Learning objectives: Explain ways in which risk management can add or destroy value for a bank. Describe structural challenges and limitations to effective risk management, including the use of VaR in setting limits. Assess the potential impact of a bank’s governance, incentive structure and risk culture on its risk profile and its performance.
Questions:
601.1. According to Stulz, a firm should identify the probability of incurring a loss that could put it in financial distress or in default. For example, a firm might decide that it prefers to limit its one-year probability of default to 0.06%. This corresponds to a one-year loss that has only a 0.06% probability of being exceeded. Stulz says this approach "leads directly" to the use of value at risk (VaR) as a firm-wide risk measure. Stulz writes "The use of VaR is ubiquitous in risk management, which gives rise to a constant debate about the merits of VaR. However, despite its weaknesses, VaR is the right risk measure in a wide range of circumstances."
Assume your bank targets a 0.06% one-year firm-wide value at risk (VaR; in other words, borrowing Stulz's illustrated example). Further assume your bank quantifies three major risk types: market, credit and operational risk. Which of the following is true?
a. To obtain firm-wide risk, we should aggregate market, credit and operational risks but exclude business risks
b. To validate (ie, prove unbiased) the one-year 0.06% VaR with a confidence level of 99.0%, we will require a backtest of approximately four or five years
c. Risk aggregation at the firm-wide level introduces substantial model risk due to both the correlation assumption (ie, between market, credit and operational risk) and the non-trivial summation of non-normal statistical distributions
d. At extremely low probability levels like this 0.06%, the issue of unknown risks--that is, Rumsfeld's "unknown unknowns" and Taleb's "black swans"--are not relevant in practice because the time time horizon specified by our VaR metric is short (it is only one year).
601.2. According to Stulz, "An important issue in setting limits is the determination of the level of aggregation for which limits are set. In practice, the issue is often described as the issue of selecting the level of granularity of limits." Which of the following guidelines is most TRUE about the calibration of limits?
a. It is best to maximize the granularity of limits
b. Less granularity might be advisable in order to capitalize on opportunities
c. A key definitional aspect of a limit is that it should never be increased or otherwise changed
d. Limits cascaded below the firm level sound good in theory, but in practice do not add value
601.3. In regard to the limits of incentive pay, Stulz writes that "Incentives should be set right, but incentives have limits. It is not possible to set up an incentive plan that is so precisely calibrated that it leads executives to take the right actions in every situation. Executives have to deal with situations that nobody contemplated. Employment contracts are by their very nature incomplete. A further issue is that not all risks can be quantified or defined. As a bank focuses on specific risks that it quantifies and can account for in employee reviews and incentive plans, there is an incentive for employees to take risks that are not quantified and monitored. Because of the limits of risk management and incentives, the ability of a firm to manage risk properly depends on its corporate culture as well."
You are currently interviewing four Compensation Consultants for the important role of giving advice to the bank's Board on the design of the bank's compensation plans. You ask each of them about their view on the role of incentive pay (e.g., annual bonus, long term incentives, equity grants) at a bank. You hear the four different answers below. Which view is the MOST AGREEABLE with Stulz's advice on incentive pay?
a. Link at least some portion of an individual's pay to the firm's overall value creation or value destruction
b. Link variable pay exclusively to individual and business unit performance in order to ensure maximum "line of sight"
c. Pay a bonus to risk managers only if they meet all of the specified criteria in a compliance-oriented checklist, where each compliance test is either passed or failed
d. Based on clinical studies, incentives are largely irrelevant because risk management should be divided into two groups: one based on formal measures and one based on intuition and impersonal relationships.
Answers:
Questions:
601.1. According to Stulz, a firm should identify the probability of incurring a loss that could put it in financial distress or in default. For example, a firm might decide that it prefers to limit its one-year probability of default to 0.06%. This corresponds to a one-year loss that has only a 0.06% probability of being exceeded. Stulz says this approach "leads directly" to the use of value at risk (VaR) as a firm-wide risk measure. Stulz writes "The use of VaR is ubiquitous in risk management, which gives rise to a constant debate about the merits of VaR. However, despite its weaknesses, VaR is the right risk measure in a wide range of circumstances."
Assume your bank targets a 0.06% one-year firm-wide value at risk (VaR; in other words, borrowing Stulz's illustrated example). Further assume your bank quantifies three major risk types: market, credit and operational risk. Which of the following is true?
a. To obtain firm-wide risk, we should aggregate market, credit and operational risks but exclude business risks
b. To validate (ie, prove unbiased) the one-year 0.06% VaR with a confidence level of 99.0%, we will require a backtest of approximately four or five years
c. Risk aggregation at the firm-wide level introduces substantial model risk due to both the correlation assumption (ie, between market, credit and operational risk) and the non-trivial summation of non-normal statistical distributions
d. At extremely low probability levels like this 0.06%, the issue of unknown risks--that is, Rumsfeld's "unknown unknowns" and Taleb's "black swans"--are not relevant in practice because the time time horizon specified by our VaR metric is short (it is only one year).
601.2. According to Stulz, "An important issue in setting limits is the determination of the level of aggregation for which limits are set. In practice, the issue is often described as the issue of selecting the level of granularity of limits." Which of the following guidelines is most TRUE about the calibration of limits?
a. It is best to maximize the granularity of limits
b. Less granularity might be advisable in order to capitalize on opportunities
c. A key definitional aspect of a limit is that it should never be increased or otherwise changed
d. Limits cascaded below the firm level sound good in theory, but in practice do not add value
601.3. In regard to the limits of incentive pay, Stulz writes that "Incentives should be set right, but incentives have limits. It is not possible to set up an incentive plan that is so precisely calibrated that it leads executives to take the right actions in every situation. Executives have to deal with situations that nobody contemplated. Employment contracts are by their very nature incomplete. A further issue is that not all risks can be quantified or defined. As a bank focuses on specific risks that it quantifies and can account for in employee reviews and incentive plans, there is an incentive for employees to take risks that are not quantified and monitored. Because of the limits of risk management and incentives, the ability of a firm to manage risk properly depends on its corporate culture as well."
You are currently interviewing four Compensation Consultants for the important role of giving advice to the bank's Board on the design of the bank's compensation plans. You ask each of them about their view on the role of incentive pay (e.g., annual bonus, long term incentives, equity grants) at a bank. You hear the four different answers below. Which view is the MOST AGREEABLE with Stulz's advice on incentive pay?
a. Link at least some portion of an individual's pay to the firm's overall value creation or value destruction
b. Link variable pay exclusively to individual and business unit performance in order to ensure maximum "line of sight"
c. Pay a bonus to risk managers only if they meet all of the specified criteria in a compliance-oriented checklist, where each compliance test is either passed or failed
d. Based on clinical studies, incentives are largely irrelevant because risk management should be divided into two groups: one based on formal measures and one based on intuition and impersonal relationships.
Answers:
