Integrated Management of Wealth and Risk: First Principles
World Scientific Series in Finance — Vol. 5 MANAGING AND MEASURING RISK Emerging Global Standards and Regulations After the Financial Crisis Copyright © 2012 by World Scientific Publishing Co. Pte. Ltd.
21 Pages Posted: 4 Mar 2018
Date Written: July 22, 2012
The objective of this paper is to explore two frequently ignored principles for the prudential management of financial systems at all levels of aggregation from a single individual to a national government. One of the ironies of the current global financial crisis is that the very innovations designed to mitigate risks have been identified as causes of the huge losses in wealth. But it is not the innovations that caused the cascade of losses; it was violations of the principles of prudent wealth management. This chapter explores some of those principles and illustrates how they have been violated by individuals, banks, pension funds, and government guarantee funds. The principles are:
Principle #1. Safety First. When faced with choices involving risk, start by identifying the safest choice, and use it as a reference point for evaluating more risky choices. A risk premium can only be earned by taking genuine risk. If you choose to take risk, be prepared for the possibility that a worse outcome might occur.
Principle #2. Mark to Market. Use market prices and fair value accounting for all assets and liabilities. Beware of illusory arbitrage opportunities created by use of accounting rules that violate market realities. If an investment opportunity seems too good to be true, it is probably not true. The destabilizing feedback loop caused by government guarantees of toobig-to-fail financial institutions, moral hazard, forbearance, and ever bigger government bailouts is familiar to analysts of the U.S. banking system. It is less familiar, but no less pernicious, in the case of the pension system. In the case of pensions, however, the vicious cycle is less transparent because of the fallacious belief that the risk of equities goes away in the long run. Until there is a recognition that equities are not a match for the fixed liabilities of defined-benefit pension liabilities, it will remain a serious source of financial instability for the U.S. economy.
Keywords: illusory arbitrage opportunity, fair value accounting, safety first, mark to market
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