Capital Markets, Financial Crisis and ‘Diversions’

Sometimes the same word can have different meanings in different languages.  One example is 'diversion'.  In English it means typically a different way.  However, in Spanish 'diversion' means having fun.  I guess that when you take a different way, it can be fun.

Once upon a time, I spent time assessing the efficiency of UK equity markets.  The key idea was that if markets are efficient and there is no manipulation (e.g. information leakage), then we should be able to use the logic of event studies and test that there are no abnormal equity price movements before a corporate announcement.  I moved on, and the initial work was eventually carried out.  It was published by the FSA (here) and as far as I can recall, it made it as far as the front page of the Financial Times! 

I thought that it would be a good diversion from my current activities to read something about capital markets.  I came across an interesting paper on market efficiency published in Institutional Investor (here).  The paper was written in the wake of the award of the 2013 Nobel Prize in Economics to three economists, including Eugene F. Fama and Robert J. Shiller.  What made the award interesting is that it recognises the challenges of assessing efficient markets; Fama pioneered the notion of efficient capital markets and Shiller has challenged it.  (The third Nobel laureate was Lars Peter Hansen who, as I understand it, deserves it for his work on the maths of finance.)

The paper is an interesting tour of many years of research by the authors – applied and academic.  It explains in simple language the ‘joint hypotheses’, i.e. the need to test jointly the assumption of efficient capital markets with an equilibrium pricing model, usually capital asset pricing model (CAPM), and the potential implications, e.g. the market may be efficient but assets may not be priced according to the CAPM

The paper also provides a clear articulation of the challenges to the efficient market hypotheses.  One of the responses is to test alternatives to the CAPM model, e.g. momentum strategies.  One of them is that there are behavioural biases, e.g. investors overreact to both good news and bad news, and capital markets are not efficient.  Overall, the authors come out in favour of efficient markets, ‘at least as the base case’, without committing to a view that markets are ‘perfectly efficient’.  One of the implications of less than perfect efficiency of capital markets is that market arrangements, including regulation, matter to some degree.

In my view, the best point made in the article is the consideration of the link between belief in market efficiency – ‘market fundamentalism’ – and the recent (or ongoing) financial crisis.  As the authors put it, financial crises are not created by someone buying something that he thinks is a fair deal in an efficient market.  Financial crises are created by people that think that markets are inefficient, i.e. an impossibly good deal is available and will continue to be available.   

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Losses Are Not Failures of Risk Management

Well, not necessarily.  But we need to remind ourselves and our stakeholders that that’s really the point.  Losses will happen with certain regularity.  This is the message of a system of a risk appetite system where the limits are calibrated to a 1-in-10 chance over a one-year horizon.   Whether the implications are really appreciated is a different point. 

A paper by Rene Stulz (here) is a good reminder that losses may not represent a failure of risk management.  This is particularly the case where “managers [know] exactly the risks they faced―and they decided to take them.  Therefore there is no sense in which risk management failed”.  He goes on further to say that “deciding whether to take a known risk is not a decision for risk managers.  The decision depends on the risk appetite of an institution.” 

This is consistent with the practitioner’s view as expressed by James Tufts, Group CRO of Guardian Financial Services, expressed in a guest post in this blog: “[T]he objective of the ‘Risk Function’ should not be ‘risk management’.  That’s a business objective.  The objective of the ‘Risk Function’ is to provide the ERM [Enterprise Risk Management] framework and the source of challenge and oversight on all aspects of the business model, relative to this framework.”

There may be risk management failures nevertheless and Stulz’s paper goes on to provide a useful classification:

1. Mismeasurement of known risks  
2. Failure to take risks into account 
3. Failure in communicating the risks to top management 
4. Failure in monitoring risks 
5. Failure in managing risks 
6. Failure to use appropriate risk metrics

I find these categories rather intuitive and I wonder how they can be used in practice.  There is an increasing regulatory expectation of formal assessment of the effectiveness of risk management and these categories could usefully feed into that process in two complementary ways. 

Firstly, banks and insurers track a range of risk events/incidents.  It would be useful to consider if reported incidents fall into any of the above categories.  Alternatively they may be consistent with risk appetite.

Secondly, insurers and banks using an internal model are expected to use it to support a profit and loss attribution.  This means explaining actual profits and losses by reference to the output of the internal model and the risk categories considered.  It would be interesting to consider if the losses arise from changes in values consistent with risk appetite or any of the reasons set out above. 

The above might seem a simple idea but learning from failures, or risk management failures in this case, is usually anything but a simple idea.

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Financial Regulation: (first) Overview of 2013

An interesting overview of 2013 from the perspective of financial regulation with a banking / trading flavour is here.  For me, the top two highlights were that:

• regulatory fines were getting bigger and their target smaller;
• regulators started to get serious about data.

I'd be interested to hear what are your top two for 2013 from that list or your own.