Vol. 19

Cutting edge financial management engineering for risk management methodology

Daisuke Nakazato

Professor, Faculty of Commerce
(Graduate School of Finance, Accounting and Law)

Cross-discipline research :From science and engineering to the financial industry
  Fifteen years ago, I began work at a bank, entering the field of financial engineering when it was a brand new topic for Japanese banks. I was somewhat unsure then as to what I could do in the financial industry, since my knowledge was limited to the fields of science and engineering.
  Although I took a full-time faculty position at Waseda University in 2004, I still keep my position as an executive researcher at the bank. Since the financial industry is constantly advancing, once one moves away from the practice, it is difficult to keep up on the latest trends. Hence it becomes hard to teach what is useful and essential for students. This is such a fast moving world: a brand new product can become obsolete in a month. Thus it is very important to have a strong foothold in the actual arena.
  My original area of specialization was engineering. After graduating in electrical engineering from Waseda University,
I proceeded to graduate school at Massachusetts Institute of Technology (MIT) and was involved in mathematical and computer science research for ten years. Some of the research I conducted there was in a sub-field of artificial intelligence: the development of computers that could do mathematical proofs, called ‘machine proof’ or ‘machine learning.' I also did research on mathematical modeling of computer networks, using the theory of stochastic processes.
  However, with the dramatic development of the Internet and the World Wide Web, engineering issues underwent radical transformation, and the research I had been conducting was no longer a central domain of the engineering field. Since I already had a sense of accomplishment after 10 years of research, I started to think about a challenge in some different area. At that time, a bunch of recruiters came from New York's Wall Street to scout what we called”rocket scientists” for the financial industry.
  There were also recruiters from Japan: staff from the Industrial Bank of Japan (now Mizuho Financial Group) came to MIT to recruit human resources. Japanese banks were also starting to employ people with a strong background in engineering mathematics; typically Ph.D. holders were preferred, but it was difficult to find the talent in Japan.  Although I had zero knowledge of financial engineering, I decided to take the job, because I heard that my research, in particular my knowledge of stochastic processes, would be of great use in that work.
Absorbing know-how from leading experts who pioneered financial engineering
  At the bank I was involved in the development of derivative products using financial engineering. Japan in those days was said to be about 10 years behind Europe and the US in developing derivative products. On the other hand, Japan's international status was high: Japanese banks were in the world top ten of banks with large assets. I made a business foundation for the bank by forming partnerships with foreign companies, which were pioneers in financial engineering. We acquired the computer design know-how needed for the development of derivative products and for trading, and in return we brought business to our partners.
 Since I have a good command of English as well as the ability to handle difficult mathematics, I often went overseas, bearing the main responsibility for negotiation. At that time the aerospace industry was already in a slump, so a large number of NASA researchers left for Wall Street. In addition, a number of university researchers with financial engineering knowledge left for the private sector, so there were not many teachers of financial engineering remaining in universities.
  The most valuable asset I acquired then was the top-ranked notions and views that I picked up through discussions with the leading financial engineering experts in the UK and the US. In this field there are two titans, Fisher Black and Myron Scholes, best known as the authors of the famous Black-Scholes formula; in 1997, some time after the death of Prof. Black, Prof. Scholes received the Nobel Prize for Economics for this achievement. I was lucky to work in partnership with late Prof. Black in my first project and with Prof. Scholes in the second. I think there are not many people, even in Europe and the US, who have worked with both of these outstanding scholars.
 It is rather easy to understand the principles or structures of derivative products once you are highly trained in the science and engineering field, because the mathematical formulae used there are self-explanatory. However, it is not easy to convert a theory into practical products for trade in the market and manage the risk of those products with computers. Mathematical formulae are just principles which simplify things, while financial engineering is a human-oriented art, closely connected with social dynamics.
  It is said that it is best to talk with lawyers and accountants while developing new derivative products. By chatting with lawyers and accountants in New York one can get up to date information about the state of the industry, information which is not yet public. There are lateral ties among such people and they exchange international information at an incredible speed, so collecting information from them is an important part of the work. A new product can be created when such information is used as a catalyst for scientific and technological concepts.
Aiming for success while recognizing potential pitfalls, pursuing profit while measuring loss tolerance
 Around the time I started at the bank, banks’ ability to control risk was beginning to be severely questioned. This was because an international organization, the Basle Committee on Banking Supervision, instituted the Basle Capital Accord in 1988 and introduced the rule, ‘banks which deal with international business should maintain capital adequacy ratios of at least 8%.’ As a result of this rule, Japanese banks were essentially shut out from the international market. The major reason was the delay in system investment. Furthermore, Japanese banks were urged to review their asset quality and faced the necessity of disposing of nonperforming loans throughout the 1990s. In the meantime, Japanese banks lagged farther and farther behind foreign banks in the field of risk control technology.
  In such times of change, my job was expanding from the development of derivative products to include the establishment of risk control methodology. The Japanese financial industry has only recently completed the cleanup of defaulted loans, and now, as business is becoming robust again, the time has finally come to start a serious shakedown of the management system.
  Recently there has been a growing tendency for financial managers, not only in the financial sector but also in corporations such as utilities and real estate, to work to acquire knowledge of financial engineering and risk control for incorporation into management work. In the Graduate School of Finance, Accounting and Law, derivative product development know-how and management risk control know-how are integrated into the curriculum as an inseparable set. We are accepting a number of mid-career graduate students from companies in a wide range of sectors.
  The iron law of risk control in business is very simple: ‘Do not incur any loss which exceeds owned resources and held debt.’ In risk control work, people can clearly recognize through data and sometimes mathematical formulae what risk their company is carrying. If the company performs risk control, the credibility of company will rise (see Figure 1).

Figure 1: Image of corporate management risk

  In general, people are not keen on looking at the risk of failure; however, if risk is expressed numerically, the probability of loss is highlighted and they have no choice but to acknowledge the possibility of loss. Corporate management used to focus on profit making but it is also necessary to envision times of loss. Financial engineering enables the assessment of whether or not a company has enough strength to survive loss.
  When a company becomes very large, it is difficult even for top management to understand the company as a whole due to its complexity. The more complicated and diversified the risk becomes, the more risk control, making full use of financial engineering, is needed. If the budget of a company is distributed to divisions or teams, loss can occur in various forms. However, not all divisions will incur loss at the same time, so it is important to conduct the most appropriate control of profit vs. risk throughout the company; this involves work beyond department-wise segmented risk management, work such as finding out the interaction among risks. In such cases, tools such as control theory can be an effective tool (see Figure 2).

Figure 2: Control theory management

Collaboration by professionals with backgrounds such as mathematics, physics and cosmology

  The extent of the need for qualifications in science and engineering in risk control work depends on the level of the work. Financial managers in ordinary companies need to know the general theory of risk management, but qualifications in science and engineering, including mathematics, are not particularly necessary. However, in cases where management is diversified and internationalized, it is necessary for managers to arm themselves with knowledge of the company's risk makeup for international compliance. So human resources with qualifications in science and engineering are required for the professional examination of risk. In particular, in a severely competitive business scene, high quality expertise in financial engineering is essential.

  Professional specialists in financial engineering, called ‘quants’, or quantitative analysts, are experts in mathematical analysis. However, the term actually refers to people who analyze things logically, not just doing statistical or mathematical analysis. In the insurance industry, there is a qualification called ‘actuary’ and no body can operate an insurance business unless they have one chief financial officer in the company's top management with an actuary qualification. In the banking and security business, ‘quant’ may well become a high-status job qualification in the future.
  One of the aspects of my job that I like best is my connection with mathematics.  People around me feel more or less the same. There are even people who entered the field because they wanted to do mathematics. This job gives such people a sense of achievement because the outcome of their mathematics can be helpful to society rather than serving as mere research. Financial engineering is engineering, not science, at base, and focuses on practical applications.
  The strong point of mathematics is its ability to simplify things. It enhances credibility when you can show the grounds of an argument using mathematics, in statements such as “The risk of the management of this company is such and such, which is reassuring.”  Furthermore, mathematics is a global communication medium, breaking the language barrier.
  However, one should not overestimate mathematics. There is a tendency for mathematics lovers to be totally absorbed in mathematics and to wish that reality would match with mathematics.  Such people believe that mathematics is everything and insist they are right. This is not healthy for society.
  Only recently a number of people in science and engineering have come to the financial industry, but those whom the industry really needs are people with ability in a wide range of applications such as physics, and such people have only begun to appear in the last few years in Japan, since the onset of the depression. Financial engineering needs a wide range of tools, such as logic and calculation methods, in order to solve problems. For example, the people involved in cosmology or quantum mechanics are using extremely advanced mathematical tools. If such people came to the financial industry, it could be possible to quickly solve difficult problems which are still open.
  For a futuristic perspective, I like to attempt things which I could not do before. For instance, when I was in high school, I read every single word of a mathematics dictionary. Later I found out that financial engineering uses only a part of the field of mathematics. I am wondering if I can explore the use of the rest of the mathematical field in financial engineering. Of course this is just my personal hobby and it might take a long time and great effort, but it is always important to have a dream of a new horizon.

Homepage of Waseda Graduate School of Finance, Accounting and Law

Daisuke Nakazato

Professor, Faculty of Commerce
(Graduate School of Finance, Accounting and Law)

 After graduating from Waseda University’s School of Science and Engineering in 1980, Prof. Nakazato entered the Graduate School at Massachusetts Institute of Technology, and received his Ph.D. in computer science in 1990. He started working at the Industrial Bank of Japan (IBJ) in the same year, and was responsible for assessing derivative products in the Financial Engineering Division. In 1996 he moved to IBJ's London branch to design the infrastructure for credit derivative trading, and in 1999 he was promoted to director of the First Financial Engineering Division and managed the Information Technology Development for risk control at the IBJ-DL FT Financial Technology. In 2002, when IBJ changed its name to Mizuho DL Financial Technology, he became director of strategic technology development and research director in charge of research and development of cutting edge technology such as applications for financial engineering and insurance engineering. In 2004 he became professor in the Graduate School of Finance, Accounting and Law of Waseda University. He has also been active as a lecturer at the Graduate School of Tokyo University and as a research director of Mizuho DL Financial Technology. He is the author of Analytical Financial Engineering: An intuitive approach to solving difficult issues on the practical level, and is the co-author of Still No Financial Technology Revolution (with Katsuto Ohno).

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Last revised: Nov 22, 2006 For inquiry:Research Promotion Division: koho-rps@list.waseda.jp
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