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Risk Management: A Maturing Discipline
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T A B L E 1-1
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Differences and Similarities Between Total Quality Management and Total Risk Management
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Total Quality Management (TQM) Extended, multidimensional, clientoriented quality term. Extended client definition: clients are internal and external. Preventive quality assurance policy. Quality assurance is the duty of all employees. Enterprisewide quality assurance.
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Total Risk Management (TRM) Integrated, multidimensional enterpriseoriented term. Internal client definition: clients are internal. Preventive and product-oriented risk management policy. TRM assurance is the duty of specially assigned and responsible persons. TRM assurance within the limits and for the risk factors to be measured according to the risk policy. Systematic risk control within the defined limits. TRM is a strategic job. TRM is a fundamental goal of the enterprise. TRM to ensure ongoing production.
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Systematic quality improvement with zero-error target. Quality assurance is a strategic job. Quality is a fundamental goal of the enterprise. Productivity through quality.
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SOURCE: Hans-J rg Bullinger, Customer Focus: Neue Trends f r eine zukunftsorientierte Unternehmungsf hrung, in Hans-J rg Bullinger (ed.), Neue Impulse f r eine erfolgreiche Unternehmungsf hrung, 13. IAO-Arbeitstagung, Forschung und Praxis, Band 43, Heidelberg u.a., 1994.
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tities, and employees focus on quality assurance and continuous improvement throughout the organization. 1.6.4 Approach and Risk Maps Figures 1-9 and 1-10 present the approach and risk maps used in this book.
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SYSTEMIC RISK
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1.7.1 Definition
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There is no uniform accepted definition of systemic risk. This book uses the definition contained in a 1992 report of the Bank for International Settlement (BIS):13
F I G U R E 1-9
Risk Categorization Used as an Integrative Framework in This Book.
Model Risk Equity Price Risk Equity Risk Product Risk Dividends "Greeks"
Model Risk Interest Rate Risk Yield Curve Risk Product Risk Currency Risk Model Risk Fx Curve Risk Model Risk Commodity Risk Commodity Curve Risk Model Risk
"Greeks" Basis / Spread Risk Prepayment "Greeks" Basis / Spread Risk "Greeks" Basis / Spread Risk
Market Risk Factors
Market Risk
Liquidity Risk
Capital Adequacy
Model Risk
Regulatory Mechanisms
Risk Disclosure
Regulatory Constraints
Current Exposure
Counterparty Risk
Potential Exposure
Cumulation Risk
Direct Credit Risk
Rating
Credit Risk Exposure
Credit Equivalent Exposure Model Risk Diversification Risk Capital Adequacy Model Risk
Credit Risk
Regulatory Mechanisms
Risk Disclosure
Regulatory Constraints
Product / Market Combination Sales Risks Distribution Order Capture & Confirmation
Customer / Transaction Risks Marketing Risks
Disclosures
Controlling Business Control Internal Audit
Operational Risk
Support Service Risks
Legal & Compliance
Accounting
Logistics
IT / Technology Risk Disclosure Regulatory Mechanisms
Regulatory Constraints
Political Stability International / National Stability Risks
Economy Legal System
Systemic Risk
Market Efficiency
Market Access / Hurdles Market Liquidity Information Transparency
F I G U R E 1-10
Example of Transaction Breakdown, Process-Oriented Flow of Different Risk Categories Involved.
Pretrade
Portfolio Management Trade Management Tools
Trade
Trade Confirmation Settlement and Reconciliation
Posttrade
Portfolio Accounting Custody or Securities Lending
Resarch
Compliance
Order Routing
Trade Execution
Compliance
Market Risk
Market Risk
Market Risk
Credit Risk
Credit Risk
Market Risk Credit Risk Operational Risk Legal / Regulatory Operational Risk Operational Risk Operational Risk Operational Risk Operational Risk Operational Risk Legal / Regulatory
Systemic Risk
During the phases of research, tactical or strategic asset allocation, and selection of instruments, there is an inherent risk of misjudgment or faulty estimation. Therefore, timing, instrument selection, and rating considerations have a market and credit component.
Compliance has to take into account all client restrictions, internal directives, and regulatory constraints affected by the intended transaction. Capital adequacy, suitability to the client's account, and so forth, also must be considered.
From the moment the trade is entered into the system until the final transaction is entered in the portfolio accounting and custody or securities lending systems, systems are crucial and have inherent risks. During the trade execution phase, the trading desk has directed exposure to system risk. Until final settlement, the trade amount is exposed to disruption in the system, which could disturb correct trade confirmation and settlement. From the moment of execution until settlement, the books are exposed to changes in the market risk factors. They are also exposed to changes in spread risk (i.e., credit risk). Market risk during the trade execution is especially high, as the market price or model pricing might give the wrong information (e.g., the market could be illiquid, or the models might not fit the instruments).
Compliance can be considered the last stop before the transaction is complete. There is the opportunity to review whether the transaction has been executed and settled correctly.
systemic risk The risk that a disruption (at a firm, in a market segment, to a settlement system, etc.) causes widespread difficulties at other firms, in other market segments, or in the financial system as a whole.
In this definition, systemic risk is based on a shock or disruption originating either within or outside the financial system that triggers disruptions to other market participants and mechanisms. Such a risk thereby substantially impairs credit allocation, payments, or the pricing of financial assets. While many would argue that no shock would be sufficient to cause a total breakdown of the financial system, there is little doubt that shocks of substantial magnitude could occur, and that their rapid propagation through the system could cause a serious system disruption, sufficient to threaten the continued operation of major financial institutions, exchanges, or settlement systems, or result in the need for supervisory agencies to step in rapidly.
1.7.2 Causes of Systemic Risk Under the BIS definition, one should consider not only the steps taken within the institution to guard against a major internal breakdown. One should also consider those features of the global financial marketplace and current approaches to risk management and supervision that could adversely affect the institution s ability to react quickly and appropriately to a shock or disturbance elsewhere. Recent developments in the financial market have produced a broad range of highly developed pricing models. Shareholder value, which is often mistakenly thought of as the generation of higher return on equity, leads financial institutions to reduce the proprietary capital used for activities that increase the profitability of equity capital. The financial institution reduces the equity capital to the bare regulatory minimum with the result that less and less capital supports the expanded trading activities, because the shareholder value concept has nothing to do with capital support. This trend is quite dangerous, as less and less capital serves as security capital in the returngeneration process for more and more risk, without generating commensurate returns, and this trend alone promotes systemic risks. The development of an internationally linked settlement system has progressed significantly; nevertheless, there are still other factors that create systemic risk.
1.7.3 Factors That Support Systemic Risk The following factors support systemic risk, based on empirical experience from previous crises or near-misses in the market:
Economic implications. Our understanding of the relationship between the financial markets and the real state of the economy is
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