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I Saw a Werewolf with a Chinese Menu in His Hand

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This blog post originally appeared on GARP – Global Association of Risk Professionals.

The late, great Warren Zevon sang about werewolves living it up in his sardonic 1978 classic “Werewolves of London.” It seems there may be more metaphorical truth to this song than meets the eye.

In his recently published book, The Hour Between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust (Penguin Press), John Coates brilliantly explains how physiological reactions to success, stress, threat and opportunity may be at the heart of the excesses that accompany, and can even define, the tail ends of financial peaks and troughs. A former Wall Street trader, Coates has some fascinating ideas for how a working understanding of this intersection of neuroscience and finance could benefit the risk management of investment banks, as well as the health of the risk takers themselves.

080712_JohnCoates_BookCover
Former Wall Street trader
John Coates’ new book
focuses on the intersection
of neuroscience and finance.

The book itself contains a large amount of hard science, centering on the body’s unconscious reactions to change in the immediate environment and how that in turn, via the natural production of hormones and steroids, dictates the conscious reaction to the situation. It also shows, as a working example, how this plays out on a trading floor, where such reactions can have an impact on both the health of the firm in question, and within the overall financial system.

I Saw a Werewolf Drinking a Piña Colada at Trader Vic’s

The results of various experiments make for truly interesting reading, with daily P&Ls being positively correlated to startling testosterone levels, but, for risk management, the further increase in testosterone that the very success generates, and the subsequent increasing tolerance for risky behavior that follows it. The book describes the euphoric rush at the peak of a successful trading day in a bull market, as a “point that traders and investors feel the bonds of terrestrial life slip from their shoulders and they begin to flex their muscles like newborn superheroes.”

This observed behavior is counterpointed by the economic theory typically employed in the same banks, which assumes rational behavior from market participants, and begins to highlight where the two views diverge, creating the volatility and exuberance seen at the height of a boom. Moving easily between neuroscience, philosophy, pop culture and financial market behavior, Coates highlights differences between the ideal (rational) and the actual (potentially irrational) trading behaviors.

Equally important is the bodily reaction to underperformance and its ability to dictate a highly risk-averse state of mind. Again moving through the subconscious to the resultant conscious reaction, it illuminates the situation at the bottom of a bad day, and how body can initiate instinctual reactions to stress, leading at the extreme to an inability to act at all.

He’s the Hairy-Handed Gent Who Ran Amok in Kent

The book concludes with a number of ways that such knowledge could be used to strengthen risk management, from hiring policy through active trading-floor risk management. The key lies between two core elements: the testosterone levels of the trader; and the trader’s ability to deal with spiking levels of uncertainty.

The first point would seem to indicate that when bringing together a cluster of younger (less experienced in dealing with stressful conditions) men (higher testosterone), and spiking that cocktail with an environment of monetary and cultural reward, short-term performance is likely to increase the severity of tail events. A more diverse mix of gender and age is likely to dilute this significantly. It is also important to recognize and intercept extreme physiological responses, and suggestions include both longer-term incentive schemes and a more pastoral management of success and failure through the cycle.

These are excellent ideas, but it is also important to employ a risk monitoring system that tracks individual traders’ successes and failures, including higher and lower P&Ls on specific positions and trades, which would logically seem to be early indicators of their subconscious drivers.

All in all, Coates’s book is a must read for risk managers who would like to progress their firm’s risk culture beyond end-of-day reporting.

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  • Read more expert insights on risk management.
  • Explore SunGard’s enterprise risk management solution, Adaptiv.

senior vice president, Astec Analytics, SunGard’s capital markets business

No “Silly Season” for Securities Lending

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The time known as the “Silly Season” is upon us. An annual tradition, the Silly Season marks that time in the year where nothing of note is happening. As a result, our newspapers usually contain bizarre stories that would never normally get any airtime and people realize that as our politicians are all on holiday, no one is actually running the country. This year is different of course; with the Queen’s Jubilee and the Olympics in London, there is no shortage of activity.

Similarly, securities lending has much going on. For example, the European Securities and Markets Authority (ESMA) has launched new guidelines on income distribution for securities lending. Of arguably more immediate importance, new short selling bans have also been re-introduced in Italy and Spain. Spain has put a three-month ban on all shares in place from July 23, and Italy mandated a new ban for one week only starting July 29 for insurance and banking shares.

In what some have described as an act of desperation, the short selling bans have been introduced as a result of market volatility even though such bans have been shown in the past to be ineffective and indeed even counter-productive to this aim. Such bans have impaired liquidity and damaged already ailing investor confidence; they have also been seen to drive short selling into other European markets.

While securities lending is not equal to short selling, it is a good proxy for measuring such activity, especially as we are now outside of the main dividend season. While it is a little early to see an impact from these bans on lending activity in these locales, prior evidence shows that such bans raise spreads, drive out liquidity and scare investors – presumably exactly what the regulators do not intend. For Spain and Italy, does this herald the start of their own Silly Season, perhaps?

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senior vice president, Astec Analytics, SunGard’s capital markets business

On Your Marks (& Spencer), Get Set, Bid

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Following a torrid first half of sales performance, shares in Marks and Spencer had fallen from this year’s high of £3.89 to a low of £3.12 on July 12, triggering speculation that a takeover bid may be in prospect. Rumors of a bid have boosted the share price almost 10 percent in the last 10 days, but not everyone agrees that this will occur.

While the possibility of a tie-up with another large retailer has been mooted in the past, it seems that the more likely suitor this time round would be a private equity house. However, with a market capital currently exceeding £5.4 billion, it would take an extremely audacious bid to move M&S into private hands, even before a purchase premium is applied which would take it closer to a price of £6bn.

As a result, short sellers have been taking up positions ready to take advantage of the rumors falling flat; shares on loan as of August 1 were just under 70 million shares, rising around a third to 93 million by the close of Friday August 3, pushing utilization up to around 18 percent (on a par with Mothercare, who are suffering their own difficulties, but way ahead of average levels in both the Multiline Retail sector and the FTSE 100).

Data from SunGard's Astec Analytics

The remainder of this week will be of great interest as we see whether the rumors turn into reality or evaporate, when we could see the short sellers heading for the check-out to count their profits.

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senior product specialist, SunGard's capital markets business

Capital Markets Regulatory Compliance: An Olympian Task

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Portions of this blog post originally appeared on Markets Media.

With the London Olympics in full swing, one can’t help but think of the state of our industry and the challenges ahead. When it comes to regulation and compliance for the capital markets, we certainly face an Olympian task.

At present, we aren’t exactly in fighting form. The industry has sustained several serious injuries, hampering its ability to perform well in forthcoming events. Despite the many stumbles and falls along the way, we are forging ahead and becoming stronger.

Our referees, the regulators and politicians, are looking on in dismay and are now busy reviewing rulebooks on how the game is played, judged and monitored. Risk is obvious, and rushed rule changes could in effect alter the sport beyond recognition.

Regulation is brought into place as protection to keep the game and all the players operating safely. But what happens if the regulators force boxers to wear pillow-sized gloves and helmets so big they can’t see clearly? There is risk, too, in over-regulation. However, recent examples in the capital markets world tell a different more balanced story.

Short selling regulation

Regulating short selling (EU Regulation 236/2012, ESMA 2012/228, which takes effect in November 2012), is essentially an attempt protect us from ourselves by controlling short selling of bank shares and sovereign debt. The intention is to ensure a level playing field across member states and to build a new reporting mechanism.

The regulation text is refreshing reading (honestly!) in that it explicitly states the benefits of short selling and the important role it plays in ensuring the proper functioning of financial markets in the context of market liquidity and sufficient price formation, while emphasizing that identified risks should be taken seriously.

This rushed-through regulation is really about reporting and measuring. This is similar to the introduction of electronic censoring of goals and ball positions in sporting events. Was the tennis ball short of the base line or not? Now, we will know the answer.

Of course, this also presents challenges for market participants, such as increased burden of already stretched back office systems and staff; the need for flexible data systems; new reporting obligations, etc.

With the short selling regulation, ESMA is looking for a level playing field and a uniform implementation and enforcement across the union. It is also empowered by the Commission to step in and enforce preventative measures across all member states.

Investor protection

The final report for ESMA Guideline 2012/387 was published on July 6, and we’re now waiting for the clock to start ticking for the guidelines to take effect, approximately four months after the publication of the translated versions.

The guidelines detail to great extent how investment firms should record and monitor sales practices and customer vetting practices, including regular follow-ups, to ensure recommendation of proposed financial products are fit for their purpose, are clearly understood, and match the risk profile of the customer.

They do not make any difference between professional and single individual customers, so the systems the guidelines are asking for are relevant for investment firms focused on professional investors as well as firms focused on retail.

Again, new rules bring new challenges. To comply, firms will need to have systems in place for efficient and easy recording and follow-up. And yet many firms are not yet gold-medal material in this regard.

MiFID and MAD marathon

We mustn’t forget our ongoing regulatory marathon in the background. Between MiFID and MAD, it’s a difficult marathon through London streets, trying to avoid pot holes. Of course, firms are still running while waiting for Commission voting, which has been postponed to mid-September.

Will the industry light its torch and bear its head high, work with politicians and regulators, resist over-regulation and arrive at a state that ensures fair, open markets that will lead to a thriving and healthy industry? There is still judging to be done, but it certainly seems we are running, cycling, and swimming in the right direction.

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senior vice president, Astec Analytics, SunGard’s capital markets business

Trouble Ahead? New Short Selling Regulations from ESMA

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The first half of this year has seen a flurry of activity among regulators as they battle to construct new regulatory regimes that reduce risk, increase efficiency and bring a new level of transparency to volatile markets. Driving this volatility is a series of unknowns, ranging from the longevity and stability of the euro to which country will be next to require a bailout.

I recently attended the annual International Securities Lending Association (ISLA) conference in Madrid, where one of the subjects up for debate was, of course, regulation. Based on the keynote, it seems very clear that increased regulation is coming, whether the industry wants it or not, and it’s coming soon. The keynote opinion stated that the political glue that holds Europe and the single currency together may be more like concrete, and the solution for Europe could be, in fact, “more Europe.”

The new SSR legislation is a prime example of this in the context of the securities lending industry. While its primary aims are to increase market settlement certainty and reduce naked short selling, the original drafts included many potentially serious unintended consequences for securities lending, and by association, the wider financial market itself through reduced liquidity, wider spreads and poorer price discovery. Thankfully, much of this has been avoided through effective use of the short consultation period available, but in the run up to implementation of the new rules in November this year we face a new problem – that of interpretation and application.

At the conference, I co-chaired a well-attended roundtable on SSR. Two aspects of that session raised concerns that are worth further debate. In a room of more than 30 people, there was only one agent lender. He agreed with two senior representatives of two large borrowers present that the lending community were generally taking little action responding to the new SSR regulations, instead expecting their borrower counterparts to create a new one-size-fits-all liquidity measuring and locate recording process for them. While this may sound like a good idea, the two major borrowers then explained that they had totally opposing positions in interpreting the regulations, so how they were going to apply them?

While as an industry, securities lending has an amazing way of finding its way through difficulties, there could be trouble ahead.

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executive vice president, Astec Analytics, SunGard's capital markets business

Securities Lending: Eyes on Facebook and Zynga

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Viewing the movement of securities lending volumes and prices for stocks during the day can provide a detailed picture of market sentiment on a minute-by-minute basis. This can be especially useful after a major announcement.

It is apparent that the price movements and market sentiment responses to corporate news are more immediate with social media associated stocks than they are with traditional manufacturing companies. Perhaps this is not so surprising given the will o’ the wisp nature of the former. At the end of the day, if Caterpillar is in trouble, you have a stockpile of large dumpers and diggers to play with in your personal sandbox, but what have you got with Internet and social media companies?

Today, the arcane market of securities lending watched for Facebook’s first earnings announcement. Facebook’s stock price was affected by the poor results from Zynga yesterday on July 25, but what were the short sellers going to do?

Well, writing at midday Thursday, July 26, the early morning was quite slow to get going, which was remarkable for its “unremarkableness.” Certainly, there was not much borrowing of shares to support increased short selling activity in either Zynga or Facebook by mid-morning. However, things have started to move since then.

By lunchtime, according to our real-time data, the cost of borrowing Zynga shares had doubled to about 1% per annum as had the cost to borrow Facebook, which rose to 0.85% per annum. In addition, the volume borrowed of Zynga shares had increased by nearly 2 million shares on an already outstanding borrowed volume of about 20 million. While not as large an increase was seen in Facebook volumes, it was ticking up slightly.

It remains to be seen what might happen following Facebook’s announcement after the close of trading.

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How to Use Cash Flow at Risk

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We’ve all been hearing a lot about Value at Risk (VaR) lately, from discussions about its usefulness as a risk metric to likening it to a hero’s journey in Star Wars. What we don’t see discussed quite as much is Cash Flow at Risk (CFaR), which can offer significant insights in as one looks to control costs. But it’s important to know the differences between VaR and CFaR, and to know how CFaR can benefit the firm.

How does CFaR differ from VaR?

VaR signifies the value which can be lost in a portfolio of financial derivatives with x% certainty (e.g. 95%), in a given time horizon (e.g. 1 day). On the other hand, CFaR signifies the cash that would be received from or paid to a portfolio of transactions with x% of certainty over a given time horizon (e.g. 365 days). Value at Risk looks at the anticipated change in the value, while Cash Flow at Risk looks at the expected cash-flows exchanged upon consummation of the transaction. This makes CFaR a value that corporate hedgers can use to identify the risk associated with changes in the prices of a commodity they may purchase or sell.

How could a firm use CFaR?

Cash Flow at Risk is a Monte Carlo simulation methodology with a longer time horizon. For example, an airline could use CFaR to simulate the future expected price of jet fuel for next quarter, or over the next six months, or even over the course of the next year.

If that airline were considering hedging their potential exposure that could result from jet fuel purchases, several critical management decisions must be made, starting with these:

  1. What is the firm’s business objective?
  2. Should we hedge at all?
  3. If so, how much should we hedge?

For more details about the best practice approach to hedging using CFaR and for the step-by-step of a real-world example, download the latest paper from SunGard’s Kiodex business unit.

Step 3 is where CFaR really comes into play. Results from running a Cash Flow at Risk calculation ultimately represent a “market consensus” forecast of the jet fuel prices that uses objective statistical analysis, eliminating subjectivity. As a result, CFaR should increase shareholder and management confidence that the company is making intelligent hedging decisions, which should lead to better cost management.

It should go without saying that an effective risk management policy requires an objective and statistically sound methodology. Cash Flow at Risk is a tool that can provide this. At the end of the day, CFaR answers one of the most pressing questions facing the company:  What is the consensus opinion on the outcome of commodity prices in the future? Knowing the answer to this question can mean the difference between making an intelligent or a misguided hedging decision.

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general manager, Stream GMI, SunGard’s capital markets business

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IS PURSUING THE DODD-FRANK END-USER CLEARING EXCEPTION WORTH THE TROUBLE?

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The Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission, (SEC) in a much anticipated ruling, have approved the final definitions of “swap” and “security-based swap.” In addition, the so-called “end-user” exceptions have been finalized.

Swap participants seeking an end-user exception will generally applaud the decision that exempts them from submitting swaps for central clearing. However, these participants may be surprised to learn that the additional burdens of noticing, documenting, and reporting, may make that decision more burdensome than beneficial.

For instance, if a swap participant seeks an exception, it must first file a notice with the CFTC, and additionally provide proof that it is using the noted type of swap to hedge or mitigate qualified commercial risk. The exception-seeking swap participant must then notify the Commission of how it generally meets its financial obligations associated with the swap. And finally, there are ongoing reporting burdens that require an excepted entity to report to the Commission or to a data repository, on a swap-by-swap basis, or annually for reduced activity. If the exception is invoked, each exempted entity is held responsible to hold itself open to the CFTC for any additional information that is required. This information may include trade capture details, position valuation, risk modeling, settlement, or other relevant trade-related data that must be adequately maintained.

Notwithstanding the inherent credit and operational risks that exist in all bilateral non-cleared swaps, resource considerations are necessary prior to seeking approval for a clearing exemption.

The practical implication makes the invocation of an exemption even more uncertain. That is, although the margin rules are not yet finalized, and the proposed rules do not impose margin requirements onto non-financial swap participants, there is a conflicting requirement that certain swap participants must have credit support arrangements in place to govern the rights and obligations of the parties, including margin. And these swap participants have a heightened responsibility to manage their swaps activities.

Logically, these entities are likely the counterparties of those seeking an end-user exception. However, these entities have an independent duty, separate and apart from any exception consideration, to model and manage all swaps. The heightened compliance requirements will likely pass to those swaps entities that seek to qualify for an end-user clearing exception.

One must consider that once these costs, including trade life cycle technologies, are passed on to the exception-seeking swap participant, together with the additional burdens of noticing, documenting, and reporting, is the end-user exception really worth the trouble?

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trading and client connectivity, SunGard’s global trading business

WHY SHOULD BROKERS FOCUS ON TOTAL COST OF OWNERSHIP?

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For smaller European broking firms, particularly those engaged in regional business, the implementation and management of technology and connectivity across multiple trading venues post-MiFID is proving increasingly costly and time-consuming. Adding to this pressure, client and regulatory demands to deliver best execution have to be met in a context of declining volumes and intense competition. The overall pressure on margins means that brokers have to consider carefully how to undertake any business development initiatives in the most efficient and cost-effective ways.

Meanwhile, the overall importance of technology in the delivery of brokerage services continues to grow; and as its use extends across all business processes, its cost also becomes more important. Making the right technology choices is therefore vital, and it is equally important to manage resources efficiently.

There is today an increasingly sharp realization that optimizing the management of technology can make a huge difference to its total cost of ownership (TCO).

It has become clear that regional brokerage firms cannot support the ongoing rise in technology costs that results from a business-as-usual approach, and one consequence of this is rapid growth in the use of managed or hosted services. Brokers can essentially go one or more of three ways (indeed we see increasing numbers now using all of these options):

  1. Outsource execution as a whole.
  2. Use managed, mutualized services for market data and trading.
  3. Apply the same approach for connectivity to clients.

Outsourcing of execution is widely used for global trading – in North America, Asia-Pacific and worldwide emerging markets. The European broker can offer its clients a full service for these regions, while behind the scenes the order flows are sent to local brokers via FIX links and order routing networks. Some firms have gone further and also outsourced expensive multi-venue European execution, including smart routing, but it might be argued that this is akin to “outsourcing your soul” and is a step too far for most. Fortunately, many options exist at the level of having technologies, as distinct from entire business functions, managed by service providers.

The outsourcing of market data management to vendor firms is of course long established, and trading connectivity is an obvious follow-up. In the U.S., order management and connection to markets have been handled almost exclusively via managed services, or software as a service (SaaS), for many years, and European firms are increasingly conscious that trading servers, order management systems and smart routers do not have to be run in-house.

Just as connecting to multiple exchanges is complex, so too is connecting to a large number of clients. A broker is typically required by its clients to deal with a range of connection types over many different networks, both FIX-based and proprietary. A managed services approach can render the technology transparent to both broker and clients, and also can help to deliver the flexibility and speed of response that is typically required by buy-side firms.

The decision to follow the SaaS managed services route is normally a straightforward financial one. Where a technical and operational business process is sufficiently standardized, a brokerage firm gains no competitive advantage by running that process itself. Engaging an experienced managed services provider will almost certainly result in lower TCO, and potentially in some real functional advantages, such as lower latency via co- or near-location of servers for a given trading venue.

For brokerage firms, the use of SaaS and associated simplification of business processes can enable them to achieve a significant reduction in their TCO and to place management emphasis where it should be: on looking after client relationships and growing revenues.

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vice president, risk solutions, SunGard's capital markets business

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SURVEY SAYS: VOLATILITY RISK A MAJOR HEADACHE FOR US FINANCIAL FIRMS

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When considering current industry views on volatility risk, it should be noted that traditionally, profitability of trading and investment banking fed on volatility. The terms “volatility” and “risk” can almost be used interchangeably; good risk management could be defined as effectively managing the varying levels of uncertainty from an expected outcome. The greater the uncertainty of an outcome, the greater the risk (or higher chance of loss), the higher the required risk premium; this is the standard risk equation.

What is most striking about the results from “Vulnerability to Volatility Risk – a Global Challenge,” a survey conducted by the Economist Intelligence Unit for SunGard, is the level of worry, particularly in the U.S., from firms around their vulnerability to volatility risk, with more than half the respondents expressing concerns over their firm’s ability to withstand increasing volatility risk over the next three years.

I see two core reasons that could be underlying this risk-centric headache, particularly in the short term: regulatory response to volatility and/or sovereign instability.

Regulatory Response to Volatility

Regulatory responses to increasingly uncertain markets have significant impact on financial firms, which is evident in the survey results. The expected regulatory response to crisis or potential crisis is to protect the system itself, rather than the firms within it. This is normal and particularly in the U.S., much of the post-crisis talk has been around prevention of systemic risk. In essence, the goal is to force liquidity buffers, collateralization and risk-driven capitalization to levels where a firm’s default is only the firm’s default and not a ‘black hole’ in the financial cosmos, into which multiple other firms are pulled. But the increase in capitalization and collateralization has the impact of removing working capital and market liquidity, which hurts smaller firms the most. They are aware of this regulatory side effect: the survey shows these firms are the least confident.

We also find that the order of risk-based worries goes market, then regulatory, then credit. This is fascinating, since it could mean that regulatory reforms are seen as effective in terms of preventing crisis contagion (reducing credit risk), through higher capitalization and collateralization, but that simply meeting those regulatory requirements becomes a more significant worry. Furthermore, the effect of those regulations being met could reduce capital flow through the market to the point that market valuations, based as they are on liquid flows and values, become more volatile as liquidity is reduced.

Finally, the cost of ‘protecting the system’ results in a reallocation of budget that would otherwise go to ‘protecting the firm.’ This can also be seen in the EIU-SunGard survey, where firms see their current level of stress testing as inadequate, and their preparedness for a more volatile environment as poor at best. However, the fact that respondents tend to feel that their investment in the future state was adequate speaks to the fact that investment in protecting the firm is being drawn from other, more profitable, activities, and should be read in conjunction with the feeling that shareholder value could fall victim to the volatility climb.

Sovereign Instability

In terms of sovereign risk, it is also interesting to reflect on the last few decades having been a remarkably stable platform for European and U.S.-based financial firms. Sovereign risk had been seen as effectively non-existent in these regions, and so a pretty effective risk reward framework had been in effect in terms of investment outside the region (horizontally) and in terms of emergent technologies and industries (vertically), across both core and emerging markets.

What has happened more recently has destabilized this platform. With the U.S.-led crisis of 2008, the ongoing euro zone crisis, and increased political risks in some emerging markets, it is challenging to determine which tremors have their epicenters at the global level, and which at the local. Most risk systems are not configured for such analysis, and even for those that can be, the inputs are less scientific and more based on guesswork, increasing the uncertainty of the result.

Such responses were made within the “Vulnerability to Volatility Risk – a Global Challenge” survey, which also points to the poor opinion of the current stress testing state, as against the more optimistic expectation of the future state (where such schisms are likely to be embedded as standard stresses).

It is also clear, from the EIU-SunGard survey, that senior management teams are becoming more focused on the risks increasing volatility poses to shareholder value and their firm’s health. This is likely a consequence of regulatory pressure and, more importantly, the fact that the recent crisis exposed how vulnerable, to volatility, financial firms within developed markets had become. For some time, the escalating effect certain risky activities could have in a crisis had been less understood or even acknowledged. That has clearly changed.

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