The Present and Future of Financial Risk Management

Current research on financial risk management applications of econometrics centers on the accurate assessment of individual market and credit risks with relatively little theoretical or applied econometric research on other types of risk, aggregation risk, data incompleteness, and optimal risk control. We argue that consideration of the model risk arising from crude aggregation rules and inadequate data could lead to a new class of reduced-form Bayesian risk assessment models. Logically, these models should be set within a common factor framework that allows proper risk aggregation methods to be developed. We explain how such a framework could also provide the essential links between risk control, risk assessments, and the optimal allocation of resources. keywords: economic capital, financial risk assessment, optimal allocation of resources, RAROC, risk control, regulatory capital The role of risk management in financial firms has evolved far beyond the simple insurance of identified risks, to a discipline that centers on complex econometric and financial models of uncertainty. Financial risk management has been defined by the Basel Committee (2001) as a sequence of four processes: the identification of events into one or more broad categories of market, credit, operational, and ‘‘other’’ risks and into specific subcategories; the assessment of risks using data and a risk model; the monitoring and reporting of the risk assessments on a timely basis; and the control of these risks by senior management. Of the trends in financial markets that have had a significant impact on risk management practices today, deregulation has been a main driving force. Since the 1970s the deregulation of capital flows has led to increased globalization (Sverrisson and Van Dijk, 2000); deregulation of industries has enabled the rapid expansion of new companies such as Enron (Bodily and Bruner, 2002; doi:10.1093/jjfinec/nbi003 Journal of Financial Econometrics, Vol. 3, No. 1, a 2005 Oxford University Press; all rights reserved. Address correspondence to Carol Alexander, Chair of Risk Management and Director of Research, ISMA Centre, Business School, University of Reading, P.O. Box 242, Reading RG6 6BA, UK, or e-mail: c.alexander@ ismacentre.rdg.ac.uk. NOT FOR PUBLIC RELEASE Journal of Financial Econometrics, 2005, Vol. 3, No. 1, 3–25