| Risk management is the analysis of risk coupled with | | | | In recent years risk management products such as |
| the implementation of quality risk controls. Risk | | | | credit derivatives have evolved into vehicles of |
| management is needed for banks and financial | | | | speculation, instruments used by financial firms and |
| institutions, mainly because it insures a margin of | | | | institutions to make speculative and sometimes |
| safety that guarantees a levered financial firm's | | | | irresponsible bets on market movements. |
| solvency. | | | | Lack of regulation, coupled with poor understanding |
| The unpredictability and inherent risks associated with | | | | of complex and Byzantine instruments, led to the |
| the financial markets makes it vital for financial | | | | credit derivative market degenerate into, to put it |
| institutions and banks to implement risk management | | | | bluntly, a Wall Street casino. |
| controls. The level of quality risk management policy | | | | The downturn in the housing markets has led this |
| and controls can make or break (literally) banks or | | | | derivative house of cards (no pun intended) to |
| financial institutions. | | | | collapse upon itself, leading to insolvency and |
| The term "risk management" has evolved over the | | | | systemic failure. Credit default swaps, however are a |
| past twenty years from the term "insurance | | | | zero sum game. Some financial institutions have |
| management". This evolved term covers a wider | | | | profited from correct bearish housing market bets. |
| variety of responsibilities than insurance management | | | | If risk management products were used responsibly |
| ever did. | | | | by banks and financial institutions, instead of used to |
| Financial risk management products, derivatives and | | | | make levered bets, the whole financial calamity could |
| other such contracts that help hedge and protect the | | | | have been minimized. It is quite ironic that systems |
| downside, include interest rate swaps, foreign | | | | put into place to reduce risks ending up being the |
| exchange swaps and contracts, as well as a plethora | | | | root of exacerbated risk. |
| of derivative securities. There are dozens of types | | | | Once the damages of the financial crash are cleaned |
| of risk management related derivative products, the | | | | up and settled, proper risk management can again be |
| most popular of them Credit Default Swaps. | | | | put into place. The need for regulation, however, is |
| The most important part of risk management is the | | | | an issue up for debate. |
| transferring of risk. A bank or a financial institution | | | | There are too many arguments for and against |
| can protect itself from the potential risks and pitfalls | | | | regulation of credit derivative markets for there to |
| of its asset portfolio by purchasing some Credit | | | | be a concrete solution to the credit derivative |
| Default Swaps. | | | | problem. |
| Credit Default Swaps, the most popular kind of | | | | There is simply too much nuance in the moral, social |
| derivative, are derivative swaps that transfer | | | | and financial ramifications of credit derivative rules, |
| exposure to fixed income assets (bonds, mortgages, | | | | regulation and policy; in no way is the credit default |
| loans) from the purchaser to the seller of said | | | | swap debate a black or white issue. |
| derivative. | | | | As long as banks and financial institutions use credit |
| Credit Default Swaps are more or less an insurance | | | | derivative products such as credit default swaps for |
| policy taken out by a creditor that pays out if the | | | | hedging purposes only, the integrity of the risk |
| borrower defaults. The underwriter of the swap, in | | | | management instruments will stay in place. |
| return for agreeing to assume the risk of the | | | | The whole concept of risk management for banks |
| underlying asset, receives a stream of premium | | | | and financial institutions is nullified by improper and |
| payments (premiums like the ones received by | | | | risky speculative activities. Risk management, if done |
| insurance companies). | | | | in a proper and responsible way, can effectively |
| Credit Default Swaps are the most popular form of | | | | mitigate systemic and market risks, risks that are |
| Credit Derivative, derivative products that protect | | | | both inherent in today's global financial marketplace. |
| creditors against systemic risks in both the market | | | | For risk management to truly be risk management |
| and in the borrower. | | | | there should be zero tolerance for rampant, |
| Risk management related credit derivative products | | | | irresponsible speculation. The last thing a bank or a |
| such as Credit Default Swaps, albeit good hedges for | | | | financial institution needs to do is exacerbate its risks |
| risk, are truly double edged swords, if coupled with | | | | by mixing gambling (speculation) with risk |
| wanton speculation and overleveraging. | | | | management. |