A Risk Professional's Survival Guide. Rossi Clifford

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up to the financial crisis of 2008–2009 was characterized by robust economic growth, relatively relaxed regulatory oversight, and fierce competition among financial institutions. This environment influenced corporate attitudes and perspectives on risk-taking and risk management. With markets and assets performing relatively well during the period, risk outcomes in the form of credit losses and other measures of risk performance were unusually low. Coupled with strong competitive conditions, risk management took on a secondary role to growth and financial performance prime directives. In such an environment, the risk manager faces significant headwinds in outlining a case for maintaining risk discipline when historical measures of risk are low and competition is high. Consider a risk manager’s situation in 2005 in establishing a view of mortgage credit risk for X Bank. As shown in Figure 2.2, home prices in the years leading up to 2005 had shown remarkable appreciation at the national level with most markets performing well above the long-term average. Armed with a formidable array of quantitative analytics to estimate expected and unexpected credit losses on the bank’s portfolio, the data would suggest that such a strong housing market would lead to low credit losses for the portfolio. Management during such periods can be biased against activities that will raise costs or impede business objectives, as reviewed in more detail in Chapter 3. While a strong risk culture and governance process can significantly mitigate management tendencies to marginalize risk departments, the risk management team must remain vigilant in the performance of its core activities and in regular and objective assessment of future performance. During such times, pressures to accede to business objectives rise, placing countervailing motivations on the risk manager that can influence his interpretation of risk-taking and prospective risk outcomes. Once the crisis began, as unprecedented risks emerged and many financial institutions failed, external conditions promoted a very different climate for risk management, where regulatory oversight of the financial industry stiffened and banks retrenched in an effort to stave off financial collapse as their capital deteriorated under the mounting pressures of large credit losses. In such an environment, greater focus on risk management, in part out of regulatory and financial necessity, becomes of paramount importance. Such vastly different internal and external conditions may introduce a set of tendencies for management, regulators, and risk managers to overreact. In such circumstances, underwriting standards may tighten to abnormal levels, resulting in a procyclical response that exacerbates the market downturn. Risk managers can seize this moment to strengthen not only the firm’s risk infrastructure but to shore up any deficiencies in governance and culture that may have been lacking previously.

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      1

      A nonbank financial company engages in financial services activities but is not a regulated depository institution such as a commercial bank, thrift or credit union. An insurance company or hedge fund would be examples of nonbank institutions.

      2

      A constant elasticity of substitution production function exhibits the property that production is a function of a constant relati

1

A nonbank financial company engages in financial services activities but is not a regulated depository institution such as a commercial bank, thrift or credit union. An insurance company or hedge fund would be examples of nonbank institutions.

2

A constant elasticity of substitution production function exhibits the property that production is a function of a constant relationship between the substitutability between factor inputs such as retail deposits and personnel.

3

Brokered deposits are a form of wholesale deposit that banks may use to augment their retail branch generated deposit base. They may be purchased in markets from brokers that buy and package these deposits from other institutions.

4

Lagrange multipliers are used in some types of constrained optimization problems where closed form solutions may be difficult to otherwise obtain.

5

The concept of risk-neutrality is a fundamental concept in financial theory and its treatment in detail is beyond the scope of this book. However, a risk-neutral investor is indifferent between accepting a risky payoff and one that is 100 percent certain to occur.

6

A finance company is a type of nondepository institution, a firm that does not rely on deposit-gathering activities like a traditional bank and instead is dependent upon capital market financing.

7

There are times when SifiBank takes an offsetting position in order to meet a client’s needs when a suitable buyer or seller is not available at that time, however, this tends to be for a very short period of time until it can unwind that position.

8

A repurchase agreement, or repo, is a sale of securities (such as Treasury instruments) typically over a short window of time (e.g., overnight). The seller buys back the securities at the end of the contractual period and in this manner the seller is in a borrowing position. A reverse repo looks at the repo transaction from the perspective of the buyer of the securities and puts them in an effective lending position.

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