Published by sunandoroy on Tue, 2008-09-16 00:09 in http://www.prmia.org
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!
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