Learnings from the Financial Crisis (3)

Gone is not always gone – another of the underpinnings of the market risk business is the constant of trading of risks. However, in the case of sub prime, some of the counterparties in these trades were very intimately related to the banks that sold the risky securities. Sometimes, they were investment funds that were sold by to bank customers; sometimes the banks lent the money to the same party that bought the security. Sometimes, the bank kept the security and bought protection from a counterparty. In each of these types of situations, banks found that they ended up needing to take back some of all of the risks that they thought that they had laid off. Insurers can learn that they need to keep relationships clear. The banking model has long suffered from the idea that they were a relationship business and they would try to do as much business as possible with the customers who they have the best relationships with. Insurers need to be constantly aware of this trap that creates more and sometimes cloudy concentration risk. Both net and gross risks need to be tracked and attended to.

One simple reason for this part of the problem is the terminology that risk managers use. Usually hedging transactions are called Risk Transfers. But in fact, they are almost never a real transfer of risk. Usually they would more appropriately be called Risk Offsets. This sloppy terminology supports sloppy thinking. And the high speed of a trading business left no time for reflection, so the misrepresentation was left totally unchallenged.

Now good risk managers knew the truth and so were concerned with counterparty risk and basis risk as well as contract risk. But in the end, the largest risk turned out to be reputation risk. Banks were usually unable to take the hit to their reputation that walking away from their closely or even semi related counterparties. Especially when those counterparties were funded with customer money.

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Explore posts in the same categories: Basis Risk, Counterparty Risk, ERM, Hedging, Reinsurance, Risk Management, risk transfer

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