Journal of Financial Regulation and Compliance

Risk quanta: an approach to understanding modern financial risk

Jong Ho Hwang
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Jong Ho Hwang , (2015),"Risk quanta: an approach to understanding modern financial risk", Journal
of Financial Regulation and Compliance, Vol. 23 Iss 2 pp. 179 - 195
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Risk quanta: an approach Risk quanta

to understanding modern
financial risk
Jong Ho Hwang 179
Office of Financial Institutions Policy, US Department of the Treasury,
Washington, District of Columbia, USA
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Abstract
Purpose – This paper aims to present a recent history of developments and innovations that, along
with advances in information technology, have caused fundamental changes in the way that financial
risk is created, transformed, transported and extinguished in modern financial intermediation systems.
A review and critique of the global supervisory response to these developments is presented.
Design/methodology/approach – A bottom-up approach to the capture, recording, disaggregation,
re-composition and measurement of new, standardized, basic elements of risk that the authors refer to
as risk quanta is proposed.
Findings – This approach provides a clearer understanding of the financial world that the people live
in today and creates a robust information platform to build innovations, advancements and economic
growth in the future.
Practical implications – This approach provides decision-makers with a clearer understanding of
the financial world that the people live in today and creates a robust information platform to build
innovations, advancements and economic growth in the future.
Social implications – This approach provides financial market participants and the public with a
clearer understanding of the financial system and creates a robust information platform to build
innovations, advancements and economic growth in the future.
Originality/value – This approach is more comprehensive unlike current international proposals for
a global financial risk framework.
Keywords Contracts, Global, Risk, Financial, Institutions, Quanta
Paper type Conceptual paper

1. Introduction
Some time ago, I visited the office of a friend of my father. He was fond of cooking and
he liked carping about how, until the 1960s and 70s, supermarkets only sold whole
chickens. In his mind, that was the only way that they should be offered. Today, one can
buy not only whole chickens but also wings, breasts, thighs, legs, strips, fillets, nuggets,
along with less desirable beaks, feet, livers, etc. That innovation increased choice
according to individual preferences.

The author is grateful to Patricia Kao, Richard Haynes, Jennifer Wine, Justin Rhudy, Con Keating,
Tomaso Aste, Kyle Moore, David Eaton, Khaldoun Khashanah, Willi Brammertz and Allan Journal of Financial Regulation
Mendelowitz for their thoughtful comments, input and discussion. The commenters do not and Compliance
Vol. 23 No. 2, 2015
necessarily agree with the contents of this paper. The views expressed here do not necessarily pp. 179-195
represent those of the US Department of the Treasury. Any errors contained in this paper are © Emerald Group Publishing Limited
1358-1988
entirely those of the author. DOI 10.1108/JFRC-02-2014-0015
 JFRC At around the same time, a similar innovation occurred with financial income
23,2 producing assets. In 1970, the US Department of Housing and Urban Development
through its Government National Mortgage Association (GNMA or Ginnie Mae) issued
the first mortgage pass-through securities. In 1983, Fannie Mae created the first
collateralized mortgage obligations (CMOs) and the Tax Reform Act of 1986 created the
real estate mortgage investment conduit (REMIC) which facilitated the issuance of
180 structured securities with different risk characteristics.
The structured finance or securitization industry did for the whole loan market what
the poultry industry had done a few years earlier in the whole chicken market.

1.1 Innovations in risk disaggregation, re-composition and portability

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The structured finance or securitization industry is often described as creating and

issuing debt securities or bonds with payments of principal and interest derived from
cash flows generated from a separate pool of assets. While this is an accurate and useful
description, this practice is examined from a risk perspective.
From this perspective, the structured finance or securitization industry gathers a
pool of assets with a specific set of attributes and risks, disaggregates these risks,
recomposes inherent elements of risk, often transforming these with the use of credit
enhancements and diversification and yields a risk pool with a different set of risk
elements.
Until this point, the discussion has been referring mostly to credit risks from lending,
but the discussion can be generalized to any type of risk, whether it is market risk,
liquidity risk, counterparty risk, etc.
This risk transformation takes place because there is supply and demand for these
reconstituted risks and the mitigation thereof. Structured finance enables the creation of
bespoke assets with carefully designed return and risk characteristics.

1.2 The emergence of the originate-to-distribute model

Traditionally, financial institutions (FIs) originated financial risk assets to hold on their
balance sheets and earn the spread between risk asset returns and their associated
funding or holding costs. This exposed FIs to the risk that actual returns and funding/
holding costs would deviate significantly from expected returns and costs over time.
The Basel capital standards (BCBS, 2011) impose additional costs onto banks and
affiliated FIs, as they impose higher capital requirements for holding risk assets on the
balance sheet.
If asset structuring were able to re-engineer supply to better match demand for
specific FI client risks and sustain a market clearing price greater than the expected
return from holding that asset, then FIs could move away from the originate-to-hold
model that had prevailed in the past. For this to work, the asset structuring exercise
would need to create additional value; the sum of the resulting parts would have to be
more valuable than the cost of the inputs. An example of how this was accomplished
was by making use of an artificial premium for investment grade assets resulting from
the “prudent man” investment rules that investment fiduciaries are subject to. This
allowed asset structurers to achieve their goal of creating assets that were more valuable
when structured as investment grade assets out of pools of non-investment grade assets.
 Securitization enabled FIs to monetize the net present value (NPV) of asset return Risk quanta
spreads on Day 1. In securitization, assets are pooled and sold as a new array of risk
elements. The sales price includes:
• the securitization sponsor’s risk asset pool origination costs;
• the NPV of the expected return spread; and
• a mark-up (premium) that reflects the current supply and demand dynamics
inherent in the markets for the newly created specific asset or risk.
181

In the sale of the structured securities, input costs do not change, but asset pool returns,
funding/holding costs (both components of the spread) and the asset markup are subject
to variability over the life of the asset; in other words, they are subject to market, credit,
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liquidity, prepayment, reinvestment and other risks. These risks are transferred upon
sale from the sponsor to new holders (to the extent that these risks are not retained by the
sponsor).
In addition, the sale of these securitized risk assets relieves the FI from its need to
hold capital for what had been FI portfolio assets and provides liquidity for further
investments, enhancing the capacity of FIs to provide future credit. The securitization
transaction process releases liquidity that had been trapped in FI balance sheets and can
be used to stimulate the economy. Altogether, FIs’ incentives to effect the originate-
to-distribute model are increasing, and their incentives to continue to effect the
originate-to-hold model are dwindling.
In retrospect, two key things occurred in the 30-year run-up to the 2008 financial
crisis. Risk was re-characterized through the use of innovative new techniques, legal
vehicles and products, namely, structured products and swaps. In addition, risk, which
had laid static on FI balance sheets, began moving from one holder to another, often too
unpredictable and unobservable parts of the financial markets.
Just as it is unlikely that whole chickens will be the predominant poultry offering at
supermarkets again, it is also unlikely that whole loans will be the principal credit
instruments traded by FIs.
Figure 1 above leaves us to wonder about what the economic value of the many risk
enhancements, mitigants and transformations in the financial system net out to when
they are all aggregated.

2. Supervisory approaches to risk aggregation

In 1991, a working group of the Governors of the central banks of the G-10 countries was
charged with the study of international inter-bank relations in non-traditional markets,
focusing on derivative markets. The group was associated with the Bank of
International Settlements’ Committee on the Global Financial System (CGFS) (1992) and
issued what is known today as the Promisel Report, which advocated the collection of
comprehensive and reliable global statistics on derivatives markets.
In 1993, the Euro-currency Standing Committee (ESC) of the G-10 was asked to
identify issues relating to the measurement of market size and macro prudential risks in
derivative markets. Due to the shortcomings in existing data available to central banks
(mainly notional amounts), the ESC asked a working group to develop measurement
concepts and monitoring techniques that would address central bank needs and would
be robust for consistent international application. The ESC published what is now
known as the Brockmeijer Report (ESC, 1995). The report recommended that central
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23,2

182
JFRC

Figure 1.
Risk complexity
 banks should regularly compile derivative market data statistics from principal Risk quanta
participants, improve comparability, disseminate the findings to improve transparency
and monitor activity in this space to aid in areas of central bank policy responsibility.
The Brockmeijer Report culminated in the publication of the April 1995 Central Bank
Survey of Derivatives Market Activity.
In 1996, the ESC again asked a working group to study and develop a framework for
more regular collection of derivative market data and recommended a triennial 183
publication schedule alongside the foreign exchange survey. The Yoshikuni Report
(ESC, 1996) proposed the collection of derivative notional amounts, positive and
negative market values and credit risk exposure. The Yoshikuni Report also recognized
the need for comprehensive aggregate measures of market risk and recommended the
use of FI’s internal risk systems, including value-at-risk. However, the Report warned
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that individual firm risk management systems used simplified models that assume
securities follow multivariate normal distributions. This use may be adequate for
short-term trading risk, but these models were derived from data with empirical
distributions with fatter tails.
In 1997, the ESC asked researchers at several central banks for research papers which
were discussed by the Committee and led to the publication of the Fukui Report (ESC,
1997) on the measurement of aggregate market risk. The Committee accepted the
researchers’ recommendation that the work that they had done did not establish an
adequate basis for the collection of aggregate market risk data. Instead, the Committee
decided to focus on specific aspects of market behavior, including the use of principal
components analysis (PCA) for stress test methodologies, dynamic market feedback and
market liquidity.
The Joint Forum (JF) was established in 1996 and included the Basel Committee on
Banking Supervision (BCBS), the International Organization of Securities Commissions
(IOSCO) and the International Association of Insurance Supervisors (IAIS) to focus on
issues with financial conglomerates and to draw supervisory expertise from banking,
securities and insurance organizations.
In 1998, a framework for supervisory information for derivative and trading activity
was published in a JF Report (BCBS, IOSCO, 1998), which attempted to catalog data
deemed important in risk evaluation and provided a common minimum framework for
internationally harmonized information about derivatives activity. The Report included
risks for both cash and derivative instruments. In 2003, the JF issued its Report on trends
in risk integration and management (BCBS, IOSCO, IAIS, 2003) at the member
organizations’ respective supervised entities.
In 2010, the JF issued its post-crisis assessment of developments in modeling risk
aggregation (BCBS, IOSCO, IAIS, 2010) focusing on firms’ risk aggregation models
(RAMs). RAMs are used by complex FIs for enterprise-wide risk aggregation, risk
identification, monitoring and mitigation. The Report found that RAMs were originally
designed to provide indications of relative risks for capital allocation, but were
being used to make capital adequacy and solvency determinations. These latter
considerations require precision in measuring absolute, not relative risks, and reliable
ways of assessing tail events. In spite of these identified weaknesses, the Report made
the following statement:
There was, however, no evidence that [risk aggregation] models [RAMs] in current use had
contributed to any failures during the recent Crisis.
 JFRC In January 2013, BCBS (2013a) issued a report titled: “Principles for effective risk data
23,2 aggregation and risk reporting”, notably without its two counterparts from the JF,
IOSCO and the IAIS. The Report was prepared as a result of a Financial Stability Board
recommendation (FSB, 2011). The Report began with the following statement:
One of the most significant lessons learned from the global financial crisis that began in 2007
was that banks’ information technology (IT) and data architectures were inadequate to
184 support the broad management of financial risks. Many banks lacked the ability to aggregate
risk exposures and identify concentrations quickly and accurately at the bank group level,
across business lines and between legal entities. Some banks were unable to manage their risks
properly because of weak risk data aggregation capabilities and risk reporting practices. This
had severe consequences to the banks themselves and to the stability of the financial system as
a whole.
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The principles apply initially to 31 global systemically important banks (G-SIBs) at the
bank and group level. National supervisors are able to designate a wider range. The
principles cover governance and infrastructure; risk data aggregation; risk reporting;
and supervision. In December 2013, a report (BCBS, 2013b) was published, based on
self-assessment through a questionnaire, gauging designated FIs’ progress toward the
2016 implementation deadline.

3. A critique of current international approaches to financial risk

aggregation
3.1 The financial institution-centric approach
Supervisory financial risk aggregation efforts were first specified by central banks that,
in addition to their core function of effecting monetary policy, were also charged with
supervising and regulating banks. This perspective, alongside the availability of data
that supervised entities were already collecting and submitting to supervisors, led to an
approach that placed the financial institution as the basic unit of risk analysis in the
financial system. Supervisors need to be mindful of the trade-offs between safety and
soundness, and the desire to contain reporting burdens while recognizing the business
impact of its regulations.
The scope of data collection was generally limited to entities that were supervised, or
some subset of this group if that group captured either representative sample statistics
that could be extrapolated, or a significant proportion of the population’s risk
characteristics. One issue with this approach is that in adaptive systems, what holds
true on Day 1 may change substantially over time. Once policy becomes regulation,
unless appropriate dynamism and an appropriate framework for observing, measuring
and reporting divergences are written into the rule, the effectiveness of the regulation
begins to decay. In a system where opportunistic market participants compete fiercely,
it can be assumed that any weakness will be exploited.
FIs serve as poor units of risk. FIs are diverse:
• structurally;
• in the businesses that they engage in;
• in the way that they capture transaction and risk data;
• in the internal methodologies they employ for risk measurement and aggregation;
and
• in the way that they chose to report information internally and externally.
 The benefit that this aggregation approach provides is that supervisors can find a lot of Risk quanta
data in one place, generally organized in a coherent way. Aggregation of consolidated FI
financial risk is difficult. FI risk aggregation in the financial system is impossible to do
robustly under current frameworks. The Basel principles for risk aggregation and
reporting (BCBS, 2013a) continue efforts in this vein.

3.2 The focus on stand-alone derivatives 185

From the 1980’s to the present day, there has been a focus on stand-alone derivatives as
a source of systemic financial risk. Although the magnitude of risks that are traded in
these markets is enormous and quantified regularly and globally by the Bank of
International Settlements, is this approach able to quantify these risks precisely to give
a good rendering of the overall risk in the financial system? The answer is no. The risk
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is large, but not representative nor complete. To be fair, no one ever claimed either of
these properties, but the specific focus on derivatives ignores that there are many other
risks in other markets that are not receiving commensurate attention.

3.3 The issue of embedded derivatives

An issue with the reporting of global derivatives risk data is that it captures stand-
alone derivative contracts. Today, many financial contracts, whether they are loans,
equities, bonds, bilateral or multi-lateral agreements, securities, etc., contain embedded
derivatives. The capture, measurement and reporting of embedded derivative risks,
whether offsetting or enhancing stand-alone derivative risks, is inconsistent at best and
altogether missing at worst. In this case, there is a lot of work to do to design systems
that capture overall derivative risks and exposures in the financial system.

3.4 The turn away from aggregate market risk measures

The May 1997 meeting of the ESC, where it was accepted that commissioned research
did not establish an adequate technical basis or justification for collecting aggregate
market risk data, was a pivotal moment, as it then stopped global efforts in this
important avenue of information gathering.

3.5 Takeaway
These past developments and identified weaknesses in the current international
framework for global risk aggregation require a new comprehensive, consistent and
coherent approach to global risk aggregation.

4. A new framework for risk capture

Currently, risk is free of its former form and structural constraints and is easily
transformed and transferable via contractual arrangements. All financial assets arise
from a contractual agreement. Financial contracts can be thought of as equities, loans,
bonds, derivatives, etc., and these can be lumped together under the assumption that
these categories have similar characteristics. The attributes of large pools of similar
categories of assets are analyzed, and characteristics can be ascribed to individual
contracts in that pool. This has been the practice of the top-down approach to risk
management.
But in an adaptive, evolving risk environment, it becomes dangerous to take past
experience and extrapolate it forward to form expectations. Past history is a useful tool,
but in a dynamic environment, it has to be enhanced by the ability to observe what is
 JFRC occurring in the present and to analyze this information both at an aggregated and
23,2 disaggregated level. To date, the top-down approach has been favored due to
information gathering costs and constraints in the technology necessary to process
large amounts of data.

4.1 A bottom-up approach

186 A contract is a set of disparate terms that have discrete characteristics. A simple term
within a contract is one that can be described by a discrete, finite number of risk
elements or quanta that are irreducible into smaller components (given today’s
technological constraints). Complex contract terms are terms that can be described by a
set of simple terms. Risk quanta are defined as the minimum, discrete, standard and
measurable units of risk arising from a financial contractual term. Risk quanta are not
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independent and very likely correlated. Goyal et al. (2012) and Varshney and Varshney
(2008) provide an example of a framework for quantization in the information theory
literature (Figure 2).
An example of one of the immediate benefits of disaggregation by risks within
contractual terms would be in facilitating the analysis of hedge effectiveness. Generally,
a risk position is taken by entering into a financial contract. Often the contract has
several, at times complex, terms. A trader may wish to or be required to hedge that
transaction. The trader will seek the most cost-effective way to hedge these risks. It is
important to recognize that there is often more than one risk associated with the
transaction. In seeking a cost-effective solution, a proxy hedge[1] may be chosen,
creating basis risks[2] in the transaction. Because of the complicated nature of many
contracts with multiple terms, traders may seek to hedge only what they consider
principal risks, leaving many other risks unhedged. This is mainly driven by
professional judgment and is often not quantified properly. When expert analysis
remains in the mind of the trader, it is not readily available to desk management,
auditors, risk managers, senior management, regulators, macro-economists and any
other observers. The illustration in Figure 3 below shows how a framework for
disaggregating risk into discrete units can help to analyze hedge effectiveness.
Ultimately the goal is to disaggregate dissimilar risk quanta and, in turn,
re-aggregate similar ones into sensible categories. This would provide, for the first time,
a granular view of aggregate stock, flows of risk and their associated mitigants
(Figure 4).

Figure 2.
Financial contract
disaggregation
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Figure 3.
187
Risk quanta

effectiveness and risk

Analysis of hedge
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23,2

188
JFRC

Figure 4.

re-aggregation
Global financial risk
 5. An approach to implementation Risk quanta
5.1 Risk capture
We propose the following as a means of capturing information needed to make a robust
assessment of financial risk:
• Make legal validity and enforceability of all financial contracts contingent upon
proper recording of every contract term in a single standard electronic financial
contract system. Amendments and extinguishments are also valid only when 189
properly recorded. This establishes an absolute obligation for financial
participants to report additions, subtractions and other changes in financial
transactions in the financial system.
• Make legal validity and enforceability of all financial contracts contingent upon
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the availability of a set of significant, relevant associated financial risk quanta,

validated through a robust, transparent governance process. Parties to the
transaction can choose to structure their transaction to conform to a standard
format that has an existing, validated set of risks. If a non-standard transaction
with unassociated risks is chosen, participants have the obligation to shepherd
the transaction successfully through the validation process. This establishes an
absolute obligation for financial participants to report additions, subtractions and
transfers of financial risks into the financial system.
• Make legal validity and enforceability of all financial contracts contingent upon
the parties to the transaction associating identified financial risks to either an
existing risk measurement model or, if one does not exist, to a robust and
validated new risk measurement model. This establishes an absolute obligation
for innovators of financial products to provide a robust and validated way to
measure the financial risks that they intend to introduce into the financial system.

Transactions that are not properly recorded would neither receive recognition nor have
right of recourse under the law. Electronic tools should be developed to facilitate
adherence to these obligations.
Note that this approach eliminates the shadow banking issue. Instead of expanding
the reach of regulation over FIs that are not currently under a supervisory authority, all
financial contracts (linked to their corresponding counterparties, issuers, etc.) and a set
of their associated risks would be visible. Supervisors, market participants and the
public would then adjust their actions accordingly based on concrete and reliable
information.
Although, at first glance, this looks like an unprecedented proposal, it is very similar
to what has been proposed and implemented in the swap clearing mandates under the
Dodd–Frank Act (DFA) (2011) in the USA and under the European Market
Infrastructure Regulation (EMIR) (2012). Under DFA/EMIR, market participants, with
some exceptions, are required to transact within swap execution and clearing platforms
that are linked to validated risk models that calculate expected losses and generate a
bilateral margin charge, effectively pricing risks in the transaction.

5.2 Risk disaggregation into basic elements or quanta, standardization and

measurement
A difficult question is how risk can be quantized or disaggregated into basic units, then
standardized and measured. Hwang (2013) proposes a framework under which these
 JFRC difficult questions can be developed, discussed and answered. A wide, collaborative
23,2 global constituency is envisioned to solve these complex problems.
We propose the establishment of an Office of International Financial Standards (OIFS),
which would include an Office of International Financial Risk Standards (OIFRS). Hwang
(2013) proposed an Office of Financial Risk which would oversee financial modeling. OIFS
would oversee the global standardization projects, including the legal entity identifier, the
190 universal product identifier and the uniform mortgage data program. The OIFRS would be
charged with the cataloguing and validation of risk quanta.
Another, more basic, question is whether risk can be quantized. To answer this
question, we look to the literature of theoretical physics and information theory. Prior to
the twentieth century, it was thought that perhaps the amount of information defining a
finite space was infinite. If this were the case, then there would be an infinite number of
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information quanta required to exhaustively define the information content in that

space, making the task of quantizing the information intractable.
In 1948, Shannon (1948) at Bell Labs mathematically derived the concept of
information entropy; the minimum measure of information capacity needed to
effectively transmit information. In 1973, Bekenstein (1973) derived the black hole
entropy bound or Bekenstein bound using the second law of thermodynamics. This
discovery posited that within a finite space with a finite mass and energy, the
information necessary to exhaustively characterize that system must also be finite.
Mathematically, the amount of information within a space, with a given, fixed mass or
density, is approximated by the change in the surface area of the gravitational or event
horizon of a black hole that would be effected by the addition of that mass onto that
black hole. The Bekenstein bound provides a limit to the information density that can
exist within a finite space with a finite mass and suggests the existence of a fundamental
unit of information that is not further divisible.
In financial markets, risk emanates from both natural and man-made phenomena. Due to
recent innovations, financial risk can now be created, transformed, transported and
extinguished at great speed and quantity through the behavior of market participants
formalized through the execution and exchange of contractual arrangements. Each
contractual arrangement is a set of discrete terms. Each of these terms gives rise to a set of
correlated risks that should be standardized, catalogued and aggregated. The capture of
quantized risks is limited by technological constraints and our ability to understand a
complex combination of exogenous and endogenous phenomena. There is a theoretical limit
to the sum of existing information in the financial system and a limit to what is at this time
knowable. We are currently very far away from both those boundaries.
It is imperative to apply a consistent, coherent approach to the investigation of financial
risks because our financial system is a significant determinant of the allocation of goods and
services in the economy, which more concretely translates into who receives food, shelter,
clothing, jobs, credit and economic opportunity and in what quantity.

6. Extension to the broader socio-economic system

An approach that disaggregates macro risk factors into risk quanta has been suggested
in the literature of other areas of inquiry. Ioannidis (2005) writes in the International
Journal of Epidemiology:
If macroscopic risk factors are indeed the result of the interplay of hundreds of other more
proximal risk factors then it should not be surprising that our results with traditional risk
 factors have been so unstable to replicate. Large heterogeneity is only to be expected. Results Risk quanta
obtained with such risk factors may be difficult, if not impossible, to generalize to other
patients and populations. Traditional risk factors are very crude composites of very
heterogeneous risk quanta each of which may have a small impact on the macroscopic risk
factor and on the final outcomes of interest. Obesity may be possible to describe eventually as
a composite of 3,000 different sub-types, and fruit consumption may be an extremely
complicated biological phenomenon to which we may be doing gross injustice by simply
measuring rations consumed per day. 191
Becker et al. (2006) writes about comparability of risks in industrial energy production
as follows:
The comparison of risks from different sources implies the trial to compare very different
forms of harm: death, different forms of remaining handicaps from accidents, diseases –
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suddenly occurring or slowly progressing. Risk comparison needs to reduce the

multidimensional forms of harm to only one dimension, expressed by a figure. This figure is
used as a measure for comparison of the risks associated with e.g. different industrial forms of
energy production. The International Commission of Radiological Protection has proposed an
“index of harm” already in 1977 as a method for comparing the risk associated with the
exposure to radiation to that from other occupational and health hazards. […] In other words,
risk results from the action of elementary “risk quanta”, and accidents result from the
improbable combination of numerous quanta.
The financial system does not exist alone, unaffected by the large number of systems
that have been erected by society to provide for its many needs and wants. In Figure 5,
we present a stylized depiction of the socio-economic system. Its component systems
overlap, are often fragmented and do not fit neatly into well-defined boxes. Many
depictions of systemic financial risk begin and end with financial actors. This is often a
result of the need to define the scope of an issue narrowly to make it tractable. However,
the financial system is only one part of a tightly integrated socio-economic construct.
Researchers in systems other than the financial have been thinking about
disaggregation of their respective risks.

Figure 5.
The socio-economic
system
 JFRC The tradition of emphasizing specialization is rooted in the theories of comparative
23,2 advantage espoused by Smith (1776) and Ricardo (1817) and is deeply engrained in
Western economic thought. This tradition propels the merits of narrowing the scope of
a field of study and burrowing deeply into its intricacies. There is great value in this
targeted approach and evidence of this abounds in the progress that we see in our
surroundings compared to what has existed in the past. But in digging deeper within our
192 respective disciplines, there is increasing distance among siloed approaches and
outputs. The question we put forward is whether marginal value would be greater in
focusing our effort toward greater depth of study or in better integration of the different
disciplines and edifices that address the needs of humanity. To address these issues, we
propose the study and development of consistent and coherent risk quanta that are
standardized across all component systems within the broader socio-economic system.
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7. Conclusion
This paper reviewed recent history to examine some of the innovative events that have
given rise to the recent free-form nature of risk. Contractual arrangements in wholesale
capital markets can effect large and sudden shifts in risk positions. Current economic
information systems are not equipped to provide substantive and meaningful
information about how financial risk is created, transformed, transported and
extinguished in modern financial intermediation systems. There is little information
about risk in singular complex transactions, much less what happens at higher levels of
aggregation because of recent innovation, market opacity, data fragmentation,
incomplete knowledge and conflicting interests.
In light of these challenges, a rational approach and framework is proposed to
capture financial transactions, identify associated financial risks, measure these risks
and aggregate these for further analysis of vulnerabilities to the many stakeholders of
the financial system. In addition, clearer visibility into how the financial system works
and does not work to facilitate the economic function of allocating goods and services
efficiently in the economy will yield information necessary to make better decisions
going forward for all people.
We are far from the exhaustive capture of all information within the financial system
and the broader socio-economic system that we live in. But it is necessary to have a
thoughtful approach about the bounds and limits of our economic and risk systems
when building the frameworks that will be used to determine how to move forward to
gain a better understanding of our world.

Notes
1. A hedge with an asset that is similar and correlated to the asset referenced in the contract
term.
2. Basic risk arises from the use of non-equivalent offsetting terms in asset and hedge contracts.
The mismatch can be in the underlying, term/maturity, method of calculation, etc.

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About the author

Jong Ho Hwang is currently a policy advisor in the US Department of the Treasury and was
formerly a large broker-dealer risk supervisor at the US Securities and Exchange Commission.
Jong Ho Hwang can be contacted at: jong.hwang@treasury.gov

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