Risk-ManagementHard

3 min read · 552 words

What the seat actually does

Somebody has to say how much the firm could lose, under what circumstances, and what it is therefore allowed to hold. That is this seat. It sits beside the desks rather than on them, it does not take positions, and it is one of the few places in a bank empowered to say no.

The output is a limit, not an opinion. A risk function that only produces reports is a reporting function; what makes it risk management is that a number it publishes constrains what somebody else may do. Everything else — the models, the stress tests, the committee papers — exists to make that constraint defensible.

• Market risk — what a position loses when prices move. See risk measures.
• Credit and counterparty risk — what is lost when somebody does not pay, including a derivative counterparty.
• Liquidity risk — being unable to fund or to exit, which is how most failures actually happen.
• Model risk — the risk that the number itself is wrong, which is a discipline of its own.

A day, and where it goes

• Limits. Who is close to one, who is through one, and what happens next.
• The overnight numbers — exposures, sensitivities, and anything that moved more than it should have.
• Backtesting, which is the model being marked against reality rather than against itself.
• New business — a trade or a product nobody has priced the risk of before, which is where the seat earns its place.

What it is measured on

• Losses inside the range that was declared. Being wrong is tolerable; being surprised is the failure.
• Backtest exceptions — how often the day's loss exceeded what the model said it would.
• Whether limits held, and whether breaches were escalated rather than negotiated away.
• Coverage. The risk that was never measured is the one that decides the outcome.

What it touches on this site

• The measures — risk measures and volatility.
• Which risk decides — the five families, one profile per instrument, which is this seat's question asked of the whole shelf.
• The other side — if the other side fails and margin and collateral.
• When it goes wrong — 1998, 2021 and 1995, which are three different failures of the same function.

How it goes wrong

• Measuring the risk that is easy to measure. Market risk has a number; liquidity and operational risk mostly do not, and they are what kills firms.
• A model calibrated on a calm decade, then used to size positions in a different one.
• Correlation assumed to hold. Diversification measured in normal markets is the first thing to disappear in abnormal ones.
• Being organisationally weaker than the revenue. A limit that can be argued away in a good year is not a limit.

Concepts to master

• A risk measure is a statement about a distribution, and it is silent about everything past its own confidence level.
• Leverage turns a survivable move into a terminal one — see leverage.
• Liquidity is the risk that turns others fatal: the loss that cannot be exited is the one that compounds. See liquidity.
• The exposure is what it becomes, not what it is. A derivative's counterparty risk grows with the market that made it profitable.