Jan 3, 2009

Risk taking and financial reward: a Q&A session with a banker

Many observers believe that "excessive risk taking" is the main culprit behind the genesis of the current crisis. In this nice column Mark Thoma neatly summarizes the models proposed to explain why "excessive" risk taking may emerge in financial decisions. Let me briefly re-summarize them in light of the current crisis.

Under the first model of "Risk Misperception", a whole set of players, rating agencies, risk analyst, investors, all committed the same mistake: they all thought that as house prices were going up, they would have continued to do so.

Under the second model of "Risk Misrepresentation", some players may have acted with fraud: they sold an atomic bomb by labelling it a nice firework. This may have to do with the sophistication and opacity of the financial instruments involved: difficult to handcraft them, but easy to sell them to some hungry investors as "safe".

Under the third model of "Risk misallocation", moral hazard comes into play, in two possible ways. Either government intervention has allocated risk from the private to the public sector, or some agents have had high incentive to take excessive risks since they could easily passed them to a "principal". Here, the example of the mortgage broker selling risky loans is paramount.

There are good reasons to believe that all of the above happened. There is academic evidence about excessive risk taking induced by the first model (Gerardi et al. 2008), and mainly anecdotal evidence about the second and the third. It is important to assess what is the right view to inform the policy making process. I like to stress that, risk is an intrinsic component of a capitalist system, and crisis just a consequence of it. Policy reforms should not be then about how to avoid crisis, but maybe on how to reduce their impact and their consequences.

In this Q&A session I ask a banker, who prefers to remain anonymous, to offer a perspective on the topic.

Q. It's not entirely clear to me why risk taking may be excessive. A risk should be without metric: something is risky or not. An investment strategy is risky or safe. Do you share the same view? Do you think risk can be properly assessed?

A. I do not share this view. VaR is considered as the classic way to asses riskiness of an investments and it's very commonly used within a bank and between investors.
Regulatory agencies very often require stricter Stress Tests to be applied to investments.
Obviously the obscure side of this approach stays with the assumptions: I think very few investors analyze in details the multiple assumptions underlying a risk assessing model.

Q. Do you, within a bank, hold some risk benchmark, or is it entirely up to you to set them up?

A.The benchmark is at the basis of every investment. The bank considers various alternatives benchmark for every financial positions it assumes as "principal" and proposes them to its own clients.

Q. Loosely speaking, is risk sensitivity determined by a bank's culture?

A.I do not have experience with different banks but I guess that each bank's culture can affect the risk sensitivity.More pressure on short term budget targets can encourage an easier risk taking approach if the bank is lacking of a well integrated system of risk management

Q. How many times did u perceive risk was excessive in your business?

A. Almost never until March 2007, when the financial world started to look too perfect (growing global markets together with implied volatilities at historical lows across asset classes). I can remember at that date a few experts starting to propose the crucial question: where is the risk being hidden?
The question was taken seriously, but I think nobody (either academic or practitioners) have been able to propose an exhaustive answer yet.

Q. And people around you, did they ever look worried about the riskiness of the investment products they were selling?

A. I can easily remember more than one occasion, when a product was re-engineered with more conservative features or not sold after some analysis had shown an excessive risky profile or exposure to risky markets. Investment banks are very cautious in terms of reputational risk: selling a defaulting product or being involved in a financial scandal can be lethal for the ability to run on going business for each well known bank.

Q. Do you or any of your colleague "saw the crisis coming?"

A. A financial crises stays with a successful banker as a cancer stays with an healthy person. Every successful banker would like to avoid seeing a coming crises.
When the crisis was clear, the natural reaction was to minimize it. At the beginning of each quarter I heard many managers saying: this will be over in 3 months. Whoever disagreed with this view could have been considered as a looser black bird.

Q. What in your view contributed to this financial collapse? Do you think there is something missing in the picture delineated above?

A. I would like to mention one more element contributing to the diffusion of the current crisis: the mental framework in accordance with which we can look at the past to well forecast the future and that -at its most trivial level- can be summarized in the sentence "but this never happened".
This framework is at the basis of the back testing methodology, which is very spread between investors.
A distortion of this framework is realized when back testing and investment engineering invert their logical role: the investment features are defined to best fit the back test. This can actually produce a leveraged effect on any unpredicted event.

Q. Do you think monetary policy played a role in triggering the crisis?

A. This is what a lot of experts seem to agree with. if this is true I just wander what can actually happen in the next few years consequently to the evidence that US rates have been moved to zero...I think new distortions will come out very soon. There are still ppl having money out there, in the Street.

Q. Do you think more transparency in the banking sector will make a difference, or the financial markets are too clever for that?

A. Financial practitioners spend most of their time thinking about the best way to the "cheat" the regulatory framework. Everybody agrees that the ratings system finally ended up producing a leverage to the crises. But this simply means that the regulatory agencies and policy makers need an extra effort to gain more transparency in the banking system, which should be considered as a fundamental condition for efficient financial markets.

Q. Do you think "squeeze banks profits" and bankers salaries is the right approach for reforms?

A. The fact that a very competitive sector as the financial one is able to make such big profits and pay such big bonus is just a clear sign that either strong inefficiency or massive risks are in place. But big profits are just a symptom of the unhealthy situation and the regulatory system should take care of the causes and not of the symptoms.


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