Inaugural lectures
Wednesday 29th February, 2012 at 5pm – Lecture Theatre SMB.0.14 (Stewart Mason Building)
Risk Appetite and Risk Aggregation: Do banks understand what they are doing?
Professor Alistair Milne, School of Business and Economics
The recent financial crisis raises fundamental questions about risk taking by banks. Financial economics offers some answers.
Standard financial economics identifies two aspects of risk appetite (the willingness of banks to take on risk). One is required shareholder return. This can be quantified using the approach known as ‘asset pricing’. The other is protection against financial stress. This can be quantified by models of extreme loss (of which the best known is Value-at-Risk or VaR).
Distinguishing these two aspects of risk is of practical value. It helps banks avoid exposure to extreme events, think consistently about aggregation of risk, and better cope with current regulatory requirements to hold higher levels of capital (shareholder funds) as a buffer against loss.
Standard analysis leaves one major issue unresolved. Should banks be aggressive (seeking high returns on capital; but experiencing substantial occasional losses) or patient (accepting lower returns on capital, but avoiding episodes of financial stress)?
In this lecture Professor Milne argues that there is no ‘one-size-fits-all’ solution. This choice should take account of the “patience/ aggression” decisions of other firms and the resulting risks to the entire financial system.