Finance, Economics and Risk Management thoughts

Extreme times and Liquidity,by Hugues Pirotte

Articles blame Quantitative Finance (QF) for not being adapted to extreme events. This is clearly a hot topic. Now, there two statements we would like to share with you:

a) Refining the current models to include a higher frequency of extreme events, etc... will make models even more complex and harder to understand.

b) Second, the kind of illiquidity you may face in extreme times creates a binary situation: you get your refinancing or you don’t get it. Therefore, more than ever, the philosophical meaning of a probability in that context is close to a fallacy. That’s why in bad times, managers revert quickly to scenarios and stress-testing.

Now, the problem with liquidity risk (as for the other risks), is that you still cannot manage if you don’t know yet how much you are exposed to it. And in most institutions, there has been a total lack of scrutiny around this subject because simply liquidity risk is absent in good times and no model really takes care of it.

A dashboard can help you in following the liquidity profile of your positions and have a global picture. FinBOARD proposes a framework where liquidity risk is monitored in parallel to your other risk profiles and you can assess your timely cash management profile as a treasurer or as a banker together with your renewal policies, etc…

Treasurers: Credit Risk component is back in the equation!,by Hugues Pirotte

Hedge effectiveness implementation will be harder this year given the evolution of the credit spread and its size for most companies. CFOs and Treasurers will have to handle this problem and solutions are to be provided.

Let’s take a simple interest-rate hedge. A FRN hedged by a swap. Since it is the same structure of interest rates that underlies both instruments, it is still quite easy to provide a clear hedge and the hedge effectiveness report will therefore be quite affordable. Now, if the credit spread increases and becomes substantial while at the same time being more volatile, it means that you have a material second source of risk that enters in the equation. Moreover, the magnitude of this materiality is such that the 80-125% band can be clearly violated, which would mean that you are not complying anymore with IAS39’s rule. Now, you have two choices: (i) explain it to your auditor to try to lower his/her worries. Well, many of you did that at the end of 2008 and the circumstances were helping. But your auditor will ask for more transparency about identifying the reason of the gap. (ii) try to provide a report where both risks are differentiated.

Thus the conclusion is that, would we like it or not, you will have to handle this issue before your next audit.

There are also two potential ways to handle it: (i) re-include credit risk in our models, (ii) try to separate the effects and to show the interest-rate hedge effectiveness apart.

Here are some additional thoughts to answer that:

a) If we have a problem of hedge effectiveness due to credit risk, it is because the perceptions of credit risk on the FRN side and on the swap side are not equivalent.

b) Moreover or more theoretically, the effect of credit risk on derivatives as swaps (called “vulnerable derivatives”) is not linear as with the underlying instruments. If you are a swap payer and the floating interest stands above the fixed rate, your counterpart will not face a direct loss (maybe still an indirect one) if you default.

c) We have to remember to IAS39 is not really for “precise computations” but for accuracy of the information and the willingness to hedge. Therefore, if there is a willingness to hedge the interest-rate risk but that risk is polluted by another one in the derivative (that were supposed originally to isolate one risk at a time), we could still try to separate both effects and to show that, on the interest-rate side, the motivation of hedging is confirmed by the results. The credit risk mismatch is just another opportunity cost due to the elimination of the first risk.

Again, FinBOARD can clearly help you to do that. And FinBOARD does not come alone. It comes with our expertise to help you in implementing the process of reporting at the same time it helps you in better monitoring your hedging policy.

Risk Management for Quants? No! For Managers!,by Hugues Pirotte

Over the last year, it is impressive the amount of garbage one can read. Articles on the responsibility of quantitative finance, on the compensation bonuses, on hedge funds’ guilt, ..., show that it is always tempting to try to blame someone and to focus attention on a escape-goat. In fact, we are all responsible and we have all been irresponsible. Let’s take some examples and show their trade-off, because there is always a trade-off between various arguments.

a)Hedge funds’ responsibility: well, remember, it is a market (well, we all hope there is still some and the economy can’t make it without it)! In a market there are buyers and sellers... And many investors including funds, pension funds, have been investing in hedge funds. Nice to blame them now but either some knew about their lack of transparency, sensitivity to illiquidity and regulatory advantage, either they were ignorant. So, some were too much cold-blood and others were ignorant. Ignorants should not work in financial markets and we should find ways to make cold-blood people more responsible.

b)Quantitative Finance (QF) . Big subject. Nice and easy to blame, but do you know how much has been developed thanks to QF? Up to some extent, QF must not be blamed. But the governance of the whole system. We have all shown a big pedantry. Taking extremes (but they did really exist?), on one extreme side, you had quants that sometimes went too far out in complex developments and making them impenetrable to the management. Their typical attitude: “managers cannot understand what we are doing and what we are developing is a true science. We are the fancy people, the smart guys.” On the other extreme side, we had managers still laughing at maths and saying that this was too complex and incomprehensible and looking at quants like astronauts, like rocket-scientists in their bubble.The problem is that managers had no real issues in making profits by buying or selling these rockets!

We advocate for the use of managerial dashboards, that conduct quant analysis but are able to deliver an aggregated information that is useful for the management to conduct business. Otherwise, it is like managing a nuclear plant and saying “well, we don’t have all the key indicators yet, but let’s start it!” But still, the fault is also on the side of the quants. Why risk management systems have to be so complex? Why couldn’t we have differentiated risk management systems? Huge back/mid-office systems for the analysis of the detailed information of the bank and WYSISWG risk management dashboards that aggregate the information and translate it into knowledge that promotes in depth transparency and business intelligence. We are there to help you in breaking the myth that risk management is for risk quants only. Btw, risk management reports are mainly risk monitoring reports produced for auditors today. Would you assume that auditors are closer to risk quants than managers? We really need to answer: for whom is the damn report? Who should use that information? For which purpose? What are the roles in risk management? Otherwise, just saying that we need to “better manage” alone, will not really help us.

c)Compensation bonuses and management misbehavior. Well. Without much risk, we can say that we all agree that some bonus policies were completely indecent. What’s a “guaranteed bonus” btw? But “guaranteed bonuses” was a well known practice in the market. Again, it is a governance problem. We all knew that these practices existed. Nobody really cared. Now, we blame them. We have to be careful with regulation and with maintaining a market freedom. We can insert some principles, we have to make information about the incentive schemes better disclosed and then allow investors to make the judgment: “Do I want to invest in a firm where the CEO can mismanage, fire 1’000 employees and get for sure a golden parachute?” We have to be careful about what is of the responsibility of the public sector and what should be enforced by the market law. Many problems we have today exist not because of “market problems” but because some people were fooling an asymmetrically-informed market. We should work towards transparency, rather than bonus cap regulations that will surely result new financial-engineering schemes in ultimately in higher costs to everybody

d)Rating agencies. Of course it is amazing to see that some rating agencies were having some problems with their Excel spreadsheets and did not communicate this information during one year (well, the good news is that they are at least using Excel spreadsheets as anyone). But at some stage, we have to ask ourselves if that is a problem of rating agencies or a problem of the system. The system allowed rating agencies to become THE reference. The Basel Accord wanted to increase the sensitivity of managers, their responsibility. Philosophically, we were letting more and more the American way to flow in our system: less based on prevention, more freedom but also more sanction and the identification of the guilty one that will face all the charge in case of problems. Pushing too much responsibility may well produce a deny of responsibility, i.e. you prefer to pay the services of a rating agency and to have somebody to blame in case of, than trying to develop your own internal assessment. So yes, very cynically, we can blame rating agencies … because we were paying them for that.

e)Regulatory arbitrage. Well, there were/are many of them. Hedge funds and rating agencies were somehow part of a regulatory arbitrage. You want to take more risks? Transfer them to a hedge fund. The Basel Accord implementation is a threat? Don’t worry, pay a rating agency and blame it thereafter for rating AAAs’ synthetic vehicles that you knew were not at all comparable with industrial tangible AAAs.

In summary, disclosure of information in an aggregative system that allows a drill-down to the sources of exposures and which allows managers to have an overview on the key risk indicators is paramount. Such a technology requires two levels of systems:

I)A detailed, stable and complete data warehouse system that makes sure the information is entirely available and verified.

II) A managerial dashboard that digest this information and allows the management to have a clear view with drill-down capabilities on the exposures and key-risk indicators.