Risk, Risk Management and Regulation in the Banking Industry

The Risk to Come

Peter Pelzer

• Publisher: Routledge
• Year: 2012
• Print ISBN:
  9781138798823
• eBook ISBN:
  9781136232091
• Topic: Economics
• Subtopic: Business General
• Index: Economics

This highly original book aims to broaden the discussion about risk, the management of risk and regulation, especially in the financial industry. By using terms of the philosopher Jacques Derrida, Peter Pelzer employs philosophical concepts to enrich the understanding of what risk is about and what is necessarily excluded in contemporary risk management.

1 What is to come?

We have no future because our present is too volatile. We have only risk management. The spinning of the given moment’s scenarios. Pattern recognition.

William Gibson (2003: 57)

Risk is a central topic in the financial industry, more than in the rest of the economy. There are not just the risks of the normal business as any other company has to face, but also the taking over of the risks of financial aspects from other businesses. Banks turn them into products and trade them, adding to the usual spectrum of risks. A central assumption underlying risk management and regulation is that these risks can be calculated and the consequences of losses dealt with by thorough management and controlling. The assumption of this book is that this is correct in many cases. Recent history of the financial markets, however, proves that crises not only occur, but that they also have a destructive potential for whole economies. Obviously there are aspects of risk which are not sufficiently managed, to put it mildly. It is exactly there, where my interest of crossing the borders into other fields of knowledge started.

This book is the result of an existence between two worlds, or, the life in both with a clear division between them. Many of the topics I wrote about in the academic part of my life are directly motivated and fed by my professional life in the banking industry. Most of the projects I’m involved in are about the introduction of new, or the replacement of existing, IT systems where my role is usually on the border between business and IT. It needs a look from both sides: understanding business requirements and translating them into IT concepts and understanding the needs of IT to realize, together with the business, what is possible and economical. This alone is an exciting perspective as such and would provide enough material for a variety of researches. In many cases, however, it is the content of the change which provides exciting theoretical discussions and sometimes, for me, challenges beyond the scope of the project in question. It is one of these situations which served as a starting point to what has now become this book. Several years ago I had the chance to work on the topic of risk and regulation from a perspective, which until then, was unfamiliar to me. An important industrial company ran a large subsidiary especially founded for trading in their volatile supply and sales markets. Buying and selling as such is a normal activity, of course. What made it so special in this case was that this kind of trading actually represented what can be seen as the origin of investment banking, a reminder, so to speak, that all the trading in the financial markets once were based in the real economy.

Due to changes in EU regulations and the resulting national legislation, as well as the introduction of Basel II as the international banking regulation standard, our client wanted to know what these changes meant for the business of their subsidiary and if they needed to acquire a banking permit. The project team had the task to investigate the current operations, the organization and the risk management to see how much of it was already sufficient to operate as a bank, and what was needed if the subsidiary would be run under a banking licence. My colleagues and I had a solid background in the kind of trading investment banks do and banking operations. Despite our general familiarity with the products and the fact that many of the employees of the trading house started their career in a bank, so that a common language was guaranteed, we had the feeling of diving into a different world.

We soon learned the crucial difference between this subsidiary and an investment bank. While the latter either acts as an intermediary for others to the financial markets and helps to arrange investments, transfer risks, to finance growth of the company or carry out proprietary trading, i.e. trading on own account without a link to the goods traded, the former exclusively traded commodities needed for, or resulting from, the production process of the mother company. This is a crucial difference which disappeared from the discussion after the global financial crisis of 2008 and the following years. A globalized organization of production and consumption needs a more sophisticated way to manage capital and cash flows. Derivatives in many forms were developed to meet these requirements. It turned out that the derivative as a trade also worked very well with just a reference to the underlying good or asset. No physical delivery is necessary, just a payment for the result of the deal. Trades which incorporated physical deliveries were marginalized. Nowadays they form only a small fraction of the market of derivative trading, the majority of trades are exclusively financial deals, based on the material world of commodities, currencies, securities etc., but as a so-called underlying. The underlying does not have to be part of the trade. A delivery is not intended. It is just a reference for calculation and differing estimations of their price development: speculation. In 2008 the world learned that the virtual world of financial markets was still connected to the world we live in: the so-called systemic risks materialized.

Perceiving this part as the normal business in a bank, it was extremely interesting to see that these kinds of trades could also have a strategic significance for a company. Yes, of course, the trading house must be profitable, but for them it was also a significant mechanism to fix prices for a future beyond the normal delivery contracts in very volatile markets. The difference between the investment horizon of production lines of about thirty years in their case, and the certainty for prices of products of a maximum of eighteen months in contracts for only parts of the production, left the company with severe calculation and planning problems. They intended to achieve more stability with their trading house by trading derivatives. Futures and options are mechanisms to fix prices with a counterpart. The difference to financial trades is the delivery of the good at the maturity of the deal.

The trading gave hints about future price developments. The enormous knowledge of the market in terms of regional and temporal price discrepancies could be used to stabilize the own expectations and the development of the actual prices. Therefore it could be claimed that the trading house represents a sophisticated form of risk management in a globalized world.

Inspired by a conference on Excess and Organization¹ I wrote my first academic paper on risk, risk management and regulation (Pelzer 2007). Analysing practical issues of risk management and the calculations required by banking regulation I wondered about a strange consequence. The excesses of the financial markets, always prone to boom and bust, representing the majority of deals detached from the real economy, result in a risk management which deals with an excess of data to calculate the required risk measures. The amount of data to be processed by the IT systems of the trading house, according to Basel II and the German regulation of this time, could only just be processed during night time after the day-end routines and before the start of business the next day. There was always the danger of violating the rule that the figures must be ready at the start of trading the next morning for consideration by the board of managing directors. The suspicion that it has become impossible to rule the markets, that the uncontrollability of excesses has to be hidden by excesses of risk management ever more intensified after each burst of a bubble, but incapable of preventing the next, motivated this research to make use of a different vocabulary to get an idea of what might be missing here.

Risk is a fascinating topic to which the financial industry adds at least two crucial dimensions: risk became a product, and with this move risk became the means to manage risk. This sounds paradoxical, at least dangerous for the ‘normal’ economy. The global financial crisis of 2008 has proven the danger of this system. My special interest in risk, risk management and regulation is the confrontation of the management of risk in the banking industry with the philosophical thinking of Jacques Derrida. A contribution to the discussion about safety and risk from the perspective of engineering asked for the significance of Derrida’s arguments (Armstrong 2003; Armstrong and Paynter 2004). The deconstruction of binary distinctions is a starting point to demonstrate the dependence of any text, also in engineering, on context, and how the context varies with changes in the use of terms, and vice versa. This has already been done in the discussion of the safety/danger distinction without the help of a philosopher. No term exists for itself, it influences the understanding of the other term; even more–they constitute each other (Derrida 1983). Above that their meaning is constantly supplemented, as will be argued in Chapter 8 during the introduction of risk as pharmakon. Thinking through the effects of dissemination and supplementarity leads to a fruitful re-evaluation of many terms. Likelihood, or probability, and severity, Armstrong and Paynter (2004) explain, are usually accepted as independent variables in judging the risk of accidents. A calculation of the likelihood compared with the severity of the accident, leads to a level of risk acceptance, so is the expectation. The problem is the underlying assumption that a measured probability is objective. The measured probability of an accident cannot be determined until the lifetime of the system has passed. So any accident happening immediately influences the risk acceptance. The fact of the accident as well as a potentially different severity will probably [sic!] lead to a re-judgement of the risk acceptance. The leading question in the following will be what Derridean terms, elaborations of paradoxes, and especially his thinking of what is ‘to come’, can add to the discussion of risk. A lot, I would claim: it adds a dimension necessarily neglected in the calculative mode of risk management today.

Using philosophy to reflect on issues in organizational theory is rare–but not completely uncommon–and very stimulating as several readers (e.g. Jones and Munroe 2005; Linstead 2003) or the work of authors like Robert Cooper prove.² After the initial article on the futility of excess regarding risk management and the interpretation of rule following in regulation (Pelzer 2007), where I used arguments of Jacques Derrida to introduce the inevitable paradoxes when reflecting on rules and their use and the derivative character of risk management, I looked more systematically for other terms in Derrida’s work which could be used to shatter the all too self-evident use of the term ‘risk’ itself. Given the background in banks where I experience the work with risk, I concentrated on risk in the financial industry and the effect of regulation in framing risk management. It turned out that the confrontation of Derrida’s writings with these terms can be very fruitful and that it provides stimulating insight and reasoning beyond the common discussion of these topics. This book is the present result of my exploration. Present–this already indicates two constant themes influencing each other permanently: on the one hand, to shatter the arrow of time as the image of a clear sequence of past over present to the future. Risk is an exemplary term which confuses the progression of times in favour of the consciousness that they constantly influence, destruct, reconstruct and deconstruct each other. On the other hand, the insistence on the ‘present’ shall raise the consciousness of the tentativeness of any result, as final as it may have been announced.

For me it was very instructive to learn about the different layers of risk management during the project, or, to be more precise, I realized that there are different layers apart from the management of the risk involved in the production and delivery of goods. Risk management in the banking business is additionally about the risk management of products designed for risk management which have come to lead a life of their own. To formulate it is apparently paradoxical: risk becomes a means for the management of risk. Encouraged by my first attempt to make use of the work of Derrida, I started to consider a variety of terms he used, or deconstructed, and became increasingly convinced that they are able to serve a valuable task to enrich a discussion about risk.

The heading used for this introduction therefore contains a double meaning and certain ambivalence. At first it is, of course, the question of what can be expected of this book. The reader expects an overview of the topics presented; an explanation of the red thread. Using the words ‘to come’, however, is also the announcement of what Derrida intends to express with the term ‘to come’: the denial of fixed meanings, the dependency on context and time, the crucial dynamic of moving targets. The examples he chooses–democracy to come (Derrida 2006), or justice to come (Derrida 1992)–show that the understanding of what democracy or justice is, changes on the way to its realization. The more we know about it, the more the moves of the target become unpredictable, because it changes as a consequence of what is tried to be realized, and what is learned on the way. It is the denial of an ideal, not just the impossibility of achieving the ideal, but the idea that that which is aimed at is also developed with the attempts to realize. It is an expression of the dynamics of human society and as such very appropriate for a topic with such a dynamic as risk.

Looking at the literature reveals that risk is certainly not a topic which does not get enough attention. On the contrary, the amount of valuable literature was almost overwhelming before the global financial crises of 2008 and even more so since. Risk is a topic which covers almost all areas of our private and professional lives. Being so extensively covered, I thought, it would be easy to find definitions to start reflecting on what we are actually talking about when we talk about risk, risk assessment, risk control or risk management. To my surprise attempts to define the phenomenon risk, as such, are scarce. Generalizations are as rare as deductions from a broader concept. Most of the texts rely on a common understanding and shape the notion specifically for the topic addressed. It is not easy to see what credit risk, as defined in the financial industry as the risk of the loss of the credit sum, has in common with the risk of sharps in a hospital for HIV patients or the risk a gambler takes. Niklas Luhmann was quite explicit about this observation. Looking for a definition of risk, he wrote, one feels like being in dense fog and unable to look beyond the own buffer-bar. He claimed that not even the literature explicitly dealing with defining risk covers the problem adequately (Luhmann 1991: 15).

Thus risk, which can be described as a vague everyday understanding, is a consequence of a decision, an action, the processes of an industrial plant, etc. Different views developed from different areas like disaster research (Perrow 1984), banking (BIS 2004), insurance (Skipper and Kwon 2007), health care (Carroll 2009) and others arrive at special understandings of risk and the necessary action to be taken. On the theoretical level it makes a huge difference if looking at risk from an economical (Knight 1921/1940), psychological (Kahneman and Tversky 1984; Slovic 1987), sociological (Beck 1986, 2008), cultural (Douglas 2003a, 2003b), mathematical (MacKenzie 2003a), statistical (Hacking 1975), postmodern (Miller 2009), or philosophical (Sloterdijk 2006) point of view. Ulrich Beck had a huge effect beyond an academic audience with coining the risk society (1986, updated as the ‘world risk society’ in 2008), publishing his book in the midst of a public debate about the risks inherent in modern life after reports about the Waldsterben and Chernobyl. Researching the global financial crisis with socio-analytic methods (Long and Sievers 2011; Sievers 2010, 2011) is another way to achieve an understanding beyond the obvious facts and figures. The conclusions partly overlap, partly they contradict each other. A good discussion about a complex, controversial topic so to speak. Hansson (2005) called the conviction that risk must have a single, well-defined meaning a myth. In the past years the decisive role of ignorance as impossibility to know for certain has increasingly found attention (Wehling 2001).³ The variety of approaches on risk clearly demonstrates that it is a relevant and fascinating topic which can and should be researched from very different angles. However, even if these theoretical and empirical contributions to the research on risk are quite diverse, they share a common understanding about the content of the notion of risk. In these works risk is usually accompanied by terms like uncertainty, probability, danger. There is a threat of potential harm, a hazard to life or property. Risk, one could say, represents a hazard, and therefore it is to be prevented.

Writing on risk started for me before the global financial crisis, but of course was very much influenced by the changes of the world as a result. The following is not an exploration into the immediate causes of the 2008 financial crisis. Others have already done this in very different and competent ways (e.g. a special issue of the Journal Critical Perspectives on International Business 2009; ECB 2008; Hellwig 2008; Sinn 2009).⁴ What I want to achieve here is a double move. On the one hand I want to demonstrate that the use of philosophical insights can be of help to explain or interpret events on the financial markets. On the other, I want to use these insights to open up the discussion on risk and regulation for a dimension other than for just the immediate practical use for changes of details in banking regulation like the Basel accords, to explore the effects of thinking the ‘im-possible’⁵ beyond calculation and pricing. The term ‘essay’ in the subtitle of this book is very consciously chosen. The chapters are by no means meant to be exhaustive of an elaboration of risk or the use of Derridean thinking for risk. The book is not a complete introduction into a new way of thinking risk and regulation. Rather, it is the curious confrontation of two worlds of thinking to see if that can be made productive for a more sophisticated view of considering the topics. The insights presented are preliminary in many ways. The most fundamental is a consequence of the expression ‘to come’ itself. What is ‘to come’ remains to come, whatever has been achieved to realize it. The crucial point is that the expectations develop with the concrete steps in direction of realizing, of making it arrive, as a result of understanding better what can be the content of what is to come. Important aspects are discussed, always linked to the situation on the financial markets, the flow of the arguments influenced by the rapid changes of the context. Perhaps, so is my hope, the arguments presented here help to develop an additional language to understand the inevitability of these kinds of crises if risk is exclusively conceptualized as calculation as it is in the banking industry and its regulation. To prevent disappointment on the part of the readers, this book restricts itself to forming an idea of what is missing and not on developing new ways, new methods. This must be left for future research.

Carter and Jackson (1997) used the term ‘riscomancy’ to indicate their discontent about the clear tendencies in risk research and risk management. What at first appeared to be a seemingly inappropriate term for the situation where risk in disaster research is part of the rationalistic, scientific tradition, turned out to be an adequate description for their purposes. The characteristics of risk management that creates structure from apparently unstructured data; the work at a distance, both in time and in space, from the site of the risk; the image of a value-free commentator on risk and a non-participant, are all ingredients which will be identified in risk management in the banking industry, as well and as part of an ongoing problem. ‘-mancy’ refers to divination and prophecy, as they found out when looking for the etymology. The connection is closer than they might have had in mind, when seeing risk as the successor of fate, as will be argued in Chapter 2.

Beck draws our attention to the fact that risk is an expression about a component of the future. Risk is about foresight, about something which has not happened yet, but which becomes real in exactly this context. By imagining what can go wrong, the images become a part of the decision. Risks are...

Table of contents

• Front Cover
• Risk Management and Regulation in the Banking Industry
• Routledge international studies in money and banking
• Title Page
• Copyright
• Contents
• Acknowledgements
• List of abbreviations
• 1 What is to come?
• 2 Thinking about the impossible risk in the financial industry
• 3 Risk – the sovereign exception
• 4 The displaced world of risk: risk management as alienated risk (perception?)
• 5 From ‘risk and responsibility’ to the risk of responsibility
• 6 ‘Who’s afraid of red, yellow and blue’: towards an aesthetics of risk
• 7 The risk to come – a different way of thinking risk
• 8 Risk and regulation disseminate: the pharmakon
• 9 Containing risk: towards a regulation to come
• 10 (This will not have been a) conclusion
• Notes
• References
• Index