB 2004-05). Interest rate risk management is a key component in the management of market risk. These guidelines describe principles the regulated entities should follow to identify, measure, monitor, and control interest rate risk. The AB is organized as follows: I. Governance A. Responsibilities of the Board B. Responsibilities of Senior Management C. Risk Management Roles and Responsibilities D. Policies and Procedures II. Interest Rate Risk Strategy, Limits, Mitigation, and Internal Controls A. Limits B. Interest Rate Risk Mitigation C. Internal Controls III. Risk Measurement System, Monitoring, and Reporting A. Interest Rate Risk Measurement System B. Scenario Analysis and Stress Testing C. Monitoring and Reporting Background Interest rate risk is the risk that changes in interest rates may adversely affect financial condition and performance. More specifically, interest rate risk is the sensitivity of cash flows, reported AB 2018-09 (September 28, 2018) Page 1 Public earnings, and economic value to changes in interest rates. As interest rates change, expected cash flows to and from a regulated entity change. The regulated entities may be exposed to changes in: the level of interest rates; the slope and curvature of the yield curve; the volatilities of interest rates; and the spread relationships between assets, liabilities, and derivatives.
    [Show full text]
  • Model Risk Management: QuanFying, Monitoring and MiGaNg Model Risk
    Model Risk Management: Quan3fying, Monitoring and Mi3ga3ng Model Risk ! Dr. Massimo Morini, Head of Interest Rate and Credit Models at IMI Bank of Intesa Sanpaolo; Professor of Fixed Income at Bocconi University in Milan; Numerix Date! QuanEtave Advisory Board ! Dr. David Eliezer, Vice President, Head of Model Validaon, Numerix ! Jim Jockle, Chief MarkeEng Officer, Numerix Feb 11, 2015 About Our Presenters Contact Our Presenters:! Massimo Morini Head of Interest Rate and Credit Models at IMI Bank of Intesa Sanpaolo; Professor of Fixed Income at Bocconi University in Milan; Numerix Quantitative Advisory Board; Author Understanding and Managing Model Risk: A Practical Guide for Quants, Traders and Validators Dr. David Eliezer Jim Jockle Chief Marketing Officer, Vice President, Head of Model Numerix Validation, Numerix [email protected] [email protected] Follow Us:! ! Twitter: ! @nxanalytics ! @jjockle" " ! ! LinkedIn: http://linkd.in/Numerix http://linkd.in/jimjockle" http://bit.ly/MMoriniLinkedIn ! How to Par3cipate • Ask Ques3ons • Submit A Ques3on At ANY TIME During the Presentaon Click the Q&A BuJon on the WebEx Toolbar located at the top of your screen to reveal the Q&A Window where you can type your quesEon and submit it to our panelists. Q: Your Question Here Note: Other attendees will not be A: Typed Answers Will Follow or We able to see your questions and you Will Cover Your Question During the Q&A At the End will not be identified during the Q&A. TYPE HERE>>>>>>> • Join The Conversaon • Add your comments and thoughts on TwiWer #ModelRisk with these hash tags and follow us #Webinar @nxanalytics • Contact Us If You’re Having Difficules • Trouble Hearing? Bad Connection? Message us using the Chat Panel also located in the Green WebEx Tool Bar at the top of your screen # We will provide the slides following the webinar to all aendees.
    [Show full text]
  • Volatility Model Risk Measurement and Strategies Against Worst Case
    Volatility Mo del Risk measurement and strategies against worst case volatilities y Risklab Pro ject in Mo del Risk 1 Mo del Risk: our approach Equilibrium or (absence of ) arbitrage mo dels, but also p ortfolio management applications and risk management pro cedures develop ed in nancial institu- tions, are based on a range of hyp otheses aimed at describing the market setting, the agents risk app etites and the investment opp ortunityset. When it comes to develop or implement a mo del, one always has to make a trade-o between realism and tractability. Thus, practical applications are based on mathematical mo dels and generally involve simplifying assumptions which may cause the mo dels to diverge from reality. Financial mo delling thus in- evitably carries its own risks that are distinct from traditional risk factors such as interest rate, exchange rate, credit or liquidity risks. For instance, supp ose that a French trader is interested in hedging a Swiss franc denominated interest rate book of derivatives. Should he/she rely on an arbitrage or an equilibrium asset pricing mo del to hedge this b o ok? Let us assume that he/she cho oses to rely on an arbitrage-free mo del, he/she then needs to sp ecify the number of factors that drive the Swiss term structure of interest rates, then cho ose the mo delling sto chastic pro cess, and nally estimate the parameters required to use the mo del. The Risklab pro ject gathers: Mireille Bossy, Ra jna Gibson, François-Serge Lhabitant, Nathalie Pistre, Denis Talay and Ziyu Zheng.
    [Show full text]
  • The Evolution of Model and Algorithmic Risk a Robust Model Risk Management Framework for Financial Institutions the Evolution of Model and Algorithmic Risk
    The evolution of model and algorithmic risk A robust model risk management framework for financial institutions The evolution of model and algorithmic risk Contents Overview of model and algorithmic risk 3 A robust model risk management framework 5 Embedding model risk management in risk culture 13 2 The evolution of model and algorithmic risk Overview of model and algorithmic risk Fundamentally, model risk management is about uncovering the assumptions that lie behind a model to understand how it contributes to risk at the organisational level. With increasing volumes of data, and recent advances in technology and computational power, including the introduction of Artificial Intelligence (AI) and Machine Learning (ML), models are at the heart of every financial institution’s operations – the backbone of every function and business line, from product design, to treasury and trading, risk management, compliance, and internal audit. But as financial institutions increasingly rely on the output of models for their decision-making, the focus on model risk – or the risk of errors in the development, implementation, or use of models – has also continued to gain momentum. There are several reasons for this. Firstly, the evolving technological capability of these algorithms have resulted in a widespread democratisation of model development, enabling individual users to develop and deploy their own algorithmic models without relying on internal IT or traditional model development functions. While this increases the speed of innovation, it also increases the level of risk that organisations are exposed to, as these new generations of models are not subjected to the same robust testing systems and governance structures as traditional ones.
    [Show full text]
  • Model Risk Management for Market Risk
    MODEL RISK MANAGEMENT FOR MARKET RISK by Marjorie Grootenboer (CID: 01442532) Department of Mathematics Imperial College London London SW7 2AZ United Kingdom Thesis submitted as part of the requirements for the award of the MSc in Mathematics and Finance, Imperial College London, 2017-2018. Declaration The work contained in this thesis is my own work unless otherwise stated. Signature and date: Marjorie Grootenboer September 11th, 2018 2 Acknowledgements First of all, I would like to express my deepest gratitude to Dr. Harry Zheng, lecturer in Mathematical Finance at Imperial College London, who kindly supervised my Master thesis. I particularly appreciated his broad reachability. His guidance was a source of inspiration in my work. I was indeed very lucky to have him as my internal supervisor. I would like to take this opportunity to thank every teacher I had this year at Imperial College London, each one of them being attentive, clear and keen. A special appreciation to Professor Mikko Pakkanen, lecturer in Mathematical Finance and Statistics at Imperial College London, who made me discover the risk management area. His Quantitative Risk Management course was one of the reasons I chose model risk as my subject. A special gratitude goes to Vivian Vu, Quantitative Finance Analyst at Mazars UK, for her constant help and support. She shared with me insightful suggestions and she spent a great amount of time challenging my ideas. I am also thankful to Xavier Larrieu, Senior Manager and Head of Quantitative Services at Mazars UK, who trusted me and offered me an internship at Mazars UK this summer.
    [Show full text]
  • Model Risk Management | September 27-28, 2018 | Boston
    MODEL RISK MANAGEMENT | SEPTEMBER 27-28, 2018 | BOSTON © 2018 Darling Consulting Group, Inc. • 260 Merrimac Street • Newburyport, MA 01950 • Tel: 978.463.0400 • DarlingConsulting.com Page 1 The Faculty Drew H. Boecher Sam Chen Jon Hill Brandon Blanchard Managing Director Quantitative Consultant former Global Head of Model Risk GovernanceVP, Operational Risk Management Darling Consulting Group, Inc. Darling Consulting Group, Inc. Credit Suisse Commerce Bank Joe Montalbano Michael R. Guglielmo Ray Brastow Liming Brotcke Quantitative Consultant Managing Director Senior Financial Economist Quantitative Manager Darling Consulting Group, Inc. Darling Consulting Group, Inc. Federal Reserve Bank of Richmond Federal Reserve Bank of Chicago © 2018 Darling Consulting Group, Inc. Page 2 Agenda – Day One Time Topic 9:00 Next Level MRM [Drew Boecher] 9:45 Regulatory MRM Perspective [Panel: Mike Guglielmo, Ray Brastow, Liming Brotcke] 10:30 Break 10:45 Establishing a Model Risk Management Culture [Brandon Blanchard and Mike Guglielmo] 12:00 Lunch 1:00 Lifecycle of a Model [Brandon Blanchard and Mike Guglielmo] 2:00 Break 2:15 Model Inventory Management [Mike Guglielmo & Jonathan Hill] 3:15 Break 3:30 Managing Inventory Risk: “Should a Model ‘Know’ Its Own ID?” [Jonathan Hill] 4:30 Assessing Model Risk In The Aggregate [Ray Brastow & Liming Brotcke] 5:15 Q&A and Open Discussion © 2018 Darling Consulting Group, Inc. Page 3 Agenda – Day Two Time Topic 9:00 New Era of Data Management [Joe Montalbano] 10:00 Break 10:15 Case Study: Validation of Statistical
    [Show full text]
  • SYSTEMIC RISK: WHAT RESEARCH TELLS US and WHAT WE NEED to FIND out Systemic Risk Centre
    Systemic Risk Centre SYSTEMIC RISK: WHAT RESEARCH TELLS US AND WHAT WE NEED TO FIND OUT Systemic Risk Centre Published by Systemic Risk Centre The London School of Economics and Political Science Houghton Street London WC2A 2AE All rights reserved. Requests for permission to reproduce the articles should be sent to the editor at the above address. The support of the Economic and Social © Systemic Risk Centre 2015 Research Council (ESRC) in funding the Designed by DesignRaphael Ltd SRC is gratefully acknowledged Illustrations pgs 9/11/20/26/28 by Judith Allan [grant number ES/K002309/1]. 1 SystemicSystemic RiskRisk CentreCentre Key messages The global financial crisis Policy responses The autumn of 2008 was not the first time that the world Laws, rules and regulations drawn up ostensibly to bolster has faced systemic risk. The threat and, at times, its financial stability and limit the build-up of risk can often realisation have been present ever since the first financial become a channel for amplification mechanisms that system was created and they are an inevitable part of any have precisely the opposite effect. This occurs when market-based economy. multiple rules have inconsistent objectives and interact in unpredicted ways. Often these perverse consequences The challenge for can remain hidden until it is too late, and this can occur policy-makers in particular when policies are drafted hastily in response Society faces a difficult dilemma when it comes to to a crisis. systemic risk. We want financial institutions to participate in economic activity and that means taking risk. We also want Financial engineering financial institutions to be safe.
    [Show full text]
  • “Risk‐Sharing Or Risk‐Taking? an Incentive Theory of Counterparty Risk
    TSE‐522 June 2014 “Risk‐sharing or risk‐taking? An incentive theory of counterparty risk, clearing and margins” Bruno Biais, Florian Heider and Marie Hoerova 7 Risk-sharing or risk-taking? An incentive theory of counterparty risk, clearing and margins Bruno Biaisy Florian Heiderz Marie Hoerovax June 19, 2014 Abstract Derivatives activity, motivated by risk—sharing, can breed risk—taking. Bad news about the risk of the asset underlying the derivative increases the expected liability of a protection seller and undermines her risk—prevention incentives. This limits risk— sharing, and may create endogenous counterparty risk and contagion from news about the hedged risk to the balance sheet of protection sellers. Margin calls after bad news can improve protection sellers’incentives and enhance the ability to share risk. Central clearing can provide insurance against counterparty risk but must be designed to preserve risk—prevention incentives. JEL classification: G21, G22, D82 Keywords: Hedging; Insurance; Derivatives; Moral hazard; Risk management; Counterparty risk; Contagion; Central clearing; Margin requirements June 19, 2014 We would like to thank the Editor (Cam Harvey), an Associate Editor and two anonymous referees, our discussants Ulf Axelson, Jonathan Berk, Sugato Bhattacharyya, Bruce Carlin, Simon Gervais, Artashes Karapetyan, Christine Parlour, Alp Simsek, Lauri Vilmi as well as numerous seminar and conference par- ticipants for their comments and suggestions. A previous version of the paper was circulated under the title “Risk-sharing or risk-taking? Counterparty risk, incentives and margins”. The views expressed do not necessarily reflectthose of the European Central Bank or the Eurosystem. Biais gratefully acknowledges the support of the European Research Council.
    [Show full text]