Do Not Read This !

Granted, nowadays 'everyone' talks about tail risk management, particularly in the financial community. But usually it is in the context of investment portfolios with the proposal of tail risk hedging strategies using derivatives or other financial instruments. However the core of tail risk management is not about buying certain financial instruments that would (perhaps) shield as an investor from extreme negative market price corrections, but rather about modifying the current risk management frameworks as well as the underlying corporate risk aware culture and even the business strategy/ model.

Despite recent regulatory action plans but forward by the Basel Committee, we are still running the risk of “wasting a good crisis”. We have already paid too high of a price to neglect the importance of tail risk management. While regulators focus on macro-prudential instruments for battling the symptoms of the crisis, the real cause remains unaddressed. Implementation of the robust tail risk management practice is paramount to the successful survival not only of a single firm but also for stability of the entire financial sector. In a different blog I will defend the case for a tail risk management framework for the manufacturing and corporate world.

Close to seven years after the start of the Global Financial Crisis (Summer 2007), which effectively opened the floodgate of the current financial meltdown. Have we learnt our lesson? I recently read an interesting article in Risk Jounral (Summer 2012), and wanted to shed some light on some of the main conclusions.

Obviously much research has been conducted about the symptoms of the 2008 financial crisis, but insufficiently about the causes of the crisis. And, contrary to popular beliefs, the crisis was caused by ineffective management of tail risks by so-called ‘too big to fail financial institutions’, and thus not by model risks, greed or globalization. Why model risk is definitely an area of discussion, financial risk models should always be seen solely as one of the tools for guiding risk management, and not as THE decision-making risk tool.

Consequently, despite the new changes been championed by regulators, their regulatory action plans may not prevent future meltdowns in the financial system unless the fundamental reasons for the crisis are properly addressed. That’s why we will focus in particular on the special nature of tail risk versus normal risk and the key lines of defense available to companies to effectively mitigate and manage tail risk crisis.

Research academics, financial professionals, regulators, politicians, as well as journalists wrote hundreds of articles about the Global Financial Crisis. The list of “evils” is still growing and embraces many things starting from risk models to globalization and bankers’ greed. But why actually did the crisis happen?

The fundamental cause was the accumulation of huge amounts of tail risks by the financial sector, leaving it unprepared to effectively mitigate its impact when the tail risk event struck. As a result, and according to the International Monetary Fund (IMF) total bank writedowns and provisions skyrocketed to stunning $2.2 trillion. Banking regulators have already provided their response to challenges revealed by the crisis (ie Basel III). Among other regulatory changes, there are three “silver bullets” in the regulatory action plan: higher capital requirements, new liquidity rules and mandated leverage.

While these measures look reasonable, the question remains: will their implementation enhance the banks’ ability to identify tail risk and reduce unexpected losses if a tail risk event unfolds? Probably not! While the mandated leverage appears to be a non-risk related old-fashion safeguard that came from the pre-BASEL era, capital and liquidity requirements are nothing more than “an air bag”. Indeed, capital, for example, is a financial buffer which answers the question as to who is responsible for taking the future losses: shareholders or the taxpayers and creditors. In addition, new regulation comes at substantial costs that will result in, among other downsides, limiting the banks’ ability to provide funds to support economic growth and in the reduction of the banking sector’s competitiveness on the global landscape.

By steering towards the creation of a stronger loss absorption capability and higher liquidity, regulators do not addressed the cause of “the fundamental risk management failure” and focus on the symptoms of the crisis. The danger is that by the time the industry completes the Basel III implementation in 2018, it will only be fully prepared for the 2008 crisis. This will hardly be adequate nor sufficient for changes that would have developed in that time.

The solution, we believe, is in the creation of a true tail risk aware culture as well as a dedicated risk management framework, which would not target a particular crisis scenario. It should ensure that tail risk is proactively identified and effectively mitigated regardless of what the crisis scenario. Conventional risk management practice does not differentiate tail risk from “normal” risk. But tail risk (low probability – extreme severity events) has a very different nature, drivers and the magnitude of its impacts. This is why a separate approach for tail risk is required. “One size fits all” does not work here. The traditional risk management framework was build to deal with normal risk and often failed to provide an effective response when a tail risk event unfolds. That is because unlike “normal” risk, tail risk often comes unmeasured, unpredicted and stems from the “unknown unknowns”. Therefore, in addition to the existing risk management framework, it is essential to have a purpose-build tail risk management architecture, which should include three lines of anti-tail risk defense.

The first line should focus on a firm’s business model & strategy. The analysis of bank failures suggests that flawed business strategy appears to be the prime cause of fiascos. It is necessary to set up an approach to examine firms’ strategies and to “diagnose” the areas outside firm’s “comfort zone” where the company is exposed to extreme unmanageable risk, such as a liquidity crisis whereby the interbank market shuts down. In order to optimize the strategy, risk appetite should be set correctly, not merely on the assets side but also on the liabilities side of the balance sheet as well as looking at the off balance sheet commitments (for example derivatives and the impact of margin calls on collateral management and liquidity). The key role of risk appetite is to optimize a firm’s exposure to tail risk by striking the right balance between businesses that the firm is going to run inside and outside its “comfort zone”.

The second line of defense is the day-to-day risk management practice to identify any potential tail risk events when they are largely invisible or look like a remote threat. The firm should create early warning system/ signal tools focusing on tail risk. Another principal way is scenario and stress testing. There is no novelty in using stress testing, but stress testing of tail risk scenarios is special. Traditional number crunching does not work here. Instead, the focus is on the thinking process around “what if” and detailed contingency planning. If scenario testing is done properly, it becomes a sort of a “flight simulator” for training people to manage tail risk, and provide a riks-benefit analysis to senior management. Even very conservative firms are not immune to tail risk crises.

And finally the last line of defense is built to mitigate the impact if such a crisis occurs. The skills of driving through the crisis to large extent determine the ability of a firm to survive the crisis. The robust tail risk crisis mitigation framework should include effective crisis alerts, multi-level contingency plans, adoptive for tail risk needs IT infrastructure and reporting, effective crisis governance, and proactive communication approach. Hence the importance of both operational risk as well as enterprise risk management.