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Financial Institutions: Problems and Applications Richard Bookstaber. Presentation for “Risk Management Strategies in an Uncertain World” April 13 th , 2002. Objective. How financial markets can: Create risk Magnify existing risks Mitigate risks . How Financial Markets Create Crises.

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financial institutions problems and applications richard bookstaber

Financial Institutions: Problems and ApplicationsRichard Bookstaber

Presentation for

“Risk Management Strategies in an Uncertain World”

April 13th, 2002

objective
Objective

How financial markets can:

  • Create risk
  • Magnify existing risks
  • Mitigate risks
how financial markets create crises
How Financial Markets Create Crises
  • Liquidity – Nurtures a demand for immediacy
  • Leverage– Magnifies the damage if liquidity is lost
  • Innovation – Creates complex, vulnerable products
an engineering view
An Engineering View

Liquidity + Leverage => “Tight Coupling”

Innovation => “Complexity”

result of market structure
Result of Market Structure

Crises for no apparent reason…

  • Crash of 1987

Loss: Market value equal to one year’s GDP for Japan

  • LTCM Debacle

Loss: $1 Trillion of market value

how financial markets can magnify crises
How Financial Markets Can Magnify Crises

If no apparent event can cause such destruction of value, think of what can happen if the markets end up on the wrong side of a real event.

can financial markets mitigate risk
Can Financial Markets Mitigate Risk?

Objective of Financial Markets:

  • For non-systematic risks: Diversify risk away.
  • For systematic risks: Spread them out to dampen effects.
what is required for financial markets to help
What is Required for Financial Markets to Help?
  • A well-defined distribution. Necessary but not sufficient: A well-defined event space.

OK: Flood, Earthquake, Hurricane

OK: Kidnapping

Not OK: “Weather-related”

Not OK: “Terrorist-related”

  • No “gaming”.

Not OK: Moral Hazard

Not OK: Feedback

looking at the problem a different way
Looking at the Problem a Different Way

A well-defined event space.

OK: Fire – no matter what the cause

OK: Death – no matter what the cause.

OK: Fire – except for “Force Majeure”

OK: Death – except for “Force Majeure”

what is required for financial markets to help10
What is Required for Financial Markets to Help?
  • A well-defined distribution
  • No “gaming”
  • Securities
    • Standardized
    • Fungible
    • Liquid

Securitization – and hence solutions from the financial markets – must be proceeded by having a market that can be securitized.

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