Human beings have been taking and managing risks for centuries. Peter Bernstein argues that the mastery of risk is what separates ancient from modern times. He attributes the calculation of probabilities, beginning in 16th-century Italy, with our ability to quantify risk and to make informed decisions on the basis of scientific forecasts.
Although risk management has been practiced for thousands of years, it was not until the 1950s that it was articulated and formally developed, by academics working in the field of insurance. Their initial focus was on “pure risk,” or “hazard risk,” where there is either a loss or no loss. For example, owning a house gives rise to the risk of loss from it burning down or being destroyed by a hurricane or other force of nature. These are risks that have traditionally been covered by insurers. Robert Mehr and Bob Hedges, widely credited as the fathers of risk management, argued that risks should be managed in a comprehensive manner and not simply insured.
Risk can also be classified as “speculative risk” if the source of risk gives rise to the possibility of gain as well as loss. For example, investing in the stock market generates the possibility of a gain if share prices rise or a loss if they fall. Such “financial risks” were of little consequence when interest rates were stable, foreign exchange rates were fixed, and inflation was low. This changed in the 1970s with the abolition of the Bretton Woods system of fixed exchange rates and the oil price increases that arose from cuts in production by the Organization of Petroleum Exporting Countries (OPEC). The oil price shocks led the U.S. Federal Reserve to focus on fighting inflation rather than stabilizing interest rates, with the result that U.S. interest rates became more volatile, leading to a spillover effect on other nations. Thus, financial risks became an important concern for companies and financial institutions, which required products to hedge them.
Most financial risks are hedged using derivative products—forwards, futures, options, and swaps. With the exception of swaps, which are a recent innovation (the first swap transaction, involving currencies, took place in 1981), derivative products based on nonfinancial assets had been in use long before they were adapted to deal with financial risks. However, it did not take long for a wide array of financial derivatives to be developed. An important catalyst was the publication of the Black-Scholes-Merton formula for pricing options. This coincided with the opening of the Chicago Board Options Exchange in 1973, the first exchange devoted solely to options trading, and laid the foundations for a rapid growth in the volume of contracts traded in this new market.
Financial risks can be classified broadly into three categories: market risk, credit risk, and operational risk. Market risk is the risk of a change in the value of a financial position arising from changes in the value of the underlying components on which that position depends, such as stock prices, bond prices, or exchange rates. All entities that own financial assets face market risk. For example, the value of currencies owned by banks depends on exchange rates. The most popular method to measure market risk is value at risk (VaR) which refers to the maximum possible loss from an unfavorable event, within a given level of confidence, for a defined holding period. It was popularized by the investment bank JP Morgan in 1994 when it published a technical document, RiskMetrics, to promote the use of VaR among the firm’s institutional clients. Before this, VaR was largely unheard of among corporate treasuries and commodity trading firms, but after the publication of RiskMetrics, its adoption spread rapidly among both financial and nonfinancial firms.
Credit risk is the change in the value of debt due to changes in the perceived ability of counterparties (borrowers) to meet their contractual obligations (or sustain their credit rating). This failure to meet a contractual obligation could take the form of nonpayment (“default”) by the borrower of the principal and/or interest on a loan; hence, credit risk is also known as “default risk” or “counterparty risk.” It is faced by banks, by corporate bondholders, and by parties involved in contractual agreements such as forward contracts. Credit risk is assessed by independent credit rating agencies (usually Moody’s, Fitch, or Standard & Poor’s) in the form of credit ratings, which are opinions on an organization’s ability to fulfill its contractual obligations on a timely basis (a probability of default).
Credit Derivatives And Securitization
Credit risk can be managed using credit derivatives or by the process of securitization. Credit derivatives are privately negotiated bilateral contracts between two parties in which the seller provides protection against the credit risk of the buyer in return for a fee. They have emerged as a major risk management tool in recent years as their use has spread beyond banks to insurance companies, mutual funds, hedge funds, pension funds, and corporate treasury departments.
Credit derivatives fall into two categories: funded and unfunded. The former refers to a bilateral contract between two counterparties, where each party is responsible for making its payments under the contract itself without recourse to other assets. Examples include “credit default swaps” and “total return swaps.” The fundamental difference between them is that the former provides protection against specific credit events whereas the latter provides protection against loss of value irrespective of the cause, which could be a default or market sentiment causing credit spreads to widen. A funded credit derivative involves the protection seller making an initial payment that is used to settle any potential claims. Examples include “credit linked notes” and “collateralized debt obligations.”
Securitization refers to the pooling and repackaging of cash flow producing financial assets (loans) into securities that are then sold to investors. The credit securitization market started in the United States in the early 1970s with the securitization of mortgage loans to create mortgage-backed securities (MBS). Since the mid-1980s, nonmortgage assets, such as consumer loans, car loans, and credit card receivables, have been increasingly securitized. The securitization of U.S. “subprime” (low-quality) mortgages— made to higher-risk borrowers with lower incomes or a worse credit history than “prime” borrowers—led to major liquidity problems (“credit crunch”) in the global banking system in 2007–08 as defaults in these mortgages began to occur. As many lenders had transferred the rights to their mortgage payments—and related credit risk—to third-party investors by means of securitization, the purchasers of the resulting MBS incurred significant losses as the value of the underlying mortgage assets declined. As a consequence of this international transfer of risk, stock markets in many countries declined significantly.
Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events. This type of risk applies mainly to banks and other financial institutions and is manifested in such events as mistakes made in carrying out or settling transactions, or the failure to set limits on, or adequately monitor, the activities of traders. Currently, although banks and financial institutions have made efforts to develop models to measure operational risk, none has gained widespread acceptance. To date, insurance is the only means by which operational risk may be managed, although not all insurance companies offer coverage.
The risk of bank failure is reduced by the requirement made of banks by the Basel Committee on Banking Supervision to put aside a minimum amount of capital, equal to at least 8 percent of their risk weighted assets (Cooke ratio). Whereas the first Basel Accord of 1988 (Basel I) only took account of credit risk, the second Accord of 2004 (Basel II) incorporated market risk and operational risk, and it provides banks with an incentive to develop sound risk management systems so that they can lower the riskiness of their asset base and thereby reduce their regulatory capital charge.
Adopting an overall approach to risk management, by integrating the management of both hazard and financial risks, has led to a relatively new field of study called enterprise risk management. This has emerged as a result of hazard risk managers and financial risk managers reporting to the same individual, usually the treasurer or chief financial officer, leading to the realization that benefits can be achieved by taking a holistic approach to risk management.
- Clark R. Abrahams and Mingyuan Zhang, Fair Lending Compliance: Intelligence and Implications for Credit Risk Management (Wiley, 2008);
- Peter Bernstein, Against the Gods: The Remarkable Story of Risk (Wiley, 1996);
- Ulrich Bindseil, Fernando Gonzalez, and Evangelos Tabakis, Risk Management for Central Banks and Other Public Investors (Cambridge University Press, 2009);
- Fisher Black and Myron Scholes, “The Pricing of Options and Corporate Liabilities,” Journal of Political Economy (v.81/3, 1973);
- Kevin Buehler, Andrew Freeman, and Ron Hulme, “The Tools: The New Arsenal of Risk Management,” Harvard Business Review (v.86/9, 2008);
- Michel Crouhy, Robert Mark, and Dan Galai, Risk Management (McGraw-Hill, 2001);
- International Risk Management Institute, Practical Risk Management: The Handbook for Risk and Financial Professionals (International Risk Management Institute, 2008);
- Robert Mehr and Bob Hedges, “Risk Management in the Business Enterprise,” Journal of Risk and Insurance (v.31/2, 1964);
- Greg Niehaus, Insurance and Risk Management (Edward Elgar, 2008);
- Linda S. Spedding, The Due Diligence Handbook: Corporate Governance, Risk Management and Business Planning (CIMA, 2009);
- Linda S. Spedding and Adam Rose, Business Risk Management Handbook: A Sustainable Approach (CIMA, 2008).
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