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Joel Bessis on Risk Management in Banking

Thu, 31 Mar 2016 03:24:00 GMT

Risk Management in Banking cover imageJoel Bessis is the author of Risk Management in Banking, 4th Edition out now published by Wiley. To receive 30% off your own copy enter our promo code MON30 at the checkout when purchasing direct from www.wiley.com

Jacob Bettany: Could you tell us about your background?

Joel Bessis: I became interested in banking while working as an academic at HEC Paris, a major business school in France. I had plenty of contacts with banks and got a research budget to investigate risk in banking with Paribas bank (later merged with BNP in 2000), an investment bank. I now have around 15 years of experience in investment banking. I am currently Emeritus Professor at HEC where I am in charge of the executive MBA programme in finance, and on the Steering Committee at PRMIA. My interest for the field and willingness to write stemmed from this dual experience, at a time were risk management was still at an early stage and did not generate as much interest as today.

Jacob Bettany: Risk management in banking is quite a broad area, is there any particular area of risk management that you’ve specialised in?

Joel Bessis: Indeed, there are many areas in the field and many theoretical contributions, such as market risk or credit risk models. I was originally interested in the implementation of risk management and in bridging the gap between models and what bankers do. I spent a lot of time dealing with credit risk, dealing with models that are now well-known, how they were implemented in banks, and how they helped the risk processes. I was also involved in asset-liability management, an area with fewer academic contributions but nevertheless very important as it is at the heart of the operations and financing of banks.

Jacob Bettany: What is the book’s intended audience?

Joel Bessis: The current version deals essentially with “what you need to know” if you are interested in or involved in risk management and/or in banking. So it is ideal for practitioners who are not specialists of risk management. It is also designed for students and the current edition has been widely inspired by my teaching experience, both with graduate students and with bank executives. The book presents the essential concepts, the models and techniques for understanding risk management and how it is implemented. Also the core models, for example the Merton model of default, or the value-at-risk (VaR) model and VaR methodologies - are considered as “need to know”. Such models are well detailed in the text and provide the necessary insights for going further in the quantitative analysis of risks. It is expected that the book continues to bridge the gap between scientific contributions and managers’ practices.

Jacob Bettany: So the book has evolved somewhat over the four editions.

Joel Bessis: Yes, it did evolve a lot. When it was first published in the late 90s there were no competitors and both the field and the text were new. The book was well received as being one of the very first dealing with the field. In 2002 I moved to Wiley to have international exposure. Later the book was translated in Chinese. The book grew much longer with the many technical developments taking place in the field. When I reached this 4th edition, my goal became to streamline the text. Indeed, the volume was nearly divided by two. The main text is clearer, concise and goes straight to the essentials. Core models are explained, but some technical developments, not directly connected to the field, were dropped and some others were put in appendixes. Also a professional colleague, who teaches with this book, set up a companion text, with slides and exercises, which will be extremely helpful for all users of the book and for others teaching risks and banking.

Jacob Bettany: What challenges did you face putting together the latest edition?

"Risk management is under-represented in business schools, in spite of the fact that many alumni end up working in financial firms."

Joel Bessis: First we need a strategy in writing. My strategy was aimed at streamlining and updating the text. When focusing on what is essential, you have to decide which models are core and which technicalities are not, which is a real challenge. The extent to which something is relevant depends on your own assessment, it’s a personal judgement. Simultaneously, you have to process the mass

of information to keep up with the technical developments and the regulations. Then you have to move away from the details and concentrate on the developments which are key within the big picture.

Jacob Bettany: In the foreword Moorad Choudhry describes the book as 'timeless'. We do still see improvements in risk management practices, could you give us a history of those developments as you see them and what trends are impacting the field right now?

Joel Bessis: The expression ‘timeless’ makes a lot of sense because banks are “risk machines”. They cannot operate without simultaneously building various risk exposures, and that will always be the case. Also risk managers have always tried to control the magnitude of the risks they are exposed to, that is to take “calculated” risks. Perhaps the major challenge and the major changes are in the way risks were calculated, that is modelled, measured, quantified. With Basel 1 and Basel 2, and subsequent developments, the modelling of risks made quantum leaps in financial firms. The development of risk models followed to a large extent the impulses of regulators. Basel imposed value at risk, then Basel 2 put a lot of emphasis on ratings and credit risk, and now liquidity risk and systemic risk are under scrutiny by regulators. As a consequence, there is today a much enhanced status of risk management. Also, compliance became a major issue with the complexity of rules. Some people say that quants were initially more involved in derivatives pricing before the crisis, and, after the crisis, they dedicate a lot of time to address the complexity of new rules.

Jacob Bettany: How do you feel about the current options available to students in risk management from business schools?

Joel Bessis: I don’t think that the field is well established in business schools. The core areas in finance are corporate finance and capital markets. Beyond these core courses, there are specialised courses, usually electives, and most of the time they deal with many other topics in finance, from asset management to mergers and acquisitions. This is understandable to the extent that there is a lot of complexity and sophistication in finance and a whole spectrum of potential specialisations. Risk management is under-represented in business schools, in spite of the fact that many alumni end up working in financial firms. I have been a Visiting Professor in Boston because the school was interested in having a course in risks and banking in its program. These observations are mitigated to the extent that there are also master programs in finance, banking and risks, which exist in a number of institutions. Many are of very good quality and offer a broad coverage of risks and of banks. However, those are not masters in business administration.

Jacob Bettany: People then have to learn about risk management within the banking institutions themselves.

"ALM would deserve a better academic treatment. Key issues for the development of research are: how do you set up a roadmap for ALM research; how do you motivate researchers to work along those lines?"

Joel Bessis: Yes, I have found this to be true, except for those who attend master programs in risk and finance. When people go into banks they become involved and very interested in risk management. Those who want to work in the financial industry need to be acquainted with the finance of financial institutions, and with the framework of risk management which now has an impact on so many banking decisions. This finance is entirely different from the standard corporate finance courses. There are many bankers who are not acquainted with the

technicalities of risk quantification and regulations, because they did not have the opportunity to be exposed to the topic, and also because of their backgrounds. But today anyone interested in the financial industry should have a minimum knowledge of these topics.

Jacob Bettany: What would you say is the cutting edge work being done in risk management at the moment? Is there any parity between the research work being done in academic and practitioner settings?

Joel Bessis: Liquidity and systemic risk are two topics for which we need innovations in thinking and research. There are now many contributions, once it became obvious that they were critical in the development of the crisis.

What the academics and the practitioners do differ in is scope and focus. If you take an academic field such as pricing derivatives for example, it is an extremely well-developed and sophisticated area with plenty of models, and stochastic equations, which is mathematical and complex. Also the modelling of risks, market risk and credit risk, has been thoroughly investigated in academia. And this is a key factor in the innovation and the development of the field.

A difference with practitioners is the focus on implementation. Quants in banks do use models but tend to focus on calibration as they put them into practice and need to define what sort of data to use and how to use it.  Practitioners who are not quants are highly involved with risk processes - such as risk committees and risk monitoring - leaving the models for the specialists who are supposed to provide them the relevant outputs for taking decisions.  Risk processes are of utmost importance, but they are not an academic field, although they evolved, hopefully, with the innovations and rules.

An area in which there is a significant gap is Asset Liability Management (ALM). People say it is more an art than a science, and it is true that there are few academic publications on it. We would like to have more research on it. The academics find it difficult to publish in this area because it looks like a set of common practices blended with various models, that is not unified. The current researches on liquidity might help to clarify some of the ALM issues. ALM would deserve a better academic treatment. Key issues for the development of research are: how do you set up a roadmap for ALM research; how do you motivate researchers to work along those lines?

There are other areas where research is needed. The field of governance is well established for corporate, non-financial firms. This is not so for banks, for which governance is key. This is because banks are not standard firms, as they generate externalities, that is losses for the public and gains being private. The regulators are trying to fill the gap with rules.

Jacob Bettany: Is there any recent research that you particularly admire?

Joel Bessis: I was impressed by the original article by Merton where he modelled credit risk as an option for default. I thought that was a very elegant model which makes a lot of sense. It is also easy to teach because the conceptual innovation is very intuitive and can be explained to anyone. But this is not a recent research. There are many other interesting and very relevant researches. Liquidity is a case in point. Until recently it was a question mark, perhaps because there was no reason good enough to investigate it. There are now plenty of works addressing liquidity, both theoretical and empirical. Systemic risk is an area in which there are many approaches, a necessity after the crisis. I am also interested in behavioural finance. The field is sometimes criticized because of no conclusive outcome, but as the herding behaviour became more obvious, it is, no doubt, relevant and important. I would also like to see more on the business model of banks, which is being disrupted by the “fintech” firms.

"The previous edition was composed very close to the crisis and had a dedicated chapter. In this edition I broke down the topic embedding it into the several different chapters to which it relates, for example liquidity and ALM, or credit."

Jacob Bettany: Systemic risk is distributed between the different actors and different markets. To what extent has the balance of power changed?

Joel Bessis: Many mention the fact that banks have drastically reduced, or eliminated their proprietary trading. That’s a big player moving away from the market. Also, it is quite noticeable that the European Central Bank developed its purchase program in bonds, hence became a major player in the fixed income compartment. Some relate such changes to the market liquidity, which appears to be much lower these days, because of less trading and less floating on the

bond market after the ECB purchases. And many point out that the bond portfolio of banks shrunk very significantly in volume. Many asset managers say that rolling over, or selling, their portfolios takes much more time nowadays that it used to be. Some also say that this might not be true since liquidity can have a price and if properly priced, it will be there again. Perhaps, but it is not the case yet.

Jacob Bettany: You have a section on some lessons from the financial crisis. It’s something a lot of people can relate to. What are the main lessons to be learned?

Joel Bessis: The previous edition was composed very close to the crisis and had a dedicated chapter. In this edition I broke down the topic embedding it into the several different chapters to which it relates, for example liquidity and ALM, or credit.

There are plenty of lessons to be learned. Some of the issues for banks have been addressed by the regulators. I can reverse the question, asking which issues have no convincing answer yet. Governance is an example. It seems that many bankers would find it desirable to behave in the same way as they did before the crisis, suggesting that the experience did not translate so much into a learning curve. And indeed, the job used to be smoother with less interference from constraining rules. But is “being the same as before” still feasible? Presumably not, and the development of regulations is here precisely to set boundaries to the behaviour of banks.

The finance industry is transforming itself post crisis, in all compartments of the industry. The capital markets are not doing well. Some funds collapsed recently became of liquidity-redemption issues. Many say that the central banks have fuelled a market bubble with the quantitative easing, which some expect to burst at any time. Liquidity became highly debated with the central bank drying up the secondary market for bonds, plus less trading by banks who refrain from proprietary trading. And we have new strong correlations. There is plenty of algorithmic trading with “robots”, doing nearly the same at the same time. Oil prices appear today inversely correlated with markets, at least for now: With oil price down banks with big exposures to the oil industry appear in bad shape. Which raises the systemic risk issue again.

Jacob Bettany: I really appreciate your time Professor, thank you very much.

Risk Management in Banking, 4th Edition is out now published by Wiley. To receive 30% off your own copy enter our promo code MON30 at the checkout when purchasing direct from www.wiley.com