Virus modelling, money laundering and tail beta

The week on Risk.net, May 2-8, 2020

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Risk.net montage

Two quants use options pricing tools to model Covid-19

New tool aims to gauge wider cost of virus control measures

Banks race to adapt AML systems for the coronavirus age

Lenders expect regulatory lashing if controls fail to keep pace with changes in criminal behaviour

Alt risk premia chasing ‘tail beta’ – again

Quant strategies that failed in the coronavirus crash face a reckoning

 

COMMENTARY: Survival skills      

The macroeconomic picture is not good. Bank of England forecasts issued this week predict a 14% contraction in the UK economy in 2020. Though few other countries have seen as many deaths from the pandemic as the UK, the economic damage is the result of precautions, not the virus itself, and contractions on a similar scale are likely elsewhere.

It’s the worst recession since 1706, according to the central bank’s records, when the costly and destructive War of the Spanish Succession, failed colonial projects and appalling weather combined to push the economies of the British Isles close to collapse. It’s certainly far steeper than the Great Recession of 2008–2009.

But, so far, the major financial institutions have survived.

This week Risk.net looked at a couple of areas where risk management shortcomings have become obvious – the pressure on French structured product issuers over their exposure through retail autocallables to now-suspended corporate dividends, and the failure of alt risk premia strategies to provide the insulation from market moves that they promised. But although the losses have certainly reached into the hundreds of millions, the institutions reporting them have survived. While major companies – especially high street retailers – head for bankruptcy or administration, the biggest failure of the pandemic in the financial markets has been Ronin Capital.

Three important points need to be made here. First, banks have survived because they are better capitalised than before. The decade of bitterly resisted reforms is now showing its value – indeed, governments and regulators are urging banks to reduce their countercyclical capital buffers in order to increase credit availability.

Second, this crisis is a radically different event; 2008 was an interbank lending crisis that turned into a macroeconomic crisis. 2020 is a macroeconomic crisis imposed from outside – by an exogenous drop in demand, supply and trade flows – and from which the financial sector is, one could argue, better protected than many other parts of the economy.

Third, and most importantly: it’s early days yet. Many countries are moving towards reopening, and in some cases this will be premature. A second wave of the coronavirus later this year is highly likely – the economic impact, on countries already staggering from the first wave, could be substantially worse.

Because, for all the differences between this year and 2008, there’s one very important similarity: a point could be reached in September 2020, as in June 2008, where the worst looks to be over. Yet that is the point at which a single foolhardy, hasty or ill-informed piece of policy-making could amplify the damage by an order of magnitude. The financial industry is a long way from safe.

 

STAT OF THE WEEK

Trading losses exceeded value-at-risk estimates at BNP Paribas on nine days in the first quarter of 2020, more times than over the whole of the global financial crisis. The French bank has incurred 31 breaches since 2007. BNP incurs nine VAR breaches in Q1

 

QUOTE OF THE WEEK

“Things are better now compared to March – that was a bit surreal. Trading has normalised and at least you get both sides these days. In March, it was like everyone was just saying ‘I want dollars’” – Stephen Chiu, Bloomberg Intelligence

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