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Home » Finance » Corporate Finance » Financial Risk Management

Financial Risk Management

Risk management, as it is understood today, largely emerged during the early 1990s, but the term “risk management” was used long before this. Since the 1960s, it has been—and frequently still is—used to describe techniques for addressing insurable risks. This form of "risk management" encompasses:

  • risk reduction through safety, quality control and hazard education,
  • alternative risk financing, including self-insurance and captive insurance, and
  • the purchase of traditional insurance products, as suitable.

More recently, derivative dealers have promoted “risk management” as the use of derivatives to hedge or customize market-risk exposures. For this reason, derivative instruments are sometimes called “risk management products.”

The new “risk management” that evolved during the 1990s is different from either of the earlier forms. Often called "financial risk management," it treats derivatives as a problem as much as a solution. It focuses on reporting, oversight and segregation of duties within organizations.

Origins

Gerald Corrigan (1992), then President of the New York Federal Reserve, set a tone for the new financial risk management in an addressed the New York Bankers Association:

… the interest rate swap market now totals several trillion dollars. Given the sheer size of the market, I have to ask myself how it is possible that so many holders of fixed or variable rate obligations want to shift those obligations from one form to the other. Since I have a great deal of difficulty in answering that question, I then have to ask myself whether some of the specific purposes for which swaps are now being used may be quite at odds with an appropriately conservative view of the purpose of a swap, thereby introducing new elements of risk or distortion into the marketplace—including possible distortions to the balance sheets and income statements of financial and nonfinancial institutions alike.

I hope this sounds like a warning, because it is. Off-balance sheet activities have a role, but they must be managed and controlled carefully, and they must be understood by top management as well as by traders and rocket scientists.

Responding to spreading concerns about OTC derivatives, in July 1993, the Group of 30 published a 68 page report entitled Derivatives: Practices and Principles. It has come to be known as the G-30 Report. It describes then-current derivatives use by dealers and end-users. The heart of the study is 20 recommendations to help dealers and end-users manage their derivatives activities. Topics addressed include:

  • the role of boards and senior management,
  • the implementation of independent financial risk management functions, and
  • the various risks that derivatives transactions entail.

With regard to the market risk faced by derivatives dealers, the report recommends that portfolios be marked-to-market daily, and that market risk be assessed with both value-at-risk and stress testing. It recommends that end-users of derivatives adopt similar practices as appropriate for their own needs.

Although the G-30 Report focuses on derivatives, most of its recommendations are applicable to the risks associated with other traded instruments. For this reason, the report largely came to define the new financial risk management of the 1990s.

In October 1994, following closely on the heals of the G-30 Report, JP Morgan launched its free RiskMetrics service. A public relations firm placed ads and articles in the financial press. Representatives of JP Morgan went on a multi-city tour to promote the service. Software vendors, who had received advance notice, started promoting compatible software. RiskMetrics got treasury professionals at non-financial firms talking about value-at-risk specifically and the new financial risk management generally.

RiskMetrics was released during a period of publicized financial losses, including

Metallgesellschaft

Metallgesellschaft (December 1993). MG Refining and Marketing, a US subsidiary of Germany’s Metallgesellschaft AG, had a program of selling long-dated fuel and oil supply commitments to end-users. These had embedded options designed to mimic for clients the optionality of holding physical supplies. MG used a "stack and roll" hedging program to hedge the long-term obligations with short-term futures. When oil prices dropped in the Fall of 1993, large variation margin calls on the futures caused liquidity problems. The firm turned to its banks for hundreds of millions of dollars in financing. Alarmed by the situation, Metallgesellschaft's supervisory board intervened, replacing the CEOs of both Metallgesellschaft and MG. They unwound outstanding positions at a USD 1300MM loss. In retrospect, it is clear that the firm's "stack and roll" hedges were unsound from a liquidity standpoint. What is less clear is the extent to which the final loss was due to overreaction of the supervisory board, which unwound positions at fire-sale prices.

Orange County

Orange County (November 1994): Orange County, California has an investment pool that supports various pension liabilities. The pool lost USD 1700 MM from structured notes and leveraged repo positions. The treasurer, Robert Citron, took the positions with oversight from the county's five-person board of supervisors. The riskiness of the pool's investments was publicly discussed when Citron ran for, and won, reelection in 1994. Members of the board of supervisors claim that they did not receive critical information which would have indicated the risks that Citron was taking.

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Keywords:

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