Extreme Operational Events

Extreme Operational Events

Maxime Laot ECB

This post about extreme operational events was added by Maxime Laot supervisor at European Central Bank.

Another type of extreme events

Extreme events in finance do not consist in stock market crashes only. Unfortunately, their scope is much broader than the volatility of asset prices such as stocks, bonds, commodities or currencies. Extreme events occur as well in the normal run of financial institutions, or in other words, in their daily, trading and non-trading operations. Actually, one could argue that frauds, fat fingers errors, rogue traders, AML and conduct issues have caused – and are still causing – more harm to large financial institutions than any stock crashes have done in the past!

Operational risk

This type of risk is branded “operational risk” by the financial sector, and the Wiley Handbook on Extreme Events in Finance explains how it has been first formalized by the banking regulators (i.e. the Basel Committee) in 1999, and with much push back from the industry at the time! Since then, banks are required to set aside capital to create a buffer that would shield themselves from against potential operational losses. The Handbook details the methods available to banks to compute this amount of capital, from the basic indicator approach (as a percentage of the Operating Income, 15%) to the advanced measurement approach (or AMA), where the banks have internal models to estimate the level of operational risk they are exposed to (usually Monte Carlo simulations combining frequency and severity distributions). The models are subject to the supervisor’s approval, and rely on and internal and external loss databases. The Handbook insists on the quality of the data, and how important it is to institutions to ensure robust data collection processes. Garbage in, garbage out.

A new framework for operational risk

However, since the Handbook has been published, the regulatory framework has been further strengthened with the Basel III reforms being finalized in December 2017. The AMA will be stopped and all internal models for operational risk with it. It is the results of the industry failure to produce a homogeneous and reliable method to model extreme operational events. The new framework, or standardized measurement approach (SMA), will, as its name suggests it, be a single non-model-based method, akin to the former standardized approach in its simplicity and comparability, but embodying also risk sensitivity by scaling the capital requirements to the level of realized losses. It will be applicable as of January 2022.

Is it the end of modelling extreme events?

Is it the end of modelling extreme events? Probably not. Institutions will always have forecasting needs in that respect, and if some valid and robust industry method emerges, it is not inconceivable to think that Basel might give AMA a successor one day.

Maxime Laot
Supervisor at European Central Bank

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Can we avoid financial crises?

Can we avoid financial crises?

Extreme events in finance are characterized by very large price fluctuations on the financial markets. These stock market crashes always occur on very short periods, a day or even a few minutes with flash crashes. But then why be interested in these events? Explanation in the video by François Longin, Professor of Finance at ESSEC Business School, Challenges partner.

Watch the 3 minutes video below (English version coming soon)!

Video by Prof. Longin about extreme events in finance
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The LTCM crisis: what can we learn 20 years after?

The LTCM crisis: what can we learn 20 years after?

Matthieu Benavoli Ace Finance Conseil LTCM crisis

This post about the LTCM crisis presents a recent resource about financial crises added by Matthieu Benavoli financial analyst at Ace Finance Conseil.

LTCM

LTCM, “Long Term Capital Management”, was a hedge fund created by John Meriwether in 1994. The mismanagement of the fund led to a major financial crisis in the late 90s. In the beginning, Meriwether had a simple strategy: being accompanied by the most brilliant minds of America. Hence, he gathered an all-star team of traders and academics composed of eminent professionals, professors, and the Nobel Prize recipients Robert Merton and Myron Scholes. This team convinced investors, including many large banks, to flock to the fund and to invest more than $1.3 billion in spite of the huge entry barriers Meriwether set. These experts team designed a strategy mainly based on convergence and relative-value trades, both combined with a high leverage effect.

What happened?

In the first years this strategy scored a huge success: LTCM marketed itself as providing the highest returns, superior to 40% in 1995 and 1996, for a risk that had no equivalent among competitors. But the catastrophe occurred in 1998. In August 1998, Russia devalued the rouble and declared a moratorium on $13.5 billion of its Treasury debt: these decisions undermined LTCM’s profit sources and trashed its hedging strategies. Russia’s default was the first strike of a long series: then the so-called “flight to liquidity” across fixed-income markets precipitated the debacle of LTCM. The fund lost a lot when the banks raised doubts about the fund’s ability to survive. On 21st September, the Fed of NYC, for the first time, organised a rescue package under which a consortium of banks injected $3.5-billion into the fund and took over its management and saved the situation at the expense of heavy losses.

What can we learn 20 years after?

What has to be taken away from this debacle? One should keep in mind that this debacle is due to the pride of talented, skilled intellectuals who could not imagine they were wrong. Warren Buffet underlined that “[The members of this team] had probably the highest average IQ of any 16 people working together in one business, 400 years of experience in their jobs […] and they went broke. That is absolutely fascinating. If I wrote a book, it’s going to be called “Why do smart people do dumb things?””. Never before had any financial institution benefited from such an impeccable reputation. That’s this “over-confidence” which dragged the fund down. So professionals and investors should take that “ego risk” into account when they invest.

Know more about the LTCM crisis…

Matthieu Benavoli
Financial analyst at Ace Finance Conseil

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