Chapter 2 - Tail Risk is the Culprit: Tail Wagging the Dog?

Abstract

Credit policy function used to be a shield against extreme risk when credit was the primary financial risk at financial institutions. The examples of Continental Bank and Penn Square Bank show that the failure of credit policy function can lead to disastrous results. With increased securitization, today's financial institutions derive a much larger proportion of their revenues from market risk. This has profoundly changed the composition and magnitude of total tail risk. Traditional risk management doesn't have an explicit focus on tail risk akin to credit policy's role. This has resulted in a relative decline of the tail risk watchdog function just when the need for such a watchdog role has increased. The net effect is that, while the evolution of revenue models has increased tail risk, the watchdog role has not kept up with its critical need. As a result, most financial institutions are more vulnerable to extreme tail risk now than they were many years ago.