Risk quanta: an approach to understanding modern financial risk

Author:Jong Ho Hwang
Position:Office of Financial Institutions Policy, U.S. Department of the Treasury, Washington, District Columbia, USA
Pages:179-195
SUMMARY

Purpose - This paper aims to present a recent history of developments and innovations that, along with advances in information technology, have caused fundamental changes in the way that financial risk is created, transformed, transported and extinguished in modern financial intermediation systems. A review and critique of the global supervisory response to these... (see full summary)

 
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Risk quanta: an approach
to understanding modern
nancial risk
Jong Ho Hwang
Ofce of Financial Institutions Policy, US Department of the Treasury,
Washington, District of Columbia, USA
Abstract
Purpose – This paper aims to present a recent history of developments and innovations that, along
with advances in information technology, have caused fundamental changes in the way that nancial
risk is created, transformed, transported and extinguished in modern nancial intermediation systems.
A review and critique of the global supervisory response to these developments is presented.
Design/methodology/approach – A bottom-up approach to the capture, recording, disaggregation,
re-composition and measurement of new, standardized, basic elements of risk that the authors refer to
as risk quanta is proposed.
Findings – This approach provides a clearer understanding of the nancial world that the people live
in today and creates a robust information platform to build innovations, advancements and economic
growth in the future.
Practical implications – This approach provides decision-makers with a clearer understanding of
the nancial world that the people live in today and creates a robust information platform to build
innovations, advancements and economic growth in the future.
Social implications – This approach provides nancial market participants and the public with a
clearer understanding of the nancial system and creates a robust information platform to build
innovations, advancements and economic growth in the future.
Originality/value – This approach is more comprehensive unlike current international proposals for
a global nancial risk framework.
Keywords Contracts, Global, Risk, Financial, Institutions, Quanta
Paper type Conceptual paper
1. Introduction
Some time ago, I visited the ofce of a friend of my father. He was fond of cooking and
he liked carping about how, until the 1960s and 70s, supermarkets only sold whole
chickens. In his mind, that was the only way that they should be offered. Today, one can
buy not only whole chickens but also wings, breasts, thighs, legs, strips, llets, nuggets,
along with less desirable beaks, feet, livers, etc. That innovation increased choice
according to individual preferences.
The author is grateful to Patricia Kao, Richard Haynes, Jennifer Wine, Justin Rhudy, Con Keating,
Tomaso Aste, Kyle Moore, David Eaton, Khaldoun Khashanah, Willi Brammertz and Allan
Mendelowitz for their thoughtful comments, input and discussion. The commenters do not
necessarily agree with the contents of this paper. The views expressed here do not necessarily
represent those of the US Department of the Treasury. Any errors contained in this paper are
entirely those of the author.
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1358-1988.htm
Risk quanta
179
Journalof Financial Regulation
andCompliance
Vol.23 No. 2, 2015
pp.179-195
©Emerald Group Publishing Limited
1358-1988
DOI 10.1108/JFRC-02-2014-0015
At around the same time, a similar innovation occurred with nancial income
producing assets. In 1970, the US Department of Housing and Urban Development
through its Government National Mortgage Association (GNMA or Ginnie Mae) issued
the rst mortgage pass-through securities. In 1983, Fannie Mae created the rst
collateralized mortgage obligations (CMOs) and the Tax Reform Act of 1986 created the
real estate mortgage investment conduit (REMIC) which facilitated the issuance of
structured securities with different risk characteristics.
The structured nance or securitization industry did for the whole loan market what
the poultry industry had done a few years earlier in the whole chicken market.
1.1 Innovations in risk disaggregation, re-composition and portability
The structured nance or securitization industry is often described as creating and
issuing debt securities or bonds with payments of principal and interest derived from
cash ows generated from a separate pool of assets. While this is an accurate and useful
description, this practice is examined from a risk perspective.
From this perspective, the structured nance or securitization industry gathers a
pool of assets with a specic set of attributes and risks, disaggregates these risks,
recomposes inherent elements of risk, often transforming these with the use of credit
enhancements and diversication and yields a risk pool with a different set of risk
elements.
Until this point, the discussion has been referring mostly to credit risks from lending,
but the discussion can be generalized to any type of risk, whether it is market risk,
liquidity risk, counterparty risk, etc.
This risk transformation takes place because there is supply and demand for these
reconstituted risks and the mitigation thereof. Structured nance enables the creation of
bespoke assets with carefully designed return and risk characteristics.
1.2 The emergence of the originate-to-distribute model
Traditionally, nancial institutions (FIs) originated nancial risk assets to hold on their
balance sheets and earn the spread between risk asset returns and their associated
funding or holding costs. This exposed FIs to the risk that actual returns and funding/
holding costs would deviate signicantly from expected returns and costs over time.
The Basel capital standards (BCBS, 2011) impose additional costs onto banks and
afliated FIs, as they impose higher capital requirements for holding risk assets on the
balance sheet.
If asset structuring were able to re-engineer supply to better match demand for
specic FI client risks and sustain a market clearing price greater than the expected
return from holding that asset, then FIs could move away from the originate-to-hold
model that had prevailed in the past. For this to work, the asset structuring exercise
would need to create additional value; the sum of the resulting parts would have to be
more valuable than the cost of the inputs. An example of how this was accomplished
was by making use of an articial premium for investment grade assets resulting from
the “prudent man” investment rules that investment duciaries are subject to. This
allowed asset structurers to achieve their goal of creating assets that were more valuable
when structured as investment grade assets out of pools of non-investment grade assets.
JFRC
23,2
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