The risks of risk management revisited
When I look out at the world, one of the major risks to the markets that I see is, ironically, risk management. I suspect that one of the primary employers of junior quants in the last 5 years has been in risk analytics (HHs, please correct me if I’m wrong). If there is any truth to that, it means there is literally an army of quants who have not lived through a business cycle building risk systems on markets that no one really understands, e.g. CDS/CDOs.
If things are at all like what I have seen, then we’ve got a bunch of fairly clueless risk managers out there with an army of fairly green quants developing sophisticated risk models that are probably pretty useless in a crisis. Nonetheless, there seems to be this completely ludicrous false sense of security.
Across the boards, vols seem to be historically low which would mean that most VaR engines are saying “smooth sailing”. What happens if vol increases? Everyone’s VaR model is going to start sending out little red flags. Assets are going to start getting reallocated. Since everyone has almost identical VaR models, the signals will be pretty much identical at all firms. I know it is not an original argument, but this could easily lead to a negative feedback. A small red flag due to increased VaR could signal everyone to make very similar reallocations. If everyone does it at the same time, the market will obviously be affected. In essence, the impact of risk management could actually increase systemic risk in the markets and amplify vol movements.
With that in mind, you can probably imagine how much I enjoyed this article by Avinash Persaud at VoxEU:
4 April 2008
I also enjoyed his 2000 article referenced in the above paper
Sending the herd off the cliff edge:
The disturbing interaction between herding and market-sensitive risk
Both are well worth reading.