Young job seeker is interviewed at a job fair in Barcelona. Spain's youth unemployment remains among the highest in the European Union. (Photo: Gustau Nacarino/Reuters/Newscom)

Young job seeker is interviewed at a job fair in Barcelona. Spain's youth unemployment remains among the highest in the European Union. (Photo: Gustau Nacarino/Reuters/Newscom)

IMF Survey: Can Risk Models Amplify Volatility?

September 24, 2007

  • Financial institutions have improved their risk management techniques
  • But their approaches to managing risk are increasingly similar
  • Using similar methods, institutions could collectively amplify market volatility

Financial institutions, many using similar risk management techniques, may reinforce instability in the financial system by moving together to adjust risky portfolios, according to a new IMF study.

Can Risk Models Amplify Volatility?

IMF study says few institutions factor in expected behavior of other firms reacting to their risk-management signals (photo: Mauricio Lima/AFP)

SUBPRIME FALLOUT

The study, released as part of the Global Financial Stability Report, said that market risk management techniques had improved over the past decade, with the use of more rigorous risk modeling and a greater awareness of market risk. But, based on simulations using a widely applied market risk management method called Value-at-Risk (VaR), the IMF researchers found that "amplification of volatility could be a consequence of increasing uniformity of models."

The report was released on September 24, at a time when policymakers around the world are trying to deal with financial market turbulence and uncertainty about the market value of some types of risky assets.

Amplifying volatility

VaR measures potential losses to a portfolio, and rises if the volatility of the underlying assets in the portfolio increases. If risk management methods—such as trading limits—are triggered by the rise, then institutions that use such techniques "may be encouraged to act simultaneously to reduce risky positions," having much larger effects than if they were acting alone. That is, a series of simultaneous actions by individual firms to reduce the risky exposures of their own portfolio means that each firm's action has the unintended consequence of amplifying volatility in the system.

Nearly all risk managers say they will not use their risk management systems so mechanistically so as to alter positions immediately. Nonetheless, the IMF found that few institutions factor in the expected behavior of other firms reacting to their risk-management signals, which the IMF said supports the results of the simulations.

Policy implications

The study identified several policy implications that arise from the simulations:

• Diverse approaches to risk management, which can be tailored to a firm's circumstances, would help reduce the chances of a common reaction.

• In assessing their risk management techniques, firms could evaluate how they and their competitors would react in a time of stress.

• Financial system regulators and supervisors ought to simulate stress situations to enable them to plan their reaction to a situation in which many institutions react in the same way.

• Banks could improve their risk management reporting to help investors, customers, and counterparties better assess their soundness.

Countries should encourage a diversity of investors with different objectives and investment positions that could act to offset trends toward similar behavior and provide a floor under asset prices in times of stress. Hedge funds could help to play this role, the IMF said, because their approach to risk management is more flexible and may "help to lessen the potential for destabilizing behavior arising from the growing uniformity of risk management practices."