Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk, 2nd Edition

CHAPTER 4

Financial Disasters

One of the fundamental goals of financial risk management is to avoid the types of disasters that can threaten the viability of a firm. So we should expect that a study of such events that have occurred in the past will prove instructive. A complete catalog of all such incidents is beyond the scope of this book, but I have tried to include the most enlightening examples that relate to the operation of financial markets, as this is the book's primary focus.

A broad categorization of financial disasters involves a three-part division:

1. Cases in which the firm or its investors and lenders were seriously misled about the size and nature of the positions it had.
2. Cases in which the firm and its investors and lenders had reasonable knowledge of its positions, but had losses resulting from unexpectedly large market moves.
3. Cases in which losses did not result from positions held by the firm, but instead resulted from fiduciary or reputational exposure to positions held by the firm's customers.

4.1 DISASTERS DUE TO MISLEADING REPORTING

A striking feature of all the financial disasters we will study involving cases in which a firm or its investors and lenders have been misled about the size and nature of its positions is that they all involve a significant degree of deliberation on the part of some individuals to create or exploit incorrect information. This is not to say situations do not exist in which firms are misled without any deliberation on the part ...