Risk Management

In finance, it’s the best of times, it’s the worst of times

It is a special moment to start a career in financial services. We are walking amid the ruins of the previous financial order. Fallen banks, broken markets, negative interest rates, shell-shocked economies and discredited theoretical assumptions. We see the enormous cost and impact to the welfare of society of a less than perfect financial system which has not kept pace with the advancement of our general knowledge and technical capabilities in most other domains.

Open Risk White Paper 7: Risk Capital for Non-Performing Loans

We develop a conceptual framework for risk capital calculation for portfolios of non-performing loans. In general banking practice, loans that pass a threshold of delinquency are declared non-performing and are provisioned. Yet there is a residual risk that the provisioning is not sufficient. This risk must be covered by capital buffers. The literature for risk capital requirements for NPL portfolios is very limited, which implies that Stress Testing and Internal Capital Adequacy Assessment (ICAAP) requirements for non-performing loans are harder to meet. Our framework builds on tools used in portfolio credit risk modeling and provides a structured approach to address the risk profile that is specific to non-performing loans.

A stress testing methodology for analyzing FX lending risk. Extends standard credit risk modelling tools to capture the increased risks of FX lending in a consistent way

Open Risk White Paper 6: Stress Testing Methodology for FX Lending

We develop a simple methodology for stress testing portfolios of credit instruments classified as foreign exchange lending. Loans whose repayment schedule is denominated in a currency other than that of the borrower’s domestic currency are commonly seen in many jurisdictions and have a risk profile that is considerably more complicated than domestic currency loans. Yet the literature for credit risk assessment and stress testing of portfolios of such loans is very limited, which means that Stress Testing and Internal Capital Adequacy Assessment (ICAAP) requirements are harder to meet. Our methodology builds on existing standard tools used in portfolio credit risk modeling and enables obtaining insights into the additional risk factors embedded in foreign currency lending.

Business Model Risk - The Forgotten Risk Type

Sustainable business models that demonstrate adequate profitability over long horizons are key to a healthy market economy. This applies to firms and organizations of any size and in any sector. But how do we determine what is sustainable and how can we tell a risky business structure from a stable one?

Open Risk White Paper 5: Identification Framework for Business Model Risks

We develop an analytical framework for the systematic identification of business model risks. The framework utilizes as a starting point a simplified business model schema known as the Business Model Canvas. We review each one of the elements of the schema in turn, identifying the main risk characteristics associated with each.

Financial services jobs continue being decimated. A recent (as of the initial post date) FT article was a sobering summary of the continuing transformation of the financial sector: 2015 alone has seen more than 10% reduction of the total workforce across large EU/US banks:

Presentation at TopQuants 2015: Open Risk API

Improved financial risk management through open data, open source and web technologies is a Presentation given at the TopQuants/DNB Autumn Meeting, Amsterdam, Nov 18, 2015.

Back-to-basics is not salvation

It has become trendy since the financial crisis to be wearing an anti-complexity hat in matters concerning the shape of the financial system. This is an understandable reaction to the entangled constructions that had sprung to existence in the hyper-leveraged markets of the naughty noughts.

Open Risk White Paper 4: Open Risk Model Taxonomy

We develop a taxonomy for risk models that aims to support an open source risk models framework. The proposal builds on and extends some commonly used risk taxonomies within financial services firms but introduces some significant new elements. We first review the motivation for risk taxonomies, the concepts and tools that are involved and some weaknesses of current schemes. We try also to clarify the link between risk models and risk taxonomies.

Talk of unbundling the banks is all the rage these days (if we believe the chatter coming from fintech startups). Yet upon closer inspection one gets the feeling that these optimistic people might not necessarily know exactly what they are trying to unbundle, the true complexity of a medium-to-large bank, which in turn reflects, at least in part, the complexity of our modern Financial System .

Open source software is all the rage those days in IT and the concept is making rapid inroads in all parts of the enterprise. An earlier comprehensive survey by Gartner, Inc. found that by 2011 more than half of organizations surveyed had adopted open-source software (OSS) solutions as part of their IT strategy. This percentage may have currently exceeded the 75% mark according to open source advisory firms.

Open Risk White Paper 3: Introducing the Open Risk API

We develop a proposal for an open source application programming interface (API) that allows for the distributed development, deployment and use of financial risk models. The proposal aims to explore the following key question: how to integrate in a robust and trustworthy manner diverse risk modeling and risk data resources, contributed by multiple authors, using different technologies, and which very likely will evolve over time.

Open Risk White Paper 2: Confidence Capital: The Principle

We review the structure of economic capital frameworks commonly used within financial institutions and identify why the derived capital metrics do not explicitly address the needs for maintaining ongoing confidence on the soundness of the firm. In the follow-up to the financial crisis the need for more explicit such tests has been highlighted by regulatory stress testing methodologies.

You know the periodic table of elements, even if you flunked your science courses! It is the large colorful and blocky table that hanged on every school’s classrooms before becoming yet another mobile app. The periodic table is one of the early and iconic achievements of science. It lists all the pure chemical elements found in nature, the building blocks of all possible material substances. Each block contains a set of numbers that unambiguously characterizes each element and a single or two letter abbreviation for each: H for Hydrogen, He for Helium and so forth, going on for over a hundred different elements. When the periodic table was discovered by Mendeleev (apparently in his dream!) it was an extraordinary realization that the physical world has an underlying order at the microscopic level. In his own words:

Open Risk White Paper 1: Revisiting Simple Concentration Indexes

We review the definitions of widely used concentration metrics such as the concentration ratio, the HHI index and the Gini and clarify their meaning and relationships. This new analytic framework helps clarify the apparent arbitrariness of simple concentration indexes and brings to the fore the underlying unifying concept behind these metrics, thereby enabling their more informed use in portfolio and risk management applications. We also propose that the sensitivity of concentration indexes to growing concentration should be a defining criterion for adopting an index and explore the sensitivity of common indexes to changing portfolio concentrations. We show that this sensitivity can vary significantly between indexes for parametric families of portfolio distributions and hence selecting and using a simple concentration index should take this aspect carefully into consideration

Securitisation versus Banking

The ever elusive CMU dream

There is(/was) renewed interest in EU-land over deepening a capital markets union, aka CMU. It is among the initiatives being pursued by the Commission in order to help accelerate growth in the European Union.

The initiative encompasses many elements, both around equity (shares) and debt markets. One important pillar of the CMU aims to re-launch some version of an EU securitisation market. This segment was never really defined in a EU-wide basis. In the pre-crisis European financial landscape there were wide disparities in the degree of adoption, legal frameworks, preferred structures etc. among the different countries comprising the EU. In any case, since the financial crisis there has been a steady decline in securitisation volumes, which amongst others, hinders certain types of exceptional central bank measures (i.e., purchasing securitised assets).

A mini course on risk management, its perils and the silver lining

When talking about risk management, it is not very clear what we are talking about in broad terms, definitely not getting clearer when we start getting into the details and it is even not clear how to best use the (possibly flawed) insights we produce.

We are happy to publish the first installment of a trilogy that focuses on the risk factors that can turn any credit portfolio toxic.

The first topic is default correlation, a topic that is both core to understanding credit risk and much misunderstood.

Enjoy!