All financial services businesses are threatened to a greater or lesser extent by the phenomenon known as tail risk - that is, the risk of an unlikely event that can create catastrophic results. A rogue trader and devastating hurricanes are examples of tail risk.
In fact, for several reasons, tail risk is a much greater threat to banks and other financial institutions than many observers of this sector appreciate.
First, although advances in risk management techniques - strong capital, loan syndications, and hedging approaches - have lessened the likelihood that traditional risks will spell catastrophe for most financial services companies, there has not been the same degree of advancement or the same utilization of available tools for tail risks.
Second, tail risks themselves are on the rise. There are many new businesses and trading practices and products that could give rise to severe losses. In addition, technological change plus globalization have made for a fundamentally faster and potentially more volatile financial services environment. Indeed, various products and services offered by banks, and some instruments they use to mitigate risks - such as credit default swaps - are so new or growing so rapidly that the risk of their causing a large unexpected event is also on the rise.
Furthermore, some of the most powerful medicines for traditional risks do not work as well for tail risks. For example it is not possible to operate a bank profitably and carry enough capital or have a large enough loan loss reserve to protect a bank from many tail events.
And addressing tail risks through blanket rules that restrict new businesses or business products stifles innovation and may actually increase tail risk in these areas.
Accordingly many risk professionals have in essence become nihilists when it comes to tail risk. Neither capital nor the allowance for loan and lease losses is sufficient protection against tail risk, and except for property and casualty losses, insurance is also only a theoretical possibility for most catastrophic risks in banking. Some risk professionals therefore view tail risk mitigation as something to study but not yet impliment.
I respectfully disagree. Although I do not believe that all tail risks can yet be fully controlled, there is actually a reasonable amount that a bank can do to mitigate tail risk. While some risk-mitigation tools, notably capital, are not as effective as one would like for tail risk, others are likely to make a positive difference, particularly when applied in combination.
The combination I believe most effective I have dubbed the "active management of risk" program. An effective AMR program has at least five parts; if each is pursued with vigor, the impact of tail-risk events can be minimized.
IDENTIFICATION
The first element is identification. By and large, tail events are identifiable. Rogue traders, freak storms, rapid changes in interest rates or exchange rates, and governments' failures to pay their debts - tail events that have caused some banks great harm - are not far-fetched risks. They are not the equivalent of an invasion from outer space.
Moreover, not only are they identifiable, but the fact that they may pose a heightened risk for some banks and not others also is identifiable. For example, tail risk increases when a bank enters certain new businesses. Tail risk also increases in the trading businesses when a bank permits small, isolated trading operations to exist.
CONTINUOUS MONITORING
The second element of the program involves continuous identification and monitoring practices.
The likelihood that a financial firm will suffer a tail-risk event depends largely on the economic environment and the firm's particular activities.
For example, when the Federal Reserve abruptly shifts policy to fight inflation, as it did in the late 1980s, short-term interest rates are going to rise substantially. Similarly, the likelihood that a dishonest trader will savage a bank or brokerage house rises when trading increases or a new trading activity is introduced.
FRESH THINKING
It is often hard for a financial institution to acknowledge that a particular tail risk exists or is on the rise. Few of us can admit to ourselves that we are operating with the potential for a massive tail event, particularly if we voluntarily took on the activity that causes the risk.
In addition, a bank's management and risk team, however astute it may be, is likely to become insular. It is hard for team members, talking among themselves, to engage in out-of-the-box thinking.
Nor are meetings with competitors to share insights - often called "peer group" sessions - wholly satisfactory. In my experience, competitors are typically reluctant, for good reasons, to tell each other their secrets.
Accordingly, obtaining periodic advice from outsiders can be quite helpful in the risk-mitigation process.
MANAGING THE RISK
The identification of tail risks and their likelihood of occurring gives banks some ability to manage these risks in an economic fashion. There are, at times, hedging, restructuring and insurance mitigants that can be used to lower the chance of a tail event happening or decrease the bite of a tail event if it does occur. Each financial institution should devote some part of its risk management framework to this task.
ACTING WITH VIGOR
When tail-risk events are about to hit, most can be mitigated to some extent by swift and decisive action. Often there are hours, days, even weeks in which an institution can respond and materially lessen the impact.
I have seen institutions take a variety of approaches, depending on the risk they are facing. It behooves every financial institution to have the right process in place so it can act with vigor when tail-risk events occur.
