A Fat Tail Risk Metric

I read an interesting paper by Peter Conti-Brown (read here:http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1548892) on a proposed Fat Tail Risk Metric (FTRM). Conti-Brown argues that a central cause of the financial crisis is the failure of risk models to account for high impact, low probability events i.e. fat tail events and proposes mandatory disclosure of a firm’s all exposures - contingent liabilities, such as guarantees for the debts of off-balance sheet entities, and all varieties of OTC derivatives contracts. To be sure such disclosure will not help the firm in any way to manage its risks (as VaR promises to do and fails), but such disclosures the author argues will force firms to maintain daily records on such obligations, a task which will open up a crucial set of data that has, until now, been completely invisible. With such data, researchers, over time, will develop analytical and econometric tools that better assess the consequences of remote events for individual firms and, more importantly, the economy as a whole.

The paper calls for disclosure of a firm’s (a)full, netted derivatives exposure (both OTC and exchange-traded derivatives); (b) value of its all other contingent liabilities, including guarantees for structured investment vehicle (SIV) and special purpose vehicle (SPV). When added to the value of a firm’s balance sheet liabilities we will get, what Conti-Brown calls Fat-Tail Risk Metric (FTRM). He hastens to add that “the FTRM is, to be sure, implausible in some senses: we must envision a world where every piece of financial property, every investment, every trade, cuts against the firm to create a colossal loss.”

Will it be of any use? I think yes. It will be a better yardstick to measure which organizations are getting too big or “a basic sense of the size of the crater an imploded firm would leave behind”. In a world of off-balance sheet contingent obligations, a balance sheet fails to capture the full measure of impact. Equally important, a regulatory requirement to report the inputs necessary for the FTRM would force the firms to maintain the information! It may appear absurd that firms will track their liabilities only if they were forced to report as if they do not keep track of their contingent liabilities now. But Conti-Brown asserts “this is precisely the condition that many derivatives-trading firms have faced… firms engaged in OTC derivatives trading had an 8-9 month backlog of unrecorded derivatives contracts…” and “… for every 100 new trades executed on the trading floor, there were about 1,000 aged unconfirmed trades…”. Finally, a requirement of such disclosure would not go easy with firms, since a lot of their profits is linked to investing in this space. I will not be surprised if large firms make a deal that the disclosure should guarantee Government / Central Bank bail-out in case of an implosion.

There are other issues: redefining what constitutes an off balance sheet liability, identifying and adequately arming an agency to enforce the disclosures, particularly when a firm takes its off balance sheet liabilities to a foreign jurisdiction.

I hope this paper starts a meaningful debate on such disclosures.