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Stress testing and its Cold War genesis

From time to time, I came across the name Herman Kahn.  He was  mentioned in papers on stress testing or scenario planning.  Both of these are important tools in risk management for financial institutions.  My Google search of Herman Kahn uncovered a number of accounts.  The best and most entertaining piece on the man is by Menand in a piece for the New Yorker.   Kahn worked at RAND  formulating strategies and policies for countering the nuclear threat from the Soviet Union.    Kahn was known as “the heavyweight of the Megadeath Intellectuals”.  The term “Megadeath Intellectuals” comes from the fact that this group of scientists or strategist were at the forefront of considering the scenarios where the US and the USSR are tipped into all out nuclear war.  Here the cost can range from one or two million to hundreds of millions of lives lost depending on how the scenario plays out.
There are some parallels in stress testing for financial services.  The most value in these exercises comes from understanding how management can respond, what level of risk can be tolerated etc.  However financial services don’t need to deal with an adversary who is “bright, knowledgeable and malevolent”.  At most banks need to think about how they handle a market that suddenly refuses to provide the capital or liquidity they need.  In Kahn’s world, Game Theory was critical, while for financial institutions, the markets and the economy are usually a given.

The creative apocalypse that wasn’t

While not related to financial services, this article by Steven Johnson is an interesting read.  It looks at digital technology has changed creative industries.  At the heart of this is the question of how the risk return balance changed in the digital era.  For example, is a mid budget independently produced movie a better or worse risk in the age of Netflix compared to 10 years ago? Are you more likely to sink money to produce such a movie?

Johnson’s article looks at the economics of the creative industries. At the start things were looking bad, given the ease with which content could be shared.  It now appears that it is not all doom and gloom.  Johnson presents a nice balance of data, analysis and anecdotes on how the industry has adapted in the last 10 years.  The smart phone for example allows musicians to reach out and sell their work to consumers almost anytime and anywhere.  This innovation among other things has opened up more avenues for artists to monetise their work – 46 distinct sources to be precise!  Read it here.

The asset management industry and financial stability

The topic of whether or not Australian banks are well capitalised has been running hot. However the asset management sector has largely gone unnoticed when talking about financial system stability. In Australia, total assets held by asset managers (including superannuation funds, insurers and units trusts) are 75% of the assets held by banks.   In fact the burning question at the moment when talking about asset management seems to be whether or not you need $1m to have a comfortable retirement. In addition, industry professionals vent plenty of frustration when talking about the apathy the Australian population seems to have towards saving for retirement. However this apathy could be one of the factors that mitigate the systemic risk from the asset management sector, according to this informative article from the RBA. (more…)

The role of the regulator and risk culture

Recently Paul Fisher of the PRA gave a speech titled “Regulation and future of the insurance industry“. In it he says:

“Solvency II will introduce an enhanced system of governance standards – promoting the embedding of a strong risk culture, demonstrable within the day-to-day operations of insurers.”

Risk culture is big in risk management now. Prudential regulations started off being directive based, then evolved to principles based regulation. Post GFC we have beyond principles to risk culture. While companies and consultants talk about it, it is an ethereal concept.

A system of governance standards is certainly very useful as it gives a common set of principles for risk processes, policies and reporting that should exist. Rules and limits are also useful where management have requirements that are NOT subject to personal judgement. But can you “implement” risk culture?

To me risk culture exists where the organisation and people value and exercise traits such as prudence, inquiry, transparency and critical thinking. Risk culture makes standards effective. Sure, standards can help with risk culture by requiring that people do things like getting models reviewed and approved.  However if people do these things only because of standards then the standards haven’t really created good risk culture…

What is a Board to do?

According to the latest paper on governance from the Basel Committee, “Board members have responsibilities to the bank’s overall interests, regardless of who appoints them.” What does this mean? What are the bank’s “overall interests”? Board members are elected by the shareholders and are there to represent their interests – right?  This statement seems to suggest that the authors believe there will be situations where the “overall interests” and shareholders’ interests diverge.

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Exploring risk based pricing for corporate loans

Previously I wrote about an approach to pricing loans, where the spread is set to cover expected losses from default, and to make a return on capital allocated. In this article I use the framework to explore the drivers of credit spreads that banks would calculate if they used the Basel IRB formula to calculate the amount of capital required.

Some banks may use regulatory capital to derive capital as this reflects the amount of regulatory capital required for the loan. The regulatory approach as specified by BCBS captures key drivers of risk such as probability of default, loss given default, systemic risk, and term.

This simple pricing approach reveals some interesting dynamics of the required credit spread. For example, with higher rated securities, the spread is driven by capital requirements and not the expected loss. Drivers of capital such as correlation between defaults and term to maturity have a larger influence.

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Risk based pricing of loans by banks

Introduction

In an earlier post, I talked about how banks set interest rates for loans compared to investors. I would like to explore the bank’s approach over a couple of posts. This post covers one approach to setting the interest rate to charge for a corporate loan.

The interest rate charged is:

  • The cost of borrowing funds
  • Expected cost of loan default
  • Expense margin
  • A rate of return on capital employed

Components of interest rate

Loan price waterfall

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