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With the evolution of risk management, we're learning more about aggregation, liquidity risk, and pairing assets with liabilities. Result: banks will de-lever; mutual funds will take on more credit and insurance risk, writes Robert Gumerlock
The past 30 years have witnessed the birth, infancy and adolescence of risk management as a profession. Although actuarial science has been practised for over zoo years, it deals primarily with assessing the risks of liability claims; its major contribution to the measurement of the risks of financial assets was the quantification of the time value of money.
In recent decades, the market prices of financial assets have been scrutinized with statistical tools, yielding an array of neo-Greek symbols - alpha, beta, gamma, delta, theta, vega - to complement the basic metrics of probability - mu, sigma, rho. The Nobel Prize work of Miller, Markowitz, Sharpe, Black, Scholes and Merton spawned analytic methods which today can decompose market risk into its fundamental elements.
How will risk management evolve in the next 30 years? The evolution of value-at-risk (VAR) in the mid 1990s and the current emphasis on stress-testing indicate that the pendulum is swinging toward risk-aggregation, in contrast to the previous dominance of risk-decomposition. As long as the supervisors hold out the possibility of reduced regulatory capital, financial institutions will continue to devote substantial resources to mastering risk aggregation. The direction which that development will take is best seen by examining the financial consequences of demographic trends, the basic paradigms of risk intermediation and the fundamental unresolved questions in risk measurement.
Demography beckons
The trends which will characterize finance in the first decades of the next century are rooted in demographics: statistics indicate that by 2050, there will be only two working-age Americans for every American over retirement age. Europe leads the US a decade in this regard, and Japan is to years ahead of Europe.
There is simply no way that a pay-as-you-- go scheme of social security and pensions can succeed in face of such figures. America was the first country to attend to these issues, by forcing companies to fully fund defined-- benefit pension schemes (ERISA reform) and by encouraging individuals to create defined-- contribution pension accounts (IRA, Keogh and 401K). This prompted a huge shift...