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Should Majority Pay For the Mistakes of Minority

Should Majority Pay For the Mistakes of Minority. Jerome Yen Department of Systems Engineering and Engineering Management Chinese University of Hong Kong. Contents. What is Risk Management and famous cases in Risk Management?

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Should Majority Pay For the Mistakes of Minority

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  1. Should Majority Pay For the Mistakes of Minority Jerome Yen Department of Systems Engineering and Engineering Management Chinese University of Hong Kong

  2. Contents • What is Risk Management and famous cases in Risk Management? • Basel II and potential impacts to the banking and financial industry • Risks faced by airline industry • Apply game theory to the decision making in airline security. • Discussion

  3. What is risk management? Every company operates in an environment of uncertainty, and as such is exposed to many risks which influence its value and day to day running. The correct management of these risks has in recent years become the main focus of interest in the finance world. Active and precise risk management will significantly reduce damages caused to the company by unexpected market events. There are three types of risk: - Market risk - Credit risk - Operating risk

  4. Market risk Market risk is the risk of change in the value of the company due to changes in market prices. The main market risks are: - currency risk - interest risk - equity risk - production costs risk - liquidity risk.

  5. Currency risk Currency risk is the risk deriving from unexpected changes in exchange rates. This risk arises when cash flow in a certain currency is not balanced, i.e. when the company holds an open position between currencies. Due to the nature of export and import activity, importers are exposed to the risk of the depreciation of the local currency and exporters are exposed to the risk of the appreciation of the same. This exposure arises due to open positions on currency futures, which expose the importer (or exporter) to movements of the exchange rate in the ‘wrong’ direction.

  6. Interest Risk Interest risk is the risk deriving from changes in the interest rate. Non-correlation of the maturities of the company’s assets and liabilities will expose the company to interest risk. For example, if a company takes credit at a 3 year fixed rate of interest in order to finance a 6 year project, the company will be exposed to changes in the rate of interest in three years’ time, at the time of the renewal of the financing of the debt. This risk is very common mainly among the larger banks or among companies with complex and long term cash flows which include extensive creditory and debitory transactions.

  7. Equity Risk Equity risk is the risk deriving from changes in the prices of equities. This risk comprises the risk of the company itself (a risk which is not given to diversification) and the risk inherent in the business dealings of the company (a risk which is given to diversification). This risk is extant mainly in companies which manage portfolios with significant exposure to equity markets.

  8. Production/Operation costs Risk Production/Operation costs risk is the risk deriving from changes in the costs of production or operation. This risk is extant in companies which purchase large quantities of raw materials in order to maintain their day to day running. An unexpected change in the price of these materials can cause significant damage to these companies.

  9. Liquidity Risk It is common to find liquidity risk included within the category of market risk, even though this risk is not directly connected to changes in prices. Liquidity risk comprises market liquidity risk and cash flow risk. Market liquidity risk occurs when it is impossible to carry out a transaction at market value due to poor levels of trading in the markets. Cash flow risk is the risk that a company may not be able to pay its debts as a result of the illiquidity of company funds. For example, if a supplier is depending on payment from a client in one week’s time in order to return a loan, he will be subject to a cash flow risk.

  10. Credit Risk Credit risk is the risk of financial loss deriving from the inability of the counter party in a transaction to pay his debt. This risk is clearly extant in the case of a lender in credit transactions, but also in any transaction where there is an element of transfer of receipts (options, swaps, forwards) and also in the purchase of bonds. For example, in the Argentina crisis in 2002, government encountered difficulties in paying its debt to the holders of its government bonds. This was credit risk at its best. In the last few years, many models have been developed which attempt to quantify credit risk in monetary terms. These models are based on micro and macro economic assessments and also on the creditworthiness of the creditor.

  11. Operational Risk Operational risk is the risk of suffering financial loss as a result of human or organizational error, incorrect use of a model, the occurrence of a natural disaster or a terror strike, or any event whose source is not within the financial world. It is customary to define operational risk as an aggregate of all the risks which are not related to either market or credit risk. For example, the losses caused to many companies in the USA and the world in the wake of the wave of terror following the 11th of September attacks.

  12. Actively managing Risk The last couple of decades has seen the development of the field of risk management principally among the banks and insurance companies, but other companies have also more recently joined the field. The main factors which have led to the increase of risk exposure among many companies, and thus caused the rapid development of the field of risk management are: globalization, the greater correlations between risk factors, the increase in the use of “linked” derivatives, and the increase in the size of transactions. In recent years, many companies have been brought to bankruptcy or caused substantial damage due to their lack of a secure risk management policy, or worse, because of an incorrect risk management policy. Following are several examples in which large companies were bankrupted due to incorrect risk management policies.

  13. LTCM : an example of liquidity risk LTCM was a fund management company which was founded by leading American economists, specializing in Hedge funds. They invested huge sums at what was apparently low risk because they had backed all the transactions with matching derivatives. However, because of the nature of the long term investments and the high leverage accumulated, the company found itself unable to meet its short term liabilities. Despite the fact that their long-term credit was satisfactory, the large banks which provided cover for the company refused to help them out on the short-term debt. The company was forced to declare bankruptcy and was rebought by the banks.

  14. BARINGS: an example of operational risk In 1993, a dealer named Nick Leeson traded in arbitrage transactions on futures contracts on the NIKKEI in Singapore and Osaka, on behalf on Barings Investment Bank. Nick Leeson was in charge of both carrying out the transactions and also recording them in the bank’s records. This overlapping of roles allowed misrepresentation of the facts by the dealer and caused very significant losses to the company. The absence of any monitoring allowed the broker to accumulate high levels of leverage on the bank’s capital account. At first this method was successful and brought the bank huge earnings, during which time no one bothered to check the cause of such success, but in the wake of the dramatic fall of the NIKKEI, the dealer suffered huge losses and as a result the bank was forced to declare bankruptcy.

  15. Metallgesellschaft : an example of production costs/ basic risk In 1993, a company named MG (Metallgesellschaft) entered into a contract with her clients for the supply of gas for 10 years. The company covered itself by the back-to-back purchase of short term futures contracts on gas, and planned to rollover the transactions from period to period for the entire 10 years, instead of protecting itself in advance for the entire period. By doing so, the company exposed itself to ‘basic risk’, in other words that the short term prices of the commodity would shift away from the long-term prices. At the end of 1993 the short-term price of petrol plummeted and MG lost around 1.3 billion dollars as a result of faulty risk management. Can Basel II New Economic Accord help the financial industry overcome some of such problems?

  16. －源自信用, 市場和操作 2001 9.11 Enron …… 巴塞爾資本協議介紹 危機

  17. －缺乏監管之下的驚人增長 巴塞爾資本協議介紹 表外業務 • BIS三月份統計資料顯示，全球每日平均衍生交易量為$1.4萬億，比三年前的調查結果增加10%。 • 交易品種增加，如天氣期權、天氣調期等。 • 風險的增長，必須加強監管。 • Barings事件：200多年的銀行毀於30,000張衍生交易合同。

  18. 1974年，Merton第一次引入模型的概念。 風險領域一次重大變革。 BIS 1996年第一次允許銀行使用模型為市場風險計算資本。 Credit Suisse －CreditRisk+ J.P. Morgan－CreditMetrics KMV Corporation－Credit Monitor －不斷發展的定量化模型 巴塞爾資本協議介紹 風險管理手段

  19. 風險管理的新概念 巴塞爾資本協議介紹 • PD －違約率 • LGD－違約損失率 • EAD－違約暴露 • EL －可預見損失 • UL －不可預見損失 • VAR－風險值 • RAROC－風險調整資本回報率 • EVA－經濟附加值

  20. 巴塞爾資本協議介紹 衡量風險名詞 違約率(POD, Probability of Default) 違約的可能性（或概率），一般為某類（或級）的貸款有一個平均的違約率，與宏觀經濟環境及借款人有關 風險暴露(EAD, Exposure at Default) 發生違約時的風額金額，銀行帳上為違約貸款金額扣除特殊準備金後的金額 違約損失率(LGD, Loss Given Default) 經催收後，最後損失額與催收費用總和與違約貸款帳面額之比， 與貸款本身有關

  21. 巴塞爾資本協議介紹 衡量風險名詞 可預見損失(EL, Expected Loss) 未來發生損失的預期值， EL = EAD x POD x LGD 不可預見損失(UL, Unexpected Loss) 衡量違約損失波動性的大小，偏離可預見損失的最大損失，根據不同的置信區間而變化 授信風險值(CVaR, Credit Value at Risk) 在一定置信區間及時間區間內的最大損失 風險調整資本回報率(RAROC, Risk Adjusted Return on Capital) 指按風險對收益進行調整

  22. 巴塞爾資本協議介紹 資本協議or 風險協議 • 將監管資本與銀行內在的風險更加緊密地聯系起來 • 不同方法對經濟資本的不同要求，激勵銀行不斷採用更加敏感的風險衡量方法，從而達到不斷提高銀行業風險衡量與管理水平之目的 銀行潛在風險 主要風險 操作性風險 信貸風險 法律 合規 市場風險 流動性風險 信息處理 稅務 安全 ---- 利率風險 信譽風險

  23. 巴塞爾資本協議介紹 回顧 • 不斷加劇的競爭使得銀行資本比率降到危險的水平。 • 資本作為銀行吸收損失的緩衝， 1988年7月G10國家的中央銀行規定，銀行資本必須達到風險資產的8%。其中，一級資本必須達到4%。 • 90年代，協議逐步被全世界銀行界所接受，100多個國家採用 • 但問題越來越多： • 監管資本≠經濟資本，因為銀行識別與衡量或管理風險能力不斷提高； • 監管套利； • 對押品、擔保及信用風險緩衝工具的漠視

  24. 巴塞爾資本協議介紹 新協議 舊協議 • 通過將資本與銀行的主要風險更加緊密地聯繫起來，提高銀行風險衡量與管理的水平 • 通過提高銀行資本水平，從而提高銀行抵禦風險能力 • 3個支柱代替了單一比率 • 只局限於資本比率 • 對所有銀行採用一個風險衡量方法 • 更靈活、更多樣的方法，驅使銀行提高風險管理水平 • 信用風險＋市場風險＋操作風險 • 信用風險＋市場風險 • 應用於銀行集團層面 • 應用於銀行 • 資本定義未變 • 資本比率為風險資產的8%未變

  25. 1988年7月 1992年年底 …… 1999年6月 2000年 2001年1月 2001年4月 2002年10月 2003年4~6月 2003年10~12月 2006年年底 舊協議正式實施 實施的最後期限 …… 新協議第一次徵循意見稿 第一次定量影響分析 新協議第二次徵詢意見稿 第二次定量影響分析 第三次定量影響分析 新協議第三次徵循意見稿 新協議正式出檯並開始實施 實施的最後期限 巴塞爾資本協議介紹 事件與時間表

  26. 資本充足率 = (信用風險, 市場風險, 操作風險) 第一支柱：最低資本要求 市場風險 巴塞爾協議對市場風險規定的演變 1995年4月 對市場風險提取資本準備發表征詢文件 • 1996年1月 • 修訂協議內容，正式加入市場風險部分 • 要求對市場風險提取資本準備，与信貸風險的原則要求一致 • 交易帳中的所有項目須以市場價格為標準 • 容計許授採用標準法或內部模型評級法 • 提供衡量市場風險的方法 1997年9月 對採用內部模型評級法所提取的特定資本準備，不能低於採用標準法所提取之50%的限制取消。 体現銀行建立內部模型的發展趨勢。 2001年1月

  27. 如何落實新資本協議的要求 授信風險管理概念框架 信貸風險識別 授信風險監督/控制 信貸風險衡量 讓管理層更有效地監控及改善貸款表現 使用統一標準及根據巴塞爾新資本協議定義來描述及比較所有中銀授信風險 使用統一標準來提供風險因素以作風險衡量 • 評級/評分 • 主觀判斷模型 • 經驗數據模型 • 暴露 • 違約概率(POD)/給定違約損失(LGD) • 可預見之損失(EL) • 不可預見之損失(UL) • 壓力測試/方案分析 • 授信風險值(CVaR) • 授信資本平衡回報率(RAROC) • 報表 • 限額之設置及監控 • 管理工具在作放貸決定上之使用 以上監控方式需與授信流程配合 • 風險資料/歷史 • 風險因素 • 風險組合 • 集團客戶及風險域 • 產品分類 • 行業分類 • 地區分類 • 國家主權分類 • 貨幣分類

  28. Bank Overall • Best-in class standard for risk management • Positive assessment from regulators, rating agencies, insurers: (Basel compliance) • Achievable strategies • BU Management • Efficient control environment (RAROC) • Lower capital charge • Group Risk Management • Enterprise wide control over risk management • Policies and tools to be able to facilitate and support BU’s and OU’s • Transparent risk reports • Comparable data • OU Management • Outperform competitors in pricing • Clarity of risks • Better performance • Reduction of losses • Effective control environment • BU Risk Management • Workable methodology and tools • Facilitate OU and BU’s to manage risks and to implement control Basel II impacts all levels of the Enterprise Regulators Board Group Risk management Business units Risk management departments Operating units …intelligent Enterprise Risk Management is needed to leverage the mass of data for competitive advantage

  29. Sales Risk Competition Risk Elasticity Risk Predictive Risk Strategic Risk Regulatory Risk Tax Risk Catastrophe Risk Currency Policy Physical Risk Physical Assets Real Estate Manufacturing Process Supply Chain Operational Risk Jurisdiction Risk Settlement Risk Systems Risk Employee Risk Strategic Decision Risk Purchasing Risk Financial Risks Market Risk Price risk (int. rate, ccy, equity, commodity) Curve risk Basis risk Correlation risk Option specific risk Cpty/Credit Risk Default risk Downgrading Liquidity Risk Funding Risk Market Liquidity Basel is only a ‘catalyst‘ - Enterprise Risk Management Must Measure & Optimize All Types of Risk Capital ENTERPRISE RISK PLATFORM RAPM ---- Optimization Enterprise-WideBusiness Unit

  30. Enterprise Risk Management Framework– layers ofsophistication Business Unit Exposures A true enterprise risk framework gives an organization the ability to examine all of the layers within it. The result is a core that drives risk adjusted performance management throughout the organization. Enterprise Risk Exposures Optimized Risk Capital Risk Adjusted Performance Management

  31. Substantial ROI comes from the changing of behavior throughout the organization • Risk Adjusted Performance Management (RAPM) • This means ... • Risk Adjusted budgeting • Risk Adjusted capital performance • Risk Adjusted compensation etc. etc.. • Risk Adjusted Decision Making

  32. Risk Adjusted Performance Management Corporate Optimization Enterprise Risk Management Business Unit Risk Management Optimize risk capital at enterprise level Improve return on investment capital Optimize risk capital at enterprise level Improve return/risk ratio on capital Communicate Corporate risk profile Maintain/advance credit ratings. Improve equity valuation Manage the Business - ‘Events’ Improve bottom line The risk solution must incorporate the intelligence needed for RAPM – to deliver needed ROI Risk Solution

  33. Shareholder Value Integrated Risk & Profitability Focus on Revenue and Cost Management Portfolio Management 2000+ Risk-adjusted performance Transfer pricing Value at Risk Fully integrated profitability and risk information Forward-looking, not just static, management tools 1990s Activity-based costing Focus on Risk Control (historical focus) Mark-to- market 1980s Evolution of Risk Decision-Making – The Future is Integrated and Forward-Looking

  34. Risk Management – requires an end-to-end approach Risk Dashboard and Reporting Presentation Data Mining, Analytics, Value at Risk Modeling Analysis Strategic Advantage Operational Optimization Data Management Data Repository, Data Cleansing Access to Multiple Data Sources, Multi-Platform Access

  35. Operational Risk is still a relatively new area– Risk Management Lifecycle Level of Development Market Risk Credit Risk Asset/Liability Management Liquidity Risk Operational Risk Relatively Slower Advancement Adoption Maturity

  36. Risks faced by an airline company • fuel - oil prices and $ • purchasing airplanes - $ and Euro • salaries, some $ • tickets $ • marketing - different currencies • payments to airports for services • terrorism • Based on the above framework to tell what risks that each issue is facing.

  37. Airline company Base currency - by major stockholder. Time horizon - by time of possible price change. Earnings at risk, not value at risk, since there is too much optionality in setting prices. One can create a one year cash flow forecast and measure its sensitivity to different market events.

  38. What is Interdependent Security? Protect against a risk by making an investment Airline can invest in baggage security system to reduce chance of bomb explosions Invest in more strict security so that terrorists could be identified Investment in computer protection against viruses and hackers BUT can be attacked by others even after investing Airline can be attacked by bags transferred or passengers from other airlines that did not invest Computer can be attacked by viruses from other computers on the same network

  39. Types of Problems • Investing in airline security • Securing computer systems against attacks. • Avoiding divisional gambles that could bring bankrupt entire firm. • Nick Leeson & collapse of Baring’s • Arthur Andersen brought into bankruptcy by Houston branch. • Investing in Research and Development (R&D) • Vaccination Against Diseases • Adoption of Basel II or not? Is our banking system an independent system?

  40. Scenario Illustrating How to use Game Theory to determine whether to invest in security or not. ChinaAirlines (CA) considers installing baggage checking system for added protection. Needs to balance the cost of this system with reduction in risk of explosion of luggage not only checked in with CA but also from bags of passengers checked in on other airlines & transferred to CA. In the following is a very simple case.

  41. Game Theory FrameworkIdentical Agents Airlines A1 and A2. • Y = income of airline before expenditure on security  • Probability contaminated bag is accepted & explodes in A i : p • Probability contaminated bag accepted by Ai is transferred to another airline where it explodes : q • Loss if a bag explodes : L. • Investment Cost of Baggage Security System: c • Threatsrespond to security measures

  42. Payoffs & Contamination Investing (S) & Not Investing (N) in Security System AIRLINE 2 S N SY -c, Y -c Y- c - qL, Y - pL AIRLINE 1 N Y- pL, Y – c - qL Y–pL– (1-p)qL, Y–pL– (1-p)qL If c < pL(1-q) then each will invest. Alone would invest if c < pL. Tighter inequality reflects reduced incentive to invest because of interdependence & risk of contamination. Investment no longer buys complete security

  43. A Simple Numerical Example Expected Costs Associated with Investing (S) and Not Investing (N) in Baggage Security System AIRLINE 2 S N SY -95, Y -95 Y-295, Y -100 AIRLINE 1 NY-100, Y -295 Y -280, Y -280 Decisions If A2 has a security system (S) then it is worthwhile for A1 to invest in one   Expected losses reduced by pL= - 100 Cost of baggage security system. = 95 If A2 does not invest in security (N) then A1 will not want to invest in one   Expected losses reduced by p(1-q)L - (280-200) = -80 Cost of baggage security system. = 95

  44. Types of Nash Equilibria for Different c Values If c > pL then (N,N) is a dominant strategy If c < pL(1-q) then (S, S) is dominant strategy If pL(1-q) < c < pL then (S,S) & (N,N) are Nash equilibria Illustrative Example: p=.1 q=.2 L=1000 If c > 100 then (N, N) is a dominant strategy If c < 80 then (S, S) is dominant strategy If 80 < c <100 then (S,S) & (N,N) are Nash equilibria

  45. Impact of Contamination on Nash Equilibria if there are n Agents Define Xi(n,0) to be the negative externalities to Agent i if it invests in security and none of the other agents do. What is expected cost to Agent i from investing in security if none of the other agents invest in security? E(Cost from Investing) = Y - c – Xi(n,0) What is expected cost to Agent i from not investing in security if none of the other agents invest in security? E(Cost from Not Investing ) = Y- pL - (1-p) Xi(n,0) Agent i will only want to invest in security if Y- c – Xi(n,0) > Y- pL- (1-p) Xi(n,0) This implies that c < p [L- Xi(n,0)]

  46. Impact of Contamination for n Agents: Airline Security Problem What is the expected loss [E(L)] to Airline i if it does not invest in security and none of the others invest in security? E (L) = pL + (1-p) Xi(n,0) In the limit as n become very large then Xi(n,0) = (1 -e-q) L We know that if c < p[ L –Xi(n,0)] then Airline i will not invest in security Hence if c < p [e-q L] then Airline i will not invest in security One can show that the negative externalities to airline i if it invests in security and none of the others do is: n-2 Xi(n,0) =[q/(n-1)]  [ [1-q/(n-1)] t] L= {1- [1-q/(n-1)] n-1} L t=0

  47. Impact of Contamination on Computer Security What is the expected loss [E(L)] to Computer i if it invests in security and none of the others do? E (L) = pL + (1-p) Xi(n,0) In the limit as n becomes very large then Xi(n,0) = L so that E(L)=L Note: c < p [ L –Xi(n,0) ] for Computer i to want to invest in security Hence in the limit c < 0 so there is no cost incentive to invest in protecting any machine against viruses or hackers if none of the other machines are protected. One unprotected computer can infect all the others in the network Expected negative externalities imposed by all other agents on i = Xi(n,0)) n-2 Xi(n,0) =q L  [ (1-q) t]= [1-(1-q) n-1] L t=0

  48. More is worse – much! • Bottom line – one unprotected firm/individual poses a contamination problem for others • Link many of them so that security of each depends on what others do and problem gets worse as number of unprotected agents increases • Some individuals/firms offer vast policy leverage because of their linkages & positions in the network (Have tipping power: Can lead everyone to protect)

  49. Game Theory Framework Heterogeneous Agents Airlines A1 and A2. • Y = income of airline before expenditure on security  • Probability contaminated bag is accepted & explodes in A i : pi • Probability contaminated bag accepted by Ai is transferred to another airline where it explodes : qi • Loss if a bag explodes : L. • Investment Cost of Baggage Security System for Ai : ci

  50. Payoffs & Contamination Investing (S) & Not Investing (N) in Security System AIRLINE 2 S N SY –c1 Y –c2Y- c2 – q1 L, Y – p2 L AIRLINE 1 N Y– p1 L, Y – c2 – q1 L Y – p1 L – (1-p1 )q 2L, Y – p2 L – (1-p2 )q 1L If ci < pi L(1-qj ) then each will invest. Alone would invest if ci < pi L. Tighter inequality reflects reduced incentive to invest because of interdependence & risk of contamination. Investment no longer buys complete security

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