The Mathematics of Financial Modelingand Investment Management

23-RiskManagement Page 754 Wednesday, February 4, 2004 1:13 PM

754 The Mathematics of Financial Modeling and Investment Management

for all funds. Among the concerns voiced is the fact that risk measure-

ment loses significance if the covariance matrix is changed daily. Also, if

the wrong measure is used, its use on a daily basis might exacerbate the

problem, leading to a too frequent rebalancing of portfolios.

Regulatory Implications of Risk Measurement

To protect the financial system and, ultimately, the broad public of

investors, financial intermediation and asset management are highly reg-

ulated, though regulations governing risk management are different for

banks and asset management firms. In many countries, an asset manage-

ment firm’s procedures are highly regulated; the firm must exhibit mini-

mum requisites of financial prowess, the ability to process transactions,

and moral qualities of its management. Asset managers are also required

to demonstrate the ability to measure risk and to communicate to the

investor the level of risk implied by their management.

Risk management has strong regulatory implications, especially for

banks. Banks are obliged to keep an amount of liquid and safe capital to

shoulder eventual adverse market movements. The amount of bank

reserves is subject to strict regulation. There are many facets related to

the amount of reserve capital that banks are obliged to maintain. Con-

sider that the amount of liquid bank reserves is a fundamental quantity

in the process of money creation and the management of the monetary

mass. A new dimension of the reserve management process is the man-

agement of the ratio between the amount of risky capital and the

amount of safe reserves. The modern view of this aspect is that regula-

tors decide the desired ratio between risky capital and safe reserves but,

under appropriate conditions, let banks measure the amount of risk they

are running with internal measurement systems. This is a substantial

novelty with respect to the past when banks where obliged to keep a

fixed percentage in liquid reserves. The point of view of the U.S. Federal

Reserve is that

By substituting banks’ internal risk measurement models

for broad, uniform regulatory measures of risk exposure,

[the new rule] should lead to capital charges that more

accurately reflect individual banks’ true risk exposures.^14

(^14) Darryll Hendricks and Beverly Hirtle, “Bank Capital Requirements for Market
Risk: The Internal Models Approach,” Federal Reserve Bank of New York, Eco-
nomic Policy Review (December 1997).