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

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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

ctapiero@poly.edu 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

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

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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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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 Financial Implications

Flight from risks Insurance-finance primes, insurance firms become market maker, banks are marketers, with an increased counterparty risks

Global and competitive multi-polar financial markets

Financial instability, dollar sub-primed, political conflicts

IT finance risks Moral hazard, financial individuation, financial litigation, inefficient regulations

Complete markets dogma threatened, complex credit and financial products innovation, default models.

Regulation, moral hazard, liquidity supply challenges, Mispricing, regulation, OTC, 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 Risk Types

Ex-Ante Personal, corporate 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 Nash-

type 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.

4 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 market-

specific 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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