Why do we need a new perspective on risk?

Now that we’re halfway through 2023, it’s time to reflect on this year's events and what it means for the future. In this Q&A, we speak to Stefano Iabichino, Cross Assets Quant, UBS, to explore the most pressing issues in the banking and financial services sector and understand key future challenges.

Tell us about yourself and your role at UBS!

My journey in finance began during my PhD studies in Quantitative Finance, where I developed a deep interest in XVAs (X-Value Adjustments). During my PhD, I worked as an XVA Quantitative Developer at Global Valuation Ltd. With my PhD supervisor, Claudio Albanese, I developed second-generation XVA metrics and risk-management frameworks such as the Legal-Entity FVA and the bottom-up Quantitative Reverse Stress Testing, works that have been published by Risk Magazine and the Quantitative Finance Journal. I worked as an XVA quantitative model reviewer at JP Morgan & Chase, and nowadays, I am a Quantitative Structurer within the Quantitative Investment Solutions team at UBS.

What big banking and broader financial services sector events shocked you this year?

The event that caught my attention this year was the banking crisis that unfolded in the first quarter of 2023. I deem funding risk as the common denominator of the default events of Silicon Valley Bank, First Republic, and Credit Suisse, a subtle and intricate risk we will aim to delve into at QuantMinds International.

What are your key takeaways from the first half of 2023?

My key observation from the first half of 2023 is that despite the considerable efforts made by regulators and banks to stabilise the financial sector after the Great Financial Crisis (GFC), inherent instability persists within the banking industry. The collapse of Lehman Brothers was also rooted in funding risk, and the funding risk management practices implemented in the aftermath of the GFC show limitations in promoting financial stability effectively. Fast-forward to the first half of 2023, we witnessed the necessity of establishing funding pools, whether privately or through initiatives like the Fed's Bank Term Funding Program, to mitigate another funding crisis.

Sounds like funding pools are not the sustainable way to go about this. Do you see more regulations to come in?

You're correct in pointing out that funding pools may not be a sustainable solution. For example, the private pool established to assist First Republic Bank did not effectively address the bank's crisis, and the Federal Reserve's funding program could interfere with the transmission of its monetary policy.

If further regulations are considered, it is essential to ponder their potential impact on the delicate equilibrium of the banking system. For instance, if the aim is to increase banks' capital buffers, increased regulations could limit the already tight margins of manoeuvre banks have to offset their funding costs. This could have unintended consequences, creating an even more unstable environment. Any new regulations will have to ensure that they strike the right balance between stability and the ability of banks to manage funding effectively.

Let’s talk about market trends. How is the rest of 2023 looking?

Considering the delicate equilibrium in which the banking sector operates, the impending LIBOR demise, and the inadequate robustness of current funding risk management practices in protecting banks' equity buffers, I don’t see a rosy future.

What would it take to achieve financial stability?

One crucial factor to significantly stabilise the banking sector is for banks to improve their funding risk management policy by enhancing their interest-rate elasticity. This solution requires banks to accurately quantify and exchange each client's impact on their total funding risk. By doing so, banks can create a robust and consistent hedge against funding risk. Elastic interest rates would help banks to absorb shocks to their funding costs naturally, preventing the risk of the funding-risk doom loops we witnessed. A bank that could automatically break a funding-risk doom loop would ease the need for extra capital or external intervention.

What practical and strategic challenges do you foresee?

Considering the industry's current state, attaining a stable equilibrium becomes possible if banks are willing to redefine their perspective on risk. A shift from the conventional counterparty-centric view of a bank’s risk to a Legal Entity centric one can help achieve this. The advancements in technology, particularly those used in machine learning (ML) and artificial intelligence (AI) context, offer opportunities for this transformation.

What advancements in AI and ML do you see as most promising?

The field of AI and ML has made significant advancements. However, it's essential to acknowledge that while ML and AI models excel in analysing repetitive patterns, applying them to financial markets can be challenging due to the non-repeatability nature of their events. For example, rare events (e.g., Covid-19 or the Russian war on Ukraine) could undermine ML and AI reliability. Furthermore, if banks base their risk and pricing platforms on ML models, they run the risk of generating prices that are not arbitrage-free. However, the requisite to advance banks’ risk management practices (e.g., adopting a Legal Entity centric view) is to employ consistent and robust models that grant arbitrage freedom across all potential future scenarios. In conclusion, caution is necessary to avoid misleading actionable insights when utilising ML and AI models in pricing and risk-management.

What are you most excited to learn and discuss at QuantMinds International later this year?

The richness and variety of QuantMinds’ agenda make it the perfect place to delve into a broad spectrum of topics. I will not miss XVA and QIS-related topics.

This Q&A represents the opinions of Stefano Iabichino, and it is not meant to represent the position or opinions of UBS or their members.