Risk management and contractual obligations

Many financial analysts, policymakers and regulators have forcefully argued that over $700 trillion in derivatives and other contractual risk management tools are a clear and unambiguous good for financial markets and economic growth because they transfer risk from organizations and individuals wanting stability and less volatility managing principal and cash flows to those with stronger more knowledgeable hands managing such risk. This wisdom thus argues that through contracts risk is shifted to those better able to handle these uncertainties while dispersing the risk across more participants. The recent global financial crisis, however, brings these claims and assumptions into doubt. Indeed these financial instruments may add to and concentrate the amount risk that must be managed and regulated rather than transferring it to more and stronger hands. Indeed recent experience with situations such as the near collapse of AIG and the bankruptcy of Lehman has caused regulators to instigate new regulations such as the Volker Rule to limit contractual risk exposure. Further some financial firms have exploited their greater sophistication to shift contractual risk to those with little understanding of the actual risks involved as in Detroit's recent bankruptcy filing. Therefore in explaining how contractual risk occurs this chapter also indicates why the laws and regulations requiring more capital, separate trading entities and the use of exchanges may not be enough to limit global contractual exposures and the related financial systemic risk.