CHAPTER 2

Institutional Background

A financial firm is, among other things, an institution that employs the talents of a variety of different people, each with her own individual set of talents and motivations. As the size of an institution grows, it becomes more difficult to organize these talents and motivations to permit the achievement of common goals. Even small financial firms, which minimize the complexity of interaction of individuals within the firm, must arrange relationships with lenders, regulators, stockholders, and other stakeholders in the firm's results.

Since financial risk occurs in the context of this interaction between individuals with conflicting agendas, it should not be surprising that corporate risk managers spend a good deal of time thinking about organizational behavior or that their discussions about mathematical models used to control risk often focus on the organizational implications of these models. Indeed, if you take a random sample of the conversations of senior risk managers within a financial firm, you will find as many references to moral hazard, adverse selection, and Ponzi scheme (terms dealing primarily with issues of organizational conflict) as you will find references to delta, standard deviation, and stochastic volatility.

For an understanding of the institutional realities that constitute the framework in which risk is managed, it is best to start with the concept of moral hazard, which lies at the heart of these conflicts.

2.1 MORAL ...

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