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Risk Management versus Risk Instruments

Many risk management texts heavily focus on hedging instruments, mainly derivatives. Jumping to instruments for managing risk without prior knowledge of the source of risks bypasses the risk oversight principle. There is a major distinction between the usage of hedging instruments and the knowledge of what should be hedged in the first place.

Because derivatives are privileged instruments for controlling risks, they are introduced in a dedicated section of this book. But they are not the main focus of this book, because we know, in general, how to hedge a risk exposure once it has been properly identified. Financial institutions develop their business through an ever-changing innovation process of products. Innovation made it feasible to customize products for matching investors' needs. It also allowed both financial and corporate entities to hedge their risks with derivatives. The need for investors to take exposures and, for those holding exposures, to hedge them provided business for both risk takers and risk hedgers.

Did that solve risk management issues in financial institutions? It did not because two basic pre-requisites of a risk management system, risk oversight and tracing risks back to risk drivers, are different issues to understanding how derivatives work. Hence, the gap remains between derivatives that makes risk management feasible and financial firms' risk management focusing on risk oversight, the prerequisite for controlling risks with proper instruments.

Reverting to Better Risk Practices and Lessons of the Crisis

This text proceeds step by step in developing the building blocks of a sound risk management scheme, with the postulate that a sound usage of risk models and techniques is a tangible advance and that the sources of the current issues have to be looked for elsewhere, in the drift of practices and policies away from "best practices," rather than flaws of techniques, even though such flaws are pointed out throughout the text.

Some of the regulatory changes that emerge from the lessons of the crisis are ongoing, and some reforms have already been identified. But it is too early to foresee how regulatory changes will be implemented. A brief overview of future reforms being considered at the time of writing concludes the book. In between, we address risk management from a technical perspective, and maintain that sound risk processes and risk models have to be re-emphasized.

Moreover, the response to the crisis by financial authorities demonstrated that a major crisis implies that gains remain private while losses become publicly shared through massive government injections of cash and capital in ailing giant banks. Such responses, with the unique choices being either the "improvised" dismantling of failing financial firms or facing a financial collapse is unsustainable in the medium and long-term. It reinforces the critical need for sound risk practices and risk models for all financial firms, plus system-wide risk oversight.

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