The evolution of risk management has resulted from the interplay of financial crises, risk management practices, and regulatory actions. In the 1970s, research lay the intellectual foundations for the risk management practices that were systematically implemented in the 1980s as bond trading revolutionized Wall Street. Quants developed dynamic hedging, Value-at-Risk, and credit risk models based on the insights of financial economics. In parallel, the Basel I framework created a level playing field among banks across countries. Following the 1987 stock market crash, the near failure of Salomon Brothers, and the failure of Drexel Burnham Lambert, in 1996 the Basel Committee on Banking Supervision published the Market Risk Amendment to the Basel I Capital Accord; the amendment went into effect in 1998. It led to a migration of bank risk management practices toward market risk regulations. The framework was further developed in the Basel II Accord, which, however, from the very beginning, was labeled as being procyclical due to the reliance of capital requirements on contemporaneous volatility estimates. Indeed, the failure to measure and manage risk adequately can be viewed as a key contributor to the 2008 global financial crisis. Subsequent innovations in risk management practices have been dominated by regulatory innovations, including capital and liquidity stress testing, macroprudential surcharges, resolution regimes, and countercyclical capital requirements.
Structured finance is one of the most innovative and rapidly growing areas of modern finance. Broadly defined, it refers to the repackaging of cash flows to transform the risk, return, and liquidity characteristics of financial portfolios. Structured financial instruments play a key role in transferring credit risk among financial institutions and between financial institutions and market participants in other sectors of the economy. But many financial supervisors and central bankers fear that some market participants may not fully understand the risks involved. They also question whether these instruments transfer risks to institutions best able to bear those risks or to those that are least regulated. To explore these issues, the IMF Institute hosted a high-level seminar on April 19-20 in Washington, D.C., where market practitioners, academics, policymakers, and regulators exchanged views with senior officials from more than 40 advanced and emerging market countries.
This Selected Issues paper on the United Kingdom reviews the IMF's Global Economy Model, which incorporates energy to examine the impact of rising energy prices on the United Kingdom. The model incorporates energy as a final consumption good as well as a primary input in the production process. With energy entering the production process, increases in energy costs affect overall aggregate supply capacity as firms reduce output and factor-utilization rates given the real increase in their cost structures.