hughk's Journal: Risk - A polite name for gambling

A while back I was working at a major UK bank in the Risk area. Essentially there are three types of risk that may be interesting to the IT person:

• Operational Risk - technical failure (may also be a major personnel issue like a flu outbreak, but technical failures are what interest us)
• Market Risk - the risk that a banks positions in instruments may be exposed by adverse market conditions
• Credit Risk - the risk that someone you have loaned capital to whether as cash or securities can no longer repay it

All areas should be monitored, but Market and Credit Risk had to be assessed and evaluated on a daily basis and the exposure of the bank controlled. These three types of risk come from the Basel II Accord which was agreed by the Bank of International Settlements in Basel. The BIS is an international organisation setup to ensure that banks area able to work with each other across borders as central banks only work within a country (or in the case of the ECB, a group of countries).

So what was I going to say, well in the old days there were straight equities and there was debt. It started when debt was securitised. The issuer of the debt was assessed (hence the AAA ratings) and the bank would protect itself (by hedging) accordingly. Now debt is being wrapped up with other instruments in something called Credit Risk Derivatives. These allow the risk to be sliced and repackaged into low-risk/low-gain instruments and high-risk/high-gain instruments. Generally the latter are referred to in the industry as toxic waste.

One of the most important things about any instrument held by a bank is there must be a way to value it. In the case of a straight liquid equity, you can look at the price on the stock exchange. Credit Derivatives tend to be traded Over the Counter or OTC. This tends to make it difficult to get a true valuation so you have to use a formula and be conservative. How conservative depends on the market. At the time of writing nobody wants to buy any more risk so there is a problem.