Financial Risk Management in a Volatile Global Environment

Abstract

The virtual collapse of several Asian markets has triggered a series of aftershocks in the global financial markets. From the alleged contagion that spread the crisis to Russia and South America to the de facto collapse of Long-Term Capital Management (LTCM), the repercussions of these events have led to endless debate. Even as participants in the global marketplace continue to seek answers to basic questions, such as the cause of the events and their implications, the public sector and industry lobbyists have offered remedies. In April 1999, the President's Working Group on Financial Markets issued a report that recommended a series of measures designed to constrain leverage in the U.S. portion of the financial system. (See Box 1) Precipitated by the collapse of LTCM, the working group saw their recommendations as a needed response to the situation leading up to capital market vulnerability, regional crises and the financial collapse of some institutions. This was followed by an industry report from the Counterparty Risk Management Group, a consortium of twelve internationally active commercial and investment banks, which was issued in June 1999. (See Box 2) The new document recommends ways to strengthen the management of market, counterparty, credit and liquidity risk without regulation and government interference. To some, the government and industry responses to the crisis that began in Malaysia and ended in the offices of the Federal Reserve Bank of New York were seen as timely. To us, they seemed premature, because neither the causes nor the effects of the tumultuous recent financial market events were well understood. To shed light on the circumstances surrounding the global crisis, and to discuss possible firm-level remedies, the Wharton Financial Institutions Center held its second Financial Engineering Roundtable on "The Measurement and Management of Global Financial Risks" last Spring in Philadelphia. The event brought together an array of distinguished academics, risk managers from the major trading houses, and financial consultants to discuss the significant issues surrounding the increased risk of today's global marketplace. In the companion papers contained in this supplement, several of the participants offer their analysis and perceptions on the events of the last year, and several others propose new risk management tools motivated by those events. Here we offer an overview of both the issues surrounding the global financial crisis, as well as the potential solutions offered to assure the stability of financial firms in the increasingly complex trading environment.