Financial Markets And Portfolio Management
BOOK REVIEW
By Simon Straumann
Published online: 1 February 2016
© Swiss Society for Financial Market Research 2016
Managing extreme financial risk: strategies and tactics for going concerns
By Karamjeet Paul
Elsevier, 2014, 145 pages
Market turbulence, harsh drawdowns, and financial crashes have repeatedly occurred in the history of financial markets over the last decades. Independent of their exact nature and origin, all these crises have one common factor, namely, tail risk. In contrast to normal risk, tail risk is only triggered in extreme situations and, hence, is one of the main contributing factors to financial crises. In his book, Karamjeet Paul develops a novel approach for handling financial risk—both normal and tail-sided. Instead of developing yet another approach for quantitatively measuring overall risk, the author introduces the concept of “sustainability management.” This concept is based on two main pillars. First, it disentangles risk management into normal risk and extreme tail risk. Whereas normal risk is rewarded with revenues (and therefore is closely linked to the institution’s revenue model), tail risks are not rewarded and, consequently, need an own perspective/management. Second, the introduced approach takes a new perspective on risk management by first focusing on an institution’s sustainability: only by understanding the shareholders’, clients’, and regulators’ views on the business and revenue model can one infer the actual willingness to take risk and, hence, the amount of risk that should be taken.
The book is divided into three main sections. The first part explains the necessity of a new view on risk management and consists of five chapters. Chapter 1 shows that current regulatory stress testing neither addresses tail risks nor is necessarily in line with going-concern considerations. This can lead to a situation in which an institution’s risk management neither represents all stakeholders’ demands nor secures the institution against extreme situations that could lead to a default. Chapters 2–4 show the critical importance of extreme tail risk in risk management. Whereas in former times, credit policy sufficed to manage tail risk, today’s international market exposure of large financial institutions is no longer captured by classical risk management mechanisms. One major reason for this can be found at the heart of (traditional) risk management, namely, its focus on quantifiable risk. However, tail risks are often not quantifiable and therefore must be managed with an alternative, sustainability-based approach. Chapter 4 underlines this finding by showing the extent to which the classical value-at-risk measure fails to capture major tail risks. The last chapter of Section 1 deals with the effectiveness of quantitative models to incorporate extreme situations. One major drawback of quantitative approaches in risk management is their linearity, which cannot capture extreme situations. Given that tail risks do not simply reduce an institution’s profit over a certain time but fundamentally threaten its survival, the author shows how predictive quant-models fail to manage such nonlinear risk structures.
The second part of the book, consisting of four chapters, explains the “sustainability management” concept. The first two chapters underline the necessity of finding an adequate way to measure extreme risk. An increasing number of complex revenue models require a simple and easy measure to quantify and manage extreme risks properly. In Chapter 8, the author introduces this measure, the “Probable Maximum Loss” (PML). PML is the highest possible loss any institution can suffer after detracting all possible safeguards and capital cushions. Consequently, the PML offers a new dimension in risk management since it deliberately considers the effects of possible tail events, thereby extending the classic risk-return view. At the same time, the PML measure is easy to handle and therefore reduces the overall complexity of risk management. In the last chapter of Section 2, the author elaborates on the need for a continuous update of the PML over time so as to remain capable of acting in the event of a changing overall environment.
In the last part of his book, Karamjeet Paul presents possible implementation issues and discusses the effects of his concept on the overall financial system. Chapters 10, 15, and 18 discuss hands-on methods for implementing “sustainability management” in an institution and how to internally and externally communicate such a strategy to different stakeholders. Chapters 11 and 12 analyze the role of capital by showing that the simple addition of capital cushions is not enough to stabilize the financial system over time. Further, the author broadens the view on regulatory issues (Chapters 13 and 14), shows critical factors in preparing for a tail event (Chapter 16), and illustrates how well-implemented “sustainability management” can become a competitive advantage.
Managing Extreme Financial Risk—Strategies and Tactics for Going Concerns develops a simple but still effective framework for handling extreme financial risk. The introduction of the PML measure enables companies to easily incorporate tail risk in their regular risk management and thereby positively contribute to their long-term survival chances. In his book, Karamjeet Paul focuses on practitioners by consciously omitting page-long derivations and formulas. His work focuses on a broad and holistic understanding of the concept rather than on a detailed implementation and problem discussion. Consequently, readers with an academic background seeking a more detailed and scientific view of the concept will have to look elsewhere in the literature.
Simon Straumann: simon.straumann@unisg.ch
University of St. Gallen, St. Gallen, Switzerland
