March 1, 2010

Preliminary: Comments welcome

The Future of Financial Risk

Management

Charles S. Tapiero, Topfer Chair Distinguished Professor

of Financial Engineering and Technology Management
Department of Finance and Risk Engineering
NYU-Polytechnic Institute, Brooklyn and New York
[email protected]
Third annual conference of the Cass-Capco Institute Paper Series on Risk,
Cass Business School, City University London, 106 Bunhill Row, London EC1Y 8TZ
Monday 19th April, 2010

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Electronic copy available at: http://ssrn.com/abstract=1562682

Abstract
The financial crisis of 2008 has revealed what we all know: That liquidity matters very
much; That the future may be unpredictable; That non-transparency, complexity and
ambiguity have conjured with greed to induce Managements Risks as being able to derail
financial sustainability and That financial models are not efficient. These revelations have
increased our awareness that our financial expectations can and do falter. This renewed
awareness may alter the financial regulatory environment, financial markets in general, our
financial attitudes and beliefs and by extension, the future of financial risk management. In
light of these events, the purpose of this paper-presentation is to assess the future of financial
risk management and point out to essential concerns that may be relevant in meeting the
challenges of a financial world increasingly in turmoil.

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Electronic copy available at: http://ssrn.com/abstract=1562682

1. Introduction
Financial Risk Management (FRM) is fueled by future needs and the future ills of
financial parties and societies interacting in an increasingly complex global financial world in
turmoil (Peter, 1995, Gleick, 1987, Grandmont and Malgrange, 1986). These future needs
and ills have implications to the future focus of financial risk management in the small
(pertaining to persons and corporate entities) and in the large (pertaining to sovereign states
and global initiatives and financial regulation). The effects of a lingering financial crisis may
expand dramatically underlying financial trends and alter the financial landscape and
therefore the future challenges of financial risk management. These trends include:

A flight from risk at all levels of the financial landscape and the increased dominance
of insurance in finance with financial banks and institutions relegated to mere
intermediaries.

The complete financial markets dogma threatened by financial default models with no
clear substitute models.

A multi-polar global finance with competing financial markets and an increased role
to sovereign interventions in financial markets and regulation.

The persistence of complex financial product innovation (in credit, insurance, etc.) as
they will remain the essential tools to increase a needed financial liquidity. At the
same time, they may contribute to recurrent liquidity and leverage risks.

The IT financial transformation and a new brand of technology risks and Oprisk.

The growth of Managements risks and their moral hazard

These factors inducing needs and ills are challenging FRM. Their implications are discussed
in greater detail in section 2 while their containment by FRM may be challengingat best,
we can outline some basic and hypothetic means. These factors summarized in the Table 1
below, with a sample of implications define a challenging financial future.
Financial Future
Flight from risks

Financial Implications

Insurance-finance primes, insurance firms

become market maker, banks are marketers,
with an increased counterparty risks
Global and competitive multi-polar Financial instability, dollar sub-primed,
financial markets
political conflicts
IT finance risks
Moral hazard, financial individuation, financial
litigation, inefficient regulations
Complete markets dogma threatened, Regulation, moral hazard, liquidity supply
complex credit and financial products challenges, Mispricing, regulation, OTC,
innovation, default models.
recurrent financial markets crises, liquidity
crises

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Managements risk, TBTF

Growth of moral hazards, Too To Big to Bear

systemic risks and risk externalities
Table 1: For elements of future needs and ills challenging FRM

FRM tools tailored to meet the needs of financial parties (personal, firms and sovereign
states) can be contradictory, one approach protecting a party and harming the other. In this
sense, FRM futures is necessarily strategic, balancing competitive and conflicting needs.
Managing financial risks can be classified in a number of approaches which we choose to
summarize by: ex-ante, ex-post, strategic and robustness. Each of these emphasizes the use
of financial tools tailored to meet specific needs (of persons, corporate and institutional
financial firms such as banks, lenders, etc., sovereign states and potentially a global party
such as a international regulatory agency). The types of risks FRM encounters are of course
varied and depend on needs and ills of each financial party. Ex-ante risks for example, may
be predictable and therefore both regulated and prevented. In such cases, the design of a
portfolio with appropriately independent securities, preventive and recovery contractual
agreements and measures may of course be used.

Risks

Financial Parties

Ex-Ante

Personal, corporate

Risk Types

External,
contracts
hazards,
dependent risks, preventive
Ex-Post
Institutional Finance Recovery,
reactive,
OTC,
litigation, moral hazard, systemic
Strategic
Sovereign
Endogenous,
moral
hazard,
litigation, externalities
Robustness
Global
Systemic, externalities
Table 2: Types of risks and financial parties

A comprehensive approach to FRM will necessarily lead to a departure from a passive eto an
active approach to FRM.

Strategic risk management arises from counterparty risks,

conflicting and information and power asymmetry risks.

In such cases, regulation,

transparency, contractual agreements and protective agencies may be used to counter the risks
that arise and can harm persons, firms and the financial system.

Ex-post is far more

challenging that FRM and pertains to both financial recovery and overcoming consequential
events that are not secured ex-ante. Robustness presumes that risks are multifaceted, ill
predicted and therefore robustness includes contracts, assurances, procedures, portfolios etc.
that are insensitive to risks that were not a-priori accounted for. In a practical sense, a
portfolio would be designed to provide planned returns under a broad set of risk scenarios.
To some extent, the current practice of stress testing based on a wealth of future scenarios
provides a foundation to dealing with these problems. VaR (Value at Risk) by contrast is a

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tool which is both liquidity specific that arises from practical concerns in day trading accounts
(JP Morgan Chase day trading accounts).

It is a statistical technique without strong

financial theoretical underpinnings (albeit, under normal risks, an equivalence of VaR and
quadratic utility functions valuation of losses and their certain equivalent can be reached with
an implied price of risk in the normal distribution tail defined by VaRs financial risk
exposure).

It is applied mostly for statistical and predictable risks.

When risks are

unpredictable, the VaR risk exposure assurance falters.

Managements incentives packages (the take home revenues of CEO and traders based on
present performance) contribute further to future risks. These have contributed to a risk
exuberance in good times and relieved their perpetrators of their real risk consequences
leading to appreciable Management risks that have contributed to the systemic meltdown in
2008. Such a system contributes of course to risk taking and to techniques of off-balance
sheet accounting that introduced a far greater non-transparency in financial accounts. Such
management risks induce extraordinary moral hazard risks, with financial institutions and
financial managers assuming far greater power and information asymmetry than is presumed
by the conventional financial dogma. The implications of these problems to financial risk
management as well as the many lessons assembled following the 2008 financial crisis are
discussed in section 4. In 2008, these lacunae in FRM have challenged the future of financial
risk theory and management to provide both the mitigation of risks by more efficient
measurement-predictors of future ills, their analysis, preventive-ex-ante as well as ex-post
recovery and management approaches designed to confront and overcome unpredictable risks
when they occur. Some theoretical facets, emphasizing the predictability of future states are
discussed next.

2. FRM and the Complete Markets Dilemma

Traditionally FRM based on conventional financial dogma has focused mostly on
predictable risks. These risks can be accounted for and mitigated when markets are complete
and are therefore far less meaningful, compared to unpredictable and consequential risks.
Taleb, 2007a, 2007b, 2010, Rubini, Fox 2009, Kutler, 2009, Tett, 2009 as well as financial
theorists and practitioners have raised our awareness that these are the risks that matter,
challenging the underlying assumptions and the uses made of complete markets models. For
example, the presumptions that current and future risks are embedded in observable prices,
and vice versa, that current prices imply financial futures (or more precisely, beliefs about
this future and on the basis of which portfolios are hedged) leads necessarily to a comfort that
all risks can be accounted for in the present. In this sense, a robust and reactive financial risk
management is not necessary since it induces costs that cannot be justified in the present.

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The underlying financial assumption that future prices are both well defined and implied in
present prices is not new (Arrow1963, 1999). St Augustine in his Confessions (volume X)
already claimed that we are always in a present: A present of the past, a present of the future
and a present of the present. Technically, we use stochastic processes, integro-differential
equations, auto-regressive and moving average models as well as fractal and other models
qualified by filtrations etc. to measure and provide a present time path of the past and the
future (Tapiero, 1978). In this context, there is only the here and now with financial future
risks experienced and confronted ex-ante. For example, the rise of trades options rich
markets can mitigate and trade away future risks or alternatively provide an opportunity to
bet on future prices now. In a predictable and complete market there is then little need for
FRM since the future is synthetic, financially defined in the present. Techniques such as
Value at Risk, providing a contingent capital to meet future real losses and liquidity as well
as trading financial products, are used because asset prices are not predictable and their
risks cannot be always mitigated in the present. In this sense, VaR is a statistical-actuarial
insurance technique (rather than a financial technique) that allows tailoring risks of losses
to regulated bearable levels. When risks are normal, aggregated and redistributed as it is
the case in insurance, VaR might be applicable (but in such cases, VaR is also irrelevant since
normal risks can be traded away). When risks are not normal and cannot be traded away,
risks can be shared (if a partner is found for this purpose) or simply bornin other words,
VaR provides a limited insurance risk protection (for VaR related literature see Artzner, 1999,
Artzner et al., 1999, Beckers, 1996), is misleading and provides a false protection. In this
context, actual insurance by willing firms such as AIG is far more efficient for trading firms
(at the expense of AIG has found out in 2008). The application of VaR as a compensatory
risk management technique by insurance firms insuring financial products (or regulated
banks) and using market pricing techniques (MTM) did profit in normal times but were
unable to meet claims or meet consequential risks when they occurred. By the same
token, traders, investors and financial institutions based on (current) marginal valuation and
management of financial risks did falter when struck by unpredictable (and increasingly
common) consequential risks.

3.

Future FRM Challenges

3.1 Flight from risk and insurance-finance

The rise of insurance institutions insuring financial products and transactions leads to
their primacy in liquidity providers.

Banks that have become marketers become

marginalized focused on their pursuits of profits. Further, trades requiring buyers and
sellers, some risk avoiding and some risk taking might not be able to conclude any exchange

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unless insurance is provided. This is of course the result of lack of faith in financials future.
For example, financial products such as CDS, CDO (Lucas et al. 2006) already require a third
party acting on both sides of the trade equation to assure both parties. In this environment,
insurance firms whose business has been to share risk are becoming the market makers that
assume as well the trading risks. Consider a future credit risk financial product (albeit,
already existing in the present):

It is engineered to sell to prospective investors

Buyers that are risk averse will buy a complex financial product if it is
transparent , with contingent and risk mitigating features

The sellers of such products will have to turn to insurance to maintain such a
market. As a result, insurance becomes the center piece of the credit risk
marketing strategy while the product becomes far less relevant. Evidence of the
growth in synthetic products being traded points out to these observations as well.

Similarly, consider a future where climate change and its effects are far more prominent.
Climate Markets will be essentially synthetic as no one owns the weather while both parties
involved in weather based financial transactions, need insurance.

In such cases risk

sharing, based on the risk bearing of parties, their information and their attitudes will
determine their exchange.

To sustain such markets in a finance fleeing from risk and

illiquidity the dominance of insurance firms is likely to grow. This role has been recognized
in New York State by Governor Paterson, announcing in January 8 the beginning of a
financial insurance market, based on the Lloyd of London model. Although such a political
decision has not yet matured in a full-fledged market for insurers and insurance, it recognizes
its fundamental role. The integration of optional products into insurance (and vice versa, the
integration of insurance in financial products) has already become a pillar trading strategy in
credit derivatives and in other products. In a world of flight from risk, it promises to be far
more. Assuming that climatic and environmental losses may in the future be Too Big to
Insure by a firm, insurance firms are likely to turn to new insurance-financial products,
marketable and sold in financial markets. Such products (such as CDS traded OTC with no
regulation) may contribute to the growth of uncontrolled Casinos with potential counterparty
and systemic risks) Such a future trading model contributes as well to a revision of the
conventional complete markets dogma (and to its many theoretical and practical
consequences) and to our inability to predict and price future prices.

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3.2 Globalization, interconnectedness and a Multi-Polar financial world.

In multi-polar, competing and strategic financial markets, information and power
asymmetries risks thrive.

In such circumstances, financial markets promise far greater

instability and far more strategic risks. This instability is evidenced by greater volatility and
greater difficulties in regulating outlier behaviors.

These factors have necessarily

implications for a financial environment, far more enslaved by global TBTF firms that have
no boundaries and no rules except the making of profits. In simple risk-statistical terms, risks
are external and independent and are therefore statistically predictable.

In a dependent

finance, they are both endogenous and strategic, based on parties motivated actions and
reactions. In practice these risks are defined explicitly by an exchange between buyers and
sellers OTC.

Issues of moral hazard, information and power asymmetries amplify the

complexity of these risks without changing their essential manifestation.

In such an

environment, controls, preventive and punitive measures become part of the FRM tool set.
Further, a non-dominant US financial world has implications that may impact FRM in
unpredictable manners. On a theoretical front, a multi-polar financial world may resist
financial equilibria, introduces uncertainty, moral hazard and conflict (presuming that Nashtype equilibria will be deemed to be financially rational, etc.).

3.3 Growth of IT Risks and Oprisks

IT risks arise because there are many more of us, IT savvy, far more aware and with a far
greater ability to affect the commons through an expanding IT technology. This results in a
tyranny of minorities, common extreme behavior fueled by excessive and unfiltered
information far more apt to generate contagious behaviors and therefore financial runs.
Further, the growth of complexity, rare events, black swans and generally deviant outliers and
behaviors may yet become the rule rather than an exception. This means that a risk of
chaos in financial markets, fueled by its own synergies is not far-fetched (see Ashbys law
of requisite variety in cybernetics).

The increased dependence of financial institutions,

markets and products on IT contribute to the needs for both IT-FRM in the small and in the
large to counter a new found power for malevolent minorities. However without a common
and concerted will such efforts will end up to being pointless. Related safety and security
risks, networks and IT etc. are emerging as important candidates that will redefine Oprisks
and the manners in which these risks will be managed.

3.4 Complete markets dogma threatened

For conventional finance, the predictable future is now. This is the underlying theory
of fundamental finance and its approach to financial risk management. Current prices reflect
future risks and future risks are implied in current prices. As a result, attention is focused on

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managing the predictable rather than unpredictable rare and consequential risks that matter
the most. The financial dogma has stood on assumptions taken for granted that financial
markets are infinitely liquid, balancing those who seek a flight from risk and those seeks it for
profit. The financial crisis of 2008 has increased our awareness that there are lacunae in our
financial models to value, price and hedge. While fundamental theories have served us well
when financial markets are predictable, they fails in turbulent, complex, rare and
unpredictable times.

Climatic changes, globalization, population and concentrations growths are causing to a

greater awareness of previously unthinkable disasters to become recurrent.

Extreme

weather is now a TV show while Terror is ever present and everywhere. The presumption
that there is an implied Martingale process that drives values, fair and expectedly constant,
has ushered in a notion for the end of risk. Such a notion is of course misguided in the
face of the flagrant manifestations of real risks. Jean Pierre Landau (Vice Governor of the
Bank of France), points out that modern finance is based in practice if not in theory on an
implied ignorance of extreme risks (and implied complexity, my addition) of financial
markets. There is thus a basic misunderstanding when theories by themselves define a reality,
becoming implied rather than based on a causal understanding of the processes that drives its
evolution. 2008 will be remembered as an era where risks and their extremely complex
manifestations have come on their ownex-ante ignored, but factual, painful and with no
recourse ex-post. Ex ante we have a tendency to presume the predictability of the future,
seeking comfort in numbers we can point out to and ignoring the others (Paul Samuelson).
For example, insurance firms concentrate on aggregate risks, providing a statistical prediction
of future claims while facing real problems when outliers struck. Yet, these outliers recur in
different forms and with a surprising regularity. Further, the notion that a real equilibrium is
a fixed point is misleading as evidence points out to a dynamic equilibrium, defined by
events, endogenous and external to our understanding of financial models (see Hsieh 1991,
Brock, Hsieh and LeBaron, 1992 and Beran, 1994 on Long Term Dependence models).

Empirical evidence has shown that financial series are not "well behaved" and cannot be
always predicted. Some series have short term memory (for example, intra-day time series
we have studied have short memory of 1 to 10 minutes) while others have a memory
converging to a translated Brownian motion (Herman and Vallois, 2010) which accounts for
this memory hidden in a process mean and volatilities evolutions. Some time series exhibit
an unpredictable and chaotic behavior which underscores the time nonlinear behavior of
financial volatility. "Bursts" of activity, "feedback volatility" and broadly varying behaviors
by stock market agents, "memory" (both long and short, exhibiting persistent behaviors) etc.

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are characteristics that contribute to the "nonlinearity of uncertainty growth" and thereby
challenging the existence fixed-point financial equilibria.

The presumption that the future is unpredictable is of course not new. An ancient Greek
school of thought was based on the claim that future manifestations are unknown and
unlikely, confirming the well known adage that the likely is unlikelycertain to occur but
unpredictable (for example, Lo et al. 2003, Mandelbrot, 1971, 1972, 1997, Mandelbrot and
Van Ness 1968, Mandelbrot and Wallis, 1968, Bullock, 2008, Taleb, 2007a).

The financial meltdown has confirmed this latent unpredictability. For a future FRM, these
misconceptions fuel a revisionary understanding of how markets in fact function and what
are our financial and risk attitudes and how do these result in a flight from risk, shying away
from complex financial (and non transparent products), lack of faith in raters and in financial
models, etc. These contribute further to questioning the financial dogma. Namely, a future
with more liquidity risks, greater volatility and a lack of faith in finance and in financial
institutions and intermediaries, more financial regulatory constraints, etc., some of which will
contribute further to the financial predicaments that sovereign policies seek to counter in the
first place. These, issues underlie of course both theoretical and practical finance and the
need for a FRM that recognizes future challenges tailored to financial parties needs.

The future of financial risk management is thus closely associated to uncommon risks
calling for a concerted effort to increase our awareness that such risks exist and motivate the
attention they deserve. While much theoretical research in such models has been made, the
FRM research needed to mitigate such risks is lagging.

3.5 Managements risk, TBTF and Financial Risk Externalities

Financial firms parties do not always have the interest of their agent-management
and principals (stock holders) aligned.

These contribute to information and power

asymmetries with little recourse when such firms are large (as they tend to be) and the
Principals have little opportunity to intervene in firms management process. In this context
traditional Principal-Agent models are misleading, underestimating the agents risks. The
2008 financial crisis, has shown that such risks are both important and will not disappear post
a financial recovery.

Further, excessive risk taking (putting Principals capital at risk,

unchecked misappropriations of returns and profits by firms etc. are putting at risk
fundamental corporate charters. Further, the growth of financial firms that are TBTF, at both
national and global scales capitalizing on their strength, size and power are raising new risk
perspectivesboth for corporate sustainability and systemic risks (for example, see Henry

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Paulsons article in the NY Times, February 16, 2010). Such firms, regardless of their size,
creating risk externalities Too Big To Bear (i.e. risks they do not assume), have grown into a
threat to finance in the large.

These firms, lead by unchecked corporate titans are then

similar to persistent polluters profiting from the damage that the commons assume.
These financial risk externalities, hitherto neglected, allow such firms to evade due process
and freely pollute the financial environment (see also Taleb and Tapiero, 2010). FRM, in
this case, is confronted to problems already experienced by environmental and pollution
regulation, policing and applying the rule of law to prevent such actions and that both the
public at large is protected and perpetrators of such risk consequences duly punished. These
future financial risks, are fueling by new needs, new ills and dislocations in the world of
finance that calls for a reappraisal and potentially new means for FRM.

Lessons, lessons more of the same lessons

Ever since the financial crisis, numerous meetings, papers and books have sought to

provide some insights and reasons for the failure of financial markets and FRM (for example,
Kindleberger, 1978, Galbraith, 1997, Bruner and Carr, 2007, Lowenstein, 2000). These
lessons, mostly a repeat of past events, were not learned (Khandari and Lo, 2008). Rounding
the usual suspects, the culprits are far from well defined. Michel Crouhy, 2001, in an NBER
presentation points out to risk measurement, model risks and to the integration of (highly
dependent) markets, credit and liquidity risks as essential factors to reckon with in the FRM.
In addition, Crouhi, indicates to dependence and contagion risks underlying financial runs in
the Asia financial crisis as well as to evolving risk trends in banks trading, seeking to
transform risk in value. This process has become the dominant factor in the MBS and credit
derivatives debacle in 2008.

At a session on the Future of Financial Risk Management, at the Courant Institute of New
York University (November 30, 2009), for example, Steve Allen points out to the failure of
financial regulation, the limits of VaR and in particular failure of the Group of Thirties (for
stabilization). The lessons calling for an effective international regulation is needed (albeit an
unlikely prospect in multi-polar and competing financial markets). In addition, Allen states
that risks, and in particular the sizable effects of latent-macroeconomic-natural risks, striking
whole portfolios at the same time and mostly unpredictable may have both substantial direct
and collateral damages. These risks, unlike statistical dependence risks, might in some cases
be accounted by VaR models (although there is much evidence to the contrary). Techniques
such as Copula, commonly practiced have also failed to assess the effects of dependence since
such techniques do not appreciate the intricate and causal facets of dependence (for example,
application of the KMV model). As a result, VaR has been largely discredited, leading risk

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managers to turn to qualitative stress-testing, However, while VaR has been and is vastly
discredited it continues to be vastly used. This is a contradiction arising from a lack of
understanding and way about what to do.

Traditional financial risk management techniques are fueled by a need for certainty
combined with a misconception and intolerance of ambiguity that seeks to simplify-and
oversimplify, everything. In this process, financial measurements and tools seek risk free
synthetic models that have no real sense. In a world where uncertainty, risk and ambiguity
prime, this leads necessarily to misconceptions and default models. The search of certainty is
implicitly recognized by stress-testing techniques which seeks (based on simulations and
predictable scenarios) policies or financial strategies that are insensitive to a broad set of
potential and predictable events defined by such scenarios. A better term might be seeking
robustness (commonly practiced in industrial designs using experimental techniques). In
the credit risk and derivative debacle, financial managers have thus removed uncertainty
through certainty models when risks were latent everywherein collaterals and financial
products over rated and thereby overpriced. Of course, a financial world with real estate
prices increasing at 10% and more clip per year, no mortgage can be toxic.

In other words,

information and ratings were tailored to meet corporate needs rather be an objective
information sources. The attempt to litigate a co-responsibility by raters in the trillion dollars
debacle of the MBS crisis has so far failed in US courts. Although unreliability of risk-free
assets and raters rating is an important issue to reckon with on both practical and theoretical
grounds.

Of course, much can be used from such lessons. But financial institutions, turned financial
intermediaries and TBTF might find that such lessons does not support their quest for profits.
Thus, for FRM, it is first necessary to recognize that over-reaching for certainty in assets
management is misleading. And therefore, financial managers ought to be mentally in tune
and tolerant of markets uncertainties and ambiguities. In this sense, FRM ought to be far
more concern about risk recovery and overcoming un-collaterized risks. The contingent
ability to recover ex-post from unpleasant events is thus essential and will be increasingly
so and need not negate the financial necessity to assume risks. The negation of risk that
underlies the traditional approach to FRM has thus to be compensated by recognizing risks,
accepting risks, living with risks and learning how to recover from risks.
Reiterating what we knew, Steve Allen also points out to the usual culprits; exotic derivative
with prices that are not market variables whose price history can be observed (and so are not
suitable for inclusion in a VaR analysis if FRM is all about VaR). If instruments have no

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liquid markets, valuation models are called that require some inputs which cannot be
extracted from liquid market prices. In other words, since risks cannot be traded away, they
have to be assumed or shared (as commonly practiced in insurance contracts). In other words,
risks, as in traditional insurance contracts cannot be traded away but sharedif a partner to
such contracts can be found. Unconscious insurance coverage, as was the case with AIG
covering financial risk, has of course implications that are likely to provide additional lessons
to the insurance profession.
At the same conference, Engle points out a need to recognize the counterparty risks of
incentive structures (a managers moral adverse selection risk) as well as failure of risk
measurement that underestimates both short and long term risks (risks that financial markets
have problems dealing with). Namely, Engle indicates that leverages risks were incurred by
lending/borrowing in a low volatility environment; trading in structured products such as
CDOs produced with apparently low risk, both of which were surprised by correlations
risks. These risks implied in orchestrated high prices could not define the correlation or
the latent-black swan effects. Insurance purchased on these positions made the risks even
lower as long as the insurer had adequate capital. When these assumptions were violated
risks hitherto not recognized came home to roost large losses (Engle, 2009).

A question such as is financial risk management about eliminating uncertainty and living in
a fictitious certain world or rather learning how to live with risk and learning how to recover
when risk are no longer a prospect but a reality? is then again an essential issue in the future
of FRM.
Pundits such as Alan Binder (The New York Times, January 25, 2009) refer as well to excess
leverage, unregulated credit risk markets, banks intermediation allowing them to assume
excessive risks, foreclosure management and the misuse of the TARP moneys as additional
culprits. These reasons, underlying a call for greater transparency and greater regulation, are
not obvious and potentially impossible. The fact is that risks are complex because of their
numbers, their intricate dependencies and to some, they are unpredictable. Leslie Rahl for
example, (Courant meeting 2009 meeting), suggests a partial plethora of risks given below,
including real, financial, virtual, personal, collective, predictable, unpredictable, political and
otherwise risks that resist their definition by a simple Brownian motion risk. According to
Rahl, a number of Lessons are to be noted: History does not repeat itself; Risk does not
disappear; There is no free lunch; Liquidity matters very much and can change unexpectedly;
complexity induces its own risk; Stress testing needs to focus on correlation assumptions; All
AAA ratings are not clear; Buying credit exposure from party exposed to the same risks is

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dangerous; Funding long terms credit with short terms credit does not always work, etc.
These lessons are also note by Ben Golub et al (2010)

For Ben Golub (Vice Chairman and Chief Risk Officer of Blackrock), the credit crisis has
clearly demonstrated the importance of a strong, independent (and institutionalized) risk
management function. It has also revealed the inadequacy of many standard methods in
quantitative risk management and called into question the efficiency of markets in general.
Many investors have taken losses well in excess of their expectations, and the subsequent
rebound in risk assets that began in the spring of 2009 has resulted in significant
underperformance for those with conservative allocations. More distressing has been the near
complete loss of liquidity and transparency as large segments of the market literally ground to
a halt. Traditional fundamental and technical drivers of risk and return were overwhelmed by
the impact of malfunctioning markets and dramatic changes in government policy. The
paramount importance of managing liquidity has been demonstrated decisively, and the
hypothesis of market efficiency as the sole defining paradigm for modeling and measuring
institutional risk has been demonstrably falsified by experience. In light of these observations
from the Credit Crisis, best practices in risk management need to be retooled for a world in
which global financial markets cannot be assumed to always be open and efficient and the
rules of the game can be dramatically in flux. (Golub et al. 2010)

To face an uncertain financial future, Golub et al. (2010) finally suggest eight principles for
institutional financial risk management:
1. Risk management requires institutional buy-in.
2. Alignment and management of institutional interests are critical to risk
management.
3. Institutions need an independent risk management organization with strong
subject-matter expertise.
4. Institutions need to understand their fiduciary responsibilities to their clients.

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5. While a top-down perspective is necessary, a bottoms-up risk management

process is vital.
6. Institutions need to get portfolio managers to think like risk managers.
7. Risk models require vigilance and skepticism.
8. Institutional risk management does not mean risk avoidance.

At more specific levels, Golub notes that institutions must recognize the paramount
importance of liquidity; that investors in securitized products need to look through data to the
behavior of the underlying (seeking to better understand risk causality rather than
correlation, my addition); That certification is useless during systemic shocks; And that
markets appetites for of risk can change dramatically. Both these institutional and marketspecific factor, lead to a greater need for a risk policy. Of course, (my addition), a policy
risk based on predictable risks is self defeating, as unpredictable risks are, by far, the risks
that matter most.
These lessons provide answers to a finance which is more of the same finance we have
already experienced in the past and therefore, sustaining its future. The Future of FRM is,
as stated earlier, necessarily fueled by tomorrows ills which points out to sizeable strategic
risks risks, uncommon, more frequent and more complex risks, with far reaching systemic
and risk externalities. In other words, in a world of new risks it might be wise not to seek
refuge in the past, a trap that believes in our well documented theories, even though they
might work most of the time. FRM is precisely meant to be outside such theories, bridging
the virtual and the real finance. Further, we ought to remember that models and theories are
in fact only hypothesesnever confirmed and always in doubt.

Current trends, already point to new perceptions of risks including among many others,
greater individuation of risk (eg in IT risks, in personal finance, in insurance, in health care
aided by advances in genetics etc.); to more common systemic risks fueled by a multi-polar
markets in conflict and TBTF firms free to exercise their tyranny etc.. By the same token, in
such an environment, Sovereign regulation is likely to ineffective and therefore FRM may be
called for to be more robust, responding to the multiple risks that the financial system cannot
handle; to more redundancy and greater costs and to a flight from risk for all financial agents.
These undermine the proper functioning of financial markets and financial parties and the
basic assumptions we make regarding FRM.

At the same they provide an appreciable

challenge to both the theory and the practice of FRM.

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Conclusions and Suggestions

Financial risks management is motivated by future needs and ills subject to complex and
multiple sources of dependent risks. In this environment, financial management is challenged
by uncommon risks, an evolving financial landscape with information and power
asymmetries and Too Big To Fail, a multi-polar financial world, IT risks, a flight from risks
(which puts at risk the proper functioning of financial markets). FRM motivated by the many
needs of financial parties it is subservient to, can proceed in different mannersboth for a
specific FRM in the small and global-Sovereign FRM (regulation) to assure a financial
system sustainability. In the small, uncommon risks, defined by multiple and interacting
risks, a robust approach to financial risk management combined with ex-post recovery and
management tools and techniques may be applied. However, the increased complexity of the
financial environment, globalization, and the interdependence of global financial markets will
continue to provide a greater dominance to the big picture of financial risks and their
management about which persons and corporate entities may have little do do. In this
context, risks are necessarily less predictable, at times unavoidable and financial risk
management far more concerned by preventive and ex-post recovery. A traditional focus on
the small picture of financial risk management and a flight from risk by persons and by
financial institutions will perpetuate trends of banks lending to the collateral and insured rich
with or without a future and avoid the collateral poor and insurance free, with a future!.

In the small concerns for risk management individuation, expressed by: A response to
real business and real personal financial needs; Sustainable liquidity and Counterparty risks.
In this vein, financial risk management and regulation are necessarily limited and ought to be
focused on the root causes that lead us to a world subservient to finance, rather than to a
world of finance subservient to ends articulated by our free society.

The tools of FRM focus may necessarily alter the concerns of finance. For example, a partial
list of such concerns may include:
(a) Finance of the unlikely (and Black Swans) through risk sharing and sovereign
insurance.
(b) Managing financial liquidity and its consequential risks, which requires firms to
be far more careful in leverage and debt maturity scheduling and debt renewal
and conversions risks. .
(c) Financial risk recovery, robust design and ex-post financial risk management
(with a lesser focus on VaR techniques) to compensate the traditional ex-ante
financial approach to risk management. A resurgence of actuarial-statistical
techniques for testing financial valuation approaches.

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(d) Contain and confine the growth of financial IT risks (information technology).
IT finance and its risks may (in a global financial world) redefine the financial
landscape of the future. For example, would wealthy retirees manage their own
accounts, rather than trusts big banks. In a financial networked world where
regulation is more constraining, can it be effective? Can it limit hidden trades
and taxes avoidance.
(e) Will the finance safety nets that produce risks too big to bear and therefore firms
too big to fail, fuel ever larger institutions to be too big to failfree to pollute
financial markets with risk externalities and to resist any effective regulation.
(f) The flight from risk, with a consequential flight from investments will lead to a
finance of trades where the essential concern is not risk but when to buy and
when to sell. Financial risk management which by its nature is forward
looking, may essentially becoming irrelevant.
(g) Integrated financial risk management (IFRM), while providing a greater
opportunity for executive financial control may also lead to a further flight from
risk and thereby to a decline of finance as we know it.

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