Book Review by Lawrence Baxter

Mr. Baxter is the William B. McGuire Professor of the Practice of Law at Duke University where he also directs the Global Financial Markets Center.

“Managing Extreme Financial Risk: Strategies & Tactics for Going Concerns” By Karamjeet Paul (Academic Press, 173 pages, $39.95)

About 30 years ago, many considered banking a mature industry. Revenue growth was sputtering, as the existing pie was being shared with new players such as GE Capital and Fidelity, and higher-credit-quality companies were turning to commercial paper. The era of bank “disintermediation” was moving into high gear.

Then came an unparalleled and fairly-sudden combination of 4 dynamics: (i) quants introduced the ability to model almost every element of financial risk, (ii) an unprecedented leap in the ability to manipulate huge amounts of data allowed quant models to create financial products manageable from desktops, (iii) securitization transformed almost any financial product into a tradable security, and (iv) the transformation wrought by the preceding 3 dynamics opened the way for a vast new world of “innovation,” in which the components of financial products could be stripped and recombined into a highly leveraged, ever more abstract world of structured securities and derivatives. Take away any one of these and the last 25 years would be very different.

This combination, akin to firing solid-rocket boosters from a craft losing altitude, enabled the industry to soar into unimagined new orbits. Capital markets, once competitors, became sources of new revenues. Instead of intermediating liquidity, financial institutions began intermediating risk between sources and users of liquidity, amassing on their books huge amounts of risk that would drive their revenue models.

With so much riding on risk, institutions invested gazillions into risk management. By 2008, risk management was the most sophisticated discipline the industry had ever had. So, why were banks so badly blind-sided?

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