1.9.4 Emergence of Risk Management

1.9.4 Emergence of Risk Management

In 1990, risk management was novel. Many financial firms lacked an independent risk management function. This concept was practically unheard of in nonfinancial firms. The term “risk management” was not new. It had long been used to describe techniques for addressing property and casualty contingencies. Doherty (2000) traces such usage to the 1960s and 1970s when organizations were exploring alternatives to insurance, including:

  • risk reduction through safety, quality control, and hazard education; and
  • alternative risk financing, including self-insurance and captive insurance.

Such techniques, together with traditional insurance, were collectively referred to as risk management.

More recently, derivative dealers had been promoting “risk management” as the use of derivatives to hedge or customize market risk exposures. For this reason, derivative instruments were sometimes called “risk management products.”

The new “risk management” that evolved during the 1990s is different from either of the earlier forms. It tends to view derivatives as a problem as much as a solution. It focuses on reporting, oversight, and segregation of duties within organizations.

On January 30, 1992, Gerald Corrigan, President of the New York Federal Reserve, addressed the New York Bankers Association. His comments set a tone for the new risk management:12

… the interest rate swap market now totals several trillion dollars. Given the sheer size of the market, I have to ask myself how it is possible that so many holders of fixed or variable rate obligations want to shift those obligations from one form to the other. Since I have a great deal of difficulty in answering that question, I then have to ask myself whether some of the specific purposes for which swaps are now being used may be quite at odds with an appropriately conservative view of the purpose of a swap, thereby introducing new elements of risk or distortion into the marketplace—including possible distortions to the balance sheets and income statements of financial and nonfinancial institutions alike. I hope this sounds like a warning, because it is. Off-balance sheet activities have a role, but they must be managed and controlled carefully, and they must be understood by top management as well as by traders and rocket scientists.

With concerns about derivatives increasing, Paul Volker, Chairman of the Group of 30, approached Dennis Weatherstone, Chairman of J.P. Morgan, and asked him to lead a study of derivatives industry practices. Weatherstone formed an international steering committee and a working group of senior managers from derivatives dealers, end users, and related legal, accounting, and academic disciplines. They produced a 68-page report, which the Group of 30 published in July 1993. Entitled Derivatives: Practices and Principles, it has come to be known as the G-30 Report. It describes then-current derivatives use by dealers and end-users. The heart of the study is a set of 20 recommendations to help dealers and end-users manage their derivatives activities. Topics addressed include:

  1. the role of boards and senior management,
  2. the implementation of independent risk management functions, and
  3. the various risks that derivatives transactions entail.

With regard to the market risk faced by derivatives dealers, the report recommends that portfolios be marked-to-market daily, and that risk be assessed with both value-at-risk and stress testing. It recommends that end-users of derivatives adopt similar practices as appropriate for their own needs.

Although the G-30 Report focuses on derivatives, most of its recommendations are applicable to the risks associated with other traded instruments. For this reason, the report largely came to define the new risk management of the 1990s. The report is also interesting because it seems to be the first published document to use the term “value-at-risk.” Alternative names, such as “capital-at-risk” and “dollars-at-risk” were also used for a time and appeared earlier in the literature.13

Still, value-at-risk remained a specialized tool known primarily to risk managers at financial firms. This changed in 1994 when J.P. Morgan introduced its free RiskMetrics service.