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SCHWESERNOTESTM 2024 FRM® PART I BOOK 1: FOUNDATIONS OF RISK MANAGEMENT
©2024 Kaplan, Inc. All rights reserved.
Published in 2024 by Kaplan, Inc.
ISBN: 978-1-0788-4239-6
Required Disclaimer: GARP® does not endorse, promote, review, or warrant the accuracy of the products or services offered by Kaplan Schweser of FRM® related information, nor does it endorse any pass rates claimed by the provider. Further, GARP® is not responsible for any fees or costs paid by the user to Kaplan Schweser, nor is GARP® responsible for any fees or costs of any person or entity providing any services to Kaplan Schweser. FRM® , GARP® , and Global Association of Risk ProfessionalsTM are trademarks owned by the Global Association of Risk Professionals, Inc. These materials may not be copied without written permission from the author. The unauthorized duplication of these notes is a violation of global copyright laws. Your assistance in pursuing potential violators of this law is greatly appreciated.
Disclaimer: The SchweserNotes should be used in conjunction with the original readings as set forth by GARP® The information contained in these books is based on the original readings and is believed to be accurate. However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success.
Thank you for trusting Kaplan Schweser to help you reach your career and educational goals. We are very pleased to be able to help you prepare for the FRM Part I exam. In this introduction, I want to explain the resources included with the SchweserNotes, suggest how you can best use Kaplan Schweser materials to prepare for the exam, and direct you toward other educational resources you will ind helpful as you study for the exam.
The SchweserNotes consist of four volumes that include complete coverage of all FRM assigned readings and learning objectives as well as module quizzes (multiple-choice questions for every reading) to help you master the material and check your retention of key concepts.
To retain the material, it is important to quiz yourself often. We offer an online version of the SchweserPro™ QBank, which contains hundreds of Part I practice questions and explanations. We also offer Topic Quizzes and Checkpoint Exams online to further help you retain and apply what you have learned.
Schweser offers four full 4-hour, 100-question practice exams. These online exams are important tools for gaining the speed and skills you will need to pass the exam. The Mock Exams contain answers with full explanations for self-grading and evaluation.
Our OnDemand Class provides comprehensive online instruction of every reading in the FRM curriculum. This video lecture series brings the personal attention of a classroom into your home or of ice with over 30 hours of instruction. The class offers in-depth coverage of dif icult concepts as well as a discussion of sample exam questions. All videos are available for viewing at any time throughout the season. Candidates enrolled in the OnDemand Class also have the ability to email questions to the instructor at any time.
Late-season review and exam practice can make all the difference. Our OnDemand Review Package helps you evaluate your exam readiness with products speci ically designed for late-season studying. This study package includes the OnDemand Review
(8-hour archived online workshop covering essential curriculum topics) and Schweser’s Secret Sauce® (concise summary of the FRM curriculum).
When preparing for the exam, be familiar with the weights assigned to each topic area within the curriculum. The Part I exam weights and questions are as follows:
The FRM Part I exam is a formidable challenge (covering 62 assigned readings and almost 500 learning objectives), so you must devote considerable time and effort to be properly prepared. There are no shortcuts! You must learn the material, know the terminology and techniques, understand the concepts, and be able to answer 100 multiple-choice questions quickly and (at least 70%) correctly. A good estimate of the study time required is 275 hours on average, but some candidates will need more or less time, depending on their individual backgrounds and experience.
Expect the Global Association of Risk Professionals (GARP) to test your knowledge in a way that will reveal how well you know the Part I curriculum. You should begin studying early and stick to your study plan. You should irst read the SchweserNotes and complete the practice questions for each reading. After completing each book, you should answer the provided topic quiz questions to understand how concepts may be tested on the exam.
It is recommended that you inish your initial study of the entire curriculum at least two weeks (earlier if possible) prior to your exam window to allow suf icient time for practice and targeted review. During this period, you should take all of your Schweser Mock Exams. This inal review period is when you will get a clear indication of how effective your study efforts have been and which readings require signi icant additional review. Answering exam-like questions across all readings and working on your exam time management skills will be important determinants of your success on exam day.
Best regards,
Eric Smith, CFA, FRM, FDP Director, Advanced Designations Kaplan SchweserReadings and Learning Objectives
STUDY SESSION 1—Risk Management Overview
READING 1
The Building Blocks of Risk Management
Exam Focus
Module 1.1: Introduction to Risk Management
Module 1.2: Types of Risk
Key Concepts
Answer Key for Module Quizzes
READING 2
How Do Firms Manage Financial Risk?
Exam Focus
Module 2.1: Corporate Risk Management
Module 2.2: Risk Management Methods and Instruments
Key Concepts
Answer Key for Module Quizzes
READING 3
The Governance of Risk Management
Exam Focus
Module 3.1: Corporate Governance and Risk Management
Module 3.2: Risk Governance Implementation
Key Concepts
Answer Key for Module Quizzes
READING 4
Credit Risk Transfer Mechanisms
Exam Focus
Module 4.1: Credit Risk Transfer
Key Concepts
Answer Key for Module Quizzes
STUDY SESSION 2—Pricing Models and Enterprise Risk Management
READING 5
Modern Portfolio Theory and the Capital Asset Pricing Model
Exam Focus
Module 5.1: Modern Portfolio Theory and the Capital Market Line
Module 5.2: Deriving and Applying the Capital Asset Pricing Model
Module 5.3: Performance Evaluation Measures
Key Concepts
Answer Key for Module Quizzes
READING 6
The Arbitrage Pricing Theory and Multifactor Models of Risk and Return
Exam Focus
Module 6.1: Multifactor Model Assumptions and Inputs
Module 6.2: Applying Multifactor Models
Key Concepts
Answer Key for Module Quizzes
READING 7
Principles for Effective Data Aggregation and Risk Reporting
Exam Focus
Module 7.1: Data Quality, Governance, and Infrastructure
Module 7.2: Risk Data Aggregation and Reporting Capabilities
Key Concepts
Answer Key for Module Quizzes
READING 8
Enterprise Risk Management and Future Trends
Exam Focus
Module 8.1: Enterprise Risk Management
Module 8.2: Risk Culture and Scenario Analysis
Key Concepts
Answer Key for Module Quizzes
READING 9
Learning from Financial Disasters
Exam Focus
Module 9.1: Case Studies on Interest Rate Risk, Liquidity Risk, and Hedging Strategy
Module 9.2: Case Studies on Model Risk and Rogue Trading
Module 9.3: Case Studies on Financial Engineering, Reputation Risk, Corporate Governance, and Cyber Risk
Key Concepts
Answer Key for Module Quizzes
READING 10
Anatomy
Exam Focus
Module 10.1: The Global Financial Crisis
Key Concepts
Answer Key for Module Quizzes
READING 11
GARP Code of Conduct
Exam Focus
Module 11.1: GARP Code of Conduct
Answer Key for Module Quizzes
Formulas Index
1. The Building Blocks of Risk Management
Global Association of Risk Professionals. Foundations of Risk Management. New York, NY: Pearson, 2023. Chapter 1.
After completing this reading, you should be able to:
a. explain the concept of risk and compare risk management with risk taking.
b. evaluate, compare, and apply tools and procedures used to measure and manage risk, including quantitative measures, qualitative risk assessment techniques, and enterprise risk management.
c. distinguish between expected loss and unexpected loss and provide examples of each.
d. interpret the relationship between risk and reward and explain how con licts of interest can impact risk management.
e. describe and differentiate between the key classes of risks, explain how each type of risk can arise, and assess the potential impact of each type of risk on an organization.
f. explain how risk factors can interact with each other and describe challenges in aggregating risk exposures.
2. How Do Firms Manage Financial Risk?
Global Association of Risk Professionals. Foundations of Risk Management. New York, NY: Pearson, 2023. Chapter 2.
After completing this reading, you should be able to:
a. compare different strategies a irm can use to manage its risk exposures and explain situations in which a irm would want to use each strategy.
b. explain the relationship between risk appetite and a irm’s risk management decisions.
c. evaluate some advantages and disadvantages of hedging risk exposures and explain challenges that can arise when implementing a hedging strategy.
d. apply appropriate methods to hedge operational and inancial risks, including pricing, foreign currency, and interest rate risk.
e. assess the impact of risk management tools and instruments, including risk limits and derivatives.
3. The Governance of Risk Management
Global Association of Risk Professionals. Foundations of Risk Management. New York, NY: Pearson, 2023. Chapter 3.
After completing this reading, you should be able to:
a. explain changes in regulations and corporate risk governance that occurred as a result of the 2007-2009 inancial crisis.
b. describe best practices for the governance of a irm’s risk management processes.
c. explain the risk management role and responsibilities of a irm’s board of directors.
d. evaluate the relationship between a irm’s risk appetite and its business strategy, including the role of incentives.
e. illustrate the interdependence of functional units within a irm as it relates to risk management.
f. assess the role and responsibilities of a irm’s audit committee.
4. Credit Risk Transfer Mechanisms
Global Association of Risk Professionals. Foundations of Risk Management. New York, NY: Pearson, 2023. Chapter 4.
After completing this reading, you should be able to:
a. compare different types of credit derivatives, explain their applications, and describe their advantages.
b. explain different traditional approaches or mechanisms that irms can use to help mitigate credit risk.
c. evaluate the role of credit derivatives in the 2007-2009 inancial crisis and explain changes in the credit derivative market that occurred as a result of the crisis.
d. explain the process of securitization, describe a special purpose vehicle (SPV), and assess the risk of different business models that banks can use for securitized products.
5. Modern Portfolio Theory and the Capital Asset Pricing Model
Global Association of Risk Professionals. Foundations of Risk Management. New York, NY: Pearson, 2023. Chapter 5.
After completing this reading, you should be able to:
a. explain Modern Portfolio Theory and interpret the Markowitz ef icient frontier.
b. understand the derivation and components of the CAPM.
c. describe the assumptions underlying the CAPM.
d. interpret and compare the capital market line and the security market line.
e. apply the CAPM in calculating the expected return on an asset.
f. interpret beta and calculate the beta of a single asset or portfolio.
g. calculate, compare, and interpret the following performance measures: the Sharpe performance index, the Treynor performance index, the Jensen performance index, the tracking error, information ratio, and Sortino ratio.
6. The Arbitrage Pricing Theory and Multifactor Models of Risk and Return
Global Association of Risk Professionals. Foundations of Risk Management. New York, NY: Pearson, 2023. Chapter 6.
After completing this reading, you should be able to:
a. explain the Arbitrage Pricing Theory (APT), describe its assumptions, and compare the APT to the CAPM.
b. describe the inputs, including factor betas, to a multifactor model and explain the challenges of using multifactor models in hedging.
c. calculate the expected return of an asset using a single-factor and a multifactor model.
d. explain how to construct a portfolio to hedge exposure to multiple factors.
e. describe and apply the Fama-French three-factor model in estimating asset returns.
7. Principles for Effective Data Aggregation and Risk Reporting
Global Association of Risk Professionals. Foundations of Risk Management. New York, NY: Pearson, 2023. Chapter 7.
After completing this reading, you should be able to:
a. explain the potential bene its of having effective risk data aggregation and reporting.
b. explain challenges to the implementation of a strong risk data aggregation and reporting process and the potential impacts of using poor-quality data.
c. describe key governance principles related to risk data aggregation and risk reporting.
d. describe characteristics of effective data architecture, IT infrastructure, and risk-reporting practices.
8. Enterprise Risk Management and Future Trends
Global Association of Risk Professionals. Foundations of Risk Management. New York, NY: Pearson, 2023. Chapter 8.
After completing this reading, you should be able to:
a. describe Enterprise Risk Management (ERM) and compare an ERM program with a traditional silo-based risk management program.
b. describe the motivations for a irm to adopt an ERM initiative.
c. explain best practices for the governance and implementation of an ERM program.
d. describe risk culture, explain the characteristics of a strong corporate risk culture, and describe challenges to the establishment of a strong risk culture at a irm.
e. explain the role of scenario analysis in the implementation of an ERM program and describe its advantages and disadvantages.
f. explain the use of scenario analysis in stress testing programs and capital planning.
9. Learning from Financial Disasters
Global Association of Risk Professionals. Foundations of Risk Management. New York, NY: Pearson, 2023. Chapter 9.
After completing this reading, you should be able to:
a. analyze the following factors that contributed to the given case studies of inancial disasters and examine the key lessons learned from these case studies:
Interest rate risk, including the 1980s savings and loan crisis in the US.
Funding liquidity risk, including Lehman Brothers, Continental Illinois, and Northern Rock. Constructing and implementing a hedging strategy, including the Metallgesellschaft case.
Model risk, including the Niederhoffer case, Long Term Capital Management, and the London Whale case.
Rogue trading and misleading reporting, including the Barings case.
Financial engineering, including Bankers Trust, the Orange County case, and Sachsen Landesbank.
Reputation risk, including the Volkswagen case.
Corporate governance, including the Enron case.
Cyber risk, including the SWIFT case.
10. Anatomy of the Great Financial Crisis of 2007–2009
Global Association of Risk Professionals. Foundations of Risk Management. New York, NY: Pearson, 2023. Chapter 10.
After completing this reading, you should be able to:
a. describe the historical background and provide an overview of the 2007–2009 inancial crisis.
b. describe the build-up to the inancial crisis and the factors that played an important role.
c. explain the role of subprime mortgages and collateralized debt obligations (CDOs) in the crisis.
d. compare the roles of different types of institutions in the inancial crisis, including banks, inancial intermediaries, mortgage brokers and lenders, and rating agencies.
e. describe trends in the short-term wholesale funding markets that contributed to the inancial crisis, including their impact on systemic risk.
f. describe responses made by central banks in response to the crisis.
11. GARP Code of Conduct
Global Association of Risk Professionals. Foundations of Risk Management. New York, NY: Pearson, 2023. Chapter 11.
After completing this reading, you should be able to:
a. describe the responsibility of each GARP Member with respect to professional integrity, ethical conduct, con licts of interest, con identiality of information, and adherence to generally accepted practices in risk management.
b. describe the potential consequences of violating the GARP Code of Conduct.
The following is a review of the Foundations of Risk Management principles designed to address the learning objectives set forth by GARP®. Cross-reference to GARP FRM Part I Foundations of Risk Management, Chapter 1.
Study Session 1
This introductory reading provides coverage of fundamental risk management concepts that will be discussed in much more detail throughout the FRM curriculum. For the exam, it is important to understand the general risk management process and its potential shortcomings, the concept of unexpected loss, and some of the underlying points regarding the relationship between risk and reward. Also, the material on the main categories of inancial and non inancial risks contains several testable concepts.
LO 1.a: Explain the concept of risk and compare risk management with risk taking.
In an investing context, risk is the uncertainty surrounding outcomes. Investors are generally more concerned about negative outcomes (unexpected investment losses) than they are about positive surprises (unexpected investment gains). Additionally, there is an observed natural trade-off between risk and return; opportunities with high risk have the potential for high returns and those with lower risk also have lower return potential.
Risk is not necessarily related to the size of the potential loss. For example, many potential losses are large but are quite predictable and can be accounted for using risk management techniques. The more important concern is the variability of the loss, especially an unexpected loss that could rise to unexpectedly high levels.
As a starting point, risk management includes the sequence of activities aimed to reduce or eliminate an entity’s potential to incur expected losses. On top of that, there is the need to manage the unexpected variability of some costs. In managing both expected and unexpected losses, risk management can be thought of as a defensive technique. However, risk management is actually broader in the sense that it considers
how an entity can consciously determine how much risk it is willing to take to earn future uncertain returns. The concept of risk taking refers to the active acceptance of incremental risk in the pursuit of incremental gains. In this context, risk taking can be thought of as an opportunistic action.
The risk management process is a formal series of actions designed to determine if the perceived reward justi ies the expected risks. A related query is whether the risks could be reduced and still provide an approximately similar reward.
There are several core building blocks in the risk management process. They are as follows:
1. Identify risks.
2. Measure and manage risks.
3. Distinguish between expected and unexpected risks.
4. Address the relationships among risks.
5. Develop a risk mitigation strategy.
6. Monitor the risk mitigation strategy and adjust as needed.
Risk managers can deploy several methods to identify relevant risks. The various types of risk are discussed later in this reading, but for now, focus on the identi ication process. One method to identify risks is brainstorming, which involves soliciting from key business leaders all potential known risks in luencing their supervision area. These key leaders may also survey their subordinates (and especially frontline personnel) for a deeper understanding of relevant risks. There may be industry-level resources (e.g., regulatory standards, industry surveys, or expert opinions) that are also available. For a more quantitative approach, a risk manager can analyze actual loss data to discern the magnitudes and frequency of various losses. Scenario analysis is another common tool used for identifying risks.
Part of the risk identi ication process is to ilter risks into degrees of being known or unknown. Figure 1.1 illustrates that risks can move along a spectrum from being expected (i.e., known) to being fully unknown. The unknown category can be subdivided into the known unknowns (i.e., Knightian uncertainty) and the unknown unknowns. The former are items that may impact a irm, while the latter are truly unknown (i.e., tail risk events). Where possible, risk managers should move a risk into the known category, but this does not work for risks that cannot be quanti ied.
The risk management process involves a four-way decision. The company might decide to avoid risk directly by selling a product line, avoiding certain markets or jurisdictions, or offshoring production. They also might decide to retain risk, depending on the expected rewards relative to the probability and frequency of any expected losses. Another option is to mitigate risk by reducing either the magnitude or the frequency of exposure to a given risk factor. Finally, risk managers could transfer risk to a third party using derivatives or structured products. They could also purchase insurance to outsource risk to an insurance company.
One of the challenges in ensuring that risk management will be bene icial to the economy is that risk must be suf iciently dispersed among willing and able participants in the economy. Unfortunately, a notable failure of risk management occurred during the inancial crisis of 2007–2009 when it was subsequently discovered that risk was too concentrated among too few participants.
Another challenge of the risk management process is that it has failed to consistently assist in preventing market disruptions or preventing inancial accounting fraud (due to corporate governance failures). For example, the existence of derivative inancial instruments greatly facilitates the ability to assume high levels of risk and the tendency of risk managers to follow each other’s actions (e.g., selling risky assets during a market crisis, which disrupts the market by increasing its volatility).
In addition, the use of derivatives as complex trading strategies assisted in overstating the inancial position (i.e., net assets on balance sheet) of many entities and complicating the level of risk assumed by many entities. Even with the best risk management policies in place, using such inaccurate information would not allow the policies to be effective.
Finally, risk management may not be effective on an overall economic basis because it only involves risk transferring by one party and risk assumption by another party. It
does not result in overall risk elimination. In other words, risk management can be thought of as a zero-sum game in that some “winning” parties will gain at the expense of some “losing” parties. However, if enough parties suffer devastating losses due to an excessive assumption of risk, it could lead to a widespread economic crisis.
LO 1.b: Evaluate, compare, and apply tools and procedures used to measure and manage risk, including quantitative measures, qualitative risk assessment techniques, and enterprise risk management.
Value at risk (VaR) calculates an estimated loss amount given a certain probability of occurrence. For example, a inancial institution may have a one-day VaR of $2.5 million at the 95% con idence level. That would be interpreted as having a 5% chance that there will be a loss greater than $2.5 million on any given day. VaR is a useful measure for liquid positions operating under normal market circumstances over a short period of time. It is less useful and potentially dangerous when attempting to measure risk in non-normal circumstances, in illiquid positions, and over a long period of time.
To further illustrate the concept of VaR, assume you have gathered 1,000 monthly returns for a security, and produced the histogram shown in Figure 1.2. You decide that you want to compute the monthly VaR for this security at a con idence level of 95%. At a 95% con idence level, the lower tail displays the lowest 5% of the underlying distribution’s returns. For this distribution, the value associated with a 95% con idence level is a return of −15.5%. If you have $1,000,000 invested in this security, the onemonth VaR is $155,000 (= −15.5% × $1,000,000).
The VaR calculated using Figure 1.2 is an example of historical VaR. In Book 4, you will learn about other approaches for calculating VaR.
Economic capital is the amount of liquid capital necessary to cover unexpected losses. For example, if one-day VaR is $2.5 million and the entity holds $2.5 million in liquid reserves, then they have suf icient economic capital (i.e., they are unlikely to go bankrupt in a one-day expected tail risk event).
Scenario analysis is a process that considers potential future risk factors and the associated alternative outcomes. The typical method is to compare a best-case scenario to a worst-case scenario, which shocks variables to their extreme known values. This process factors the potential impact of several categories of risk and in luences risk manager decision making by attempting to put a value on an otherwise qualitative concept (i.e., what-if analysis). This exercise is an attempt to understand the assumed full magnitude of potential losses even if the probability of the loss is very small.
Stress testing is a form of scenario analysis that examines a inancial outcome based on a given “stress” on the entity. This technique adjusts one parameter at a time to estimate the impact on the irm. For example, it is plausible for interest rates to adjust severely in an economic crisis. Stress testing will estimate the impact of this one parameter on the entity.
There are two types of parameters that could be considered using either scenario analysis or stress testing. The irst type of parameter is historically sourced. This parameter has the bene it of being observable, but the past trend may not continue into the future. The second type of parameter is an estimated variable, which is a hypothetical forecast based on a risk manager’s assumptions. This approach can introduce estimation error and model risk, but it may be a useful exercise to fully understand a irm’s sensitivity to qualitative risk factors.
In practice, the term enterprise risk management (ERM) refers to a general process by which risk is managed within an organization. An ERM system is highly integrative in that it is deployed at the enterprise level and not siloed at the department level. The value in this top-down approach is that risk is not considered independently, but rather in relation to its potential impact on multiple divisions of a company.
One challenge with the ERM approach is a tendency to reduce risk management to a single value (e.g., either VaR or economic capital). This attempt is too simplistic in a dynamic-risk environment. Risk managers learned from the inancial crisis of 2007–2009 that risk is multi-dimensional, and it requires consideration from various vantage points. Risk also develops across different risk types, as you will learn later in this reading. The reality is that proper application of an ERM framework requires both statistical analysis and informed judgment on the part of risk managers.
The ultimate goal of an ERM is to understand company-wide risks and to integrate risk planning into strategic business planning. If the risk management process does not link information with action, then it is an exercise in futility. ERM is not just about risk aggregation at the company level. It considers risk holistically and its appropriate in luence on strategic planning for an organization.
LO 1.c: Distinguish between expected loss and unexpected loss and provide examples of each.
Expected loss (EL) considers how much an entity expects to lose in the normal course of business. These losses can be calculated through statistical analysis with relative reliability over short time horizons. The EL of a portfolio can generally be calculated as a function of: (1) the probability of a risk occurring; (2) the dollar exposure to the risk event; and (3) the expected severity of the loss if the risk event does occur.
For example, a retail business that provides credit terms on sales of goods to its customers (i.e., no need to pay immediately) incurs the risk of nonpayment by some of those customers. If the business has been in operation for at least a few years, it could use its operating history to reasonably estimate the percentage of annual credit sales that will never be collected. The amount of the loss is therefore predictable and is treated as a regular cost of doing business (i.e., bad debt expense on the income statement). It can be priced into the cost of the goods directly in the case of the retail business. In a banking context, EL could be modeled as the product of a borrower’s probability of default (PD), the bank’s exposure at default (EAD), and the magnitude of the loss given default (LGD).
EL = EAD × PD × LGD
Banks will often address ELs by charging a higher spread (and possibly a shorter time horizon) for riskier borrowers. Most expected losses can be logically considered as a function of several more granular losses.
When EL can be modeled with con idence, it can be treated like a predictable expense or a variable cost.
Unexpected loss (UL) considers how much an entity could lose in excess of their average (expected) loss scenarios. There is considerable challenge involved with predicting unexpected losses because they are, by de inition, unexpected.
For example, consider a commercial loan portfolio that is focused on loans to automotive manufacturing companies. During an economic expansion that favors such companies (because individuals have more disposable income to spend on items such as automobiles), the lender will realize very few, if any, loan defaults. However, during an economic recession, there is less disposable income to spend and many more loan defaults are likely to occur from borrowers. It is also likely that many of these losses will be clustered at the same time. This is an example of correlation risk, when
unfavorable events happen together. The correlation risk drives potential losses to unexpected levels.
Another example of correlation risk lies with real estate loans secured by real property. Borrowers tend to default on loans (i.e., default rate risk) at the same time that the real property values fall (i.e., recovery rate risk—the creditor’s collateral is worth less, thereby compromising the recovery rate on the funds lent to the borrowers). These two risks occurring simultaneously could also bring potential losses to unexpected levels.
LO 1.d: Interpret the relationship between risk and reward and explain how con licts of interest can impact risk management.
As previously mentioned, there is a natural trade-off between risk and reward. In general, the greater the risk taken, the greater the potential reward. However, one must consider the variability of the potential reward. The portion of the variability that is measurable as a probability function could be thought of as risk (EL) whereas the portion that is not measurable could be thought of as uncertainty (unexpected loss).
For example, government bonds have less credit/default risk than corporate bonds. Therefore, government bonds will trade with lower yields than corporate bonds (all else equal). However, for a given maturity, the full relationship between risk and return goes further than merely credit risk (e.g., liquidity risks and taxation impacts may make the relationship less clear). Additionally, the risk tolerances (i.e., ability and willingness to take on certain risks) of market participants may change over time. When risk tolerances are high, the spread between riskless and risky bonds may narrow to an abnormally low level, which again disguises the true relationship between risk and return.
The risk/reward trade-off becomes much more complex to analyze for assets that are either thinly traded or not publicly traded. This is especially true for illiquid assets.
Because risk and reward are linked, it is very important for risk managers to properly consider relevant risks. As previously mentioned, a bank’s EL could be modeled as the product of a borrower’s PD, the bank’s EAD, and the magnitude of the LGD. Risk managers could drill down on the PD to discern underlying loss drivers that need to be monitored. Some of the drivers could be the borrower’s inancial condition (e.g., sales growth trends, input cost trends, etc.) or it could be an external factor (e.g., weakening global trade or unfavorable tax policy changes). The potential list of loss drivers could be exhaustive. The advent of arti icial intelligence and machine learning greatly enhances a risk manager’s ability to consider and isolate economically important loss drivers to monitor.
In complex systems (e.g., inancial markets), extreme unexpected losses (risk) sometimes occur. These tail risk events can be tragic for a risk management system.
This is especially true when the correlation between risk factors increases. The triggers for lockstep movement between risk factors could be structural changes such as behavioral shifts, industry trends, government interventions, and new innovations. Danger arises when the frequency of tail events increases because the pace of structural uncertainty accelerates.
One of the biggest structural concerns is the potential for con licts of interest. Those in the position to be most aware of the presence, probability, and potential impact of various risk factors are sometimes the ones who try to pro it from its presence. This reality could be seen in the actions of rogue traders. It may also be seen from managers who conceal knowledge of a risk factor to maximize short-term stock price movements to enhance personal compensation through stock-based remuneration structures.
The best way to combat the potential for con licts of interest to skew risk recognition is the following three-step process:
1. Risk recognition by frontline employees and division managers.
2. A robust risk management system with daily oversight.
3. Periodic independent audits to ensure that steps 1 and 2 are functioning properly.
. Which of the following statements regarding risk and risk management is correct?
A. Risk management is more concerned with unexpected losses than expected losses.
B. There is a relationship between the amount of risk taken and the size of the potential loss.
C. The final step of the risk management process involves developing a risk mitigation strategy.
D. If executed properly, the risk management process may allow for risk elimination within an economy.
. Which of the following items is not a building block of the risk management process?
A. Identifying relevant risk.
B. Measuring risks.
C. Avoiding all known risks.
D. Attempting to quantify any expected losses.
. Examining the impact of a dramatic increase in interest rates on the value of a bond investment portfolio could be performed using which of the following tools?
I. Stress testing.
II. Enterprise risk management.
A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.
. Which of the following items would be associated with unexpected losses?
I. Loan defaults are increasing simultaneously while recovery rates are decreasing.
II. Lending losses are covered by charging a spread between the cost of funds and the lending rate.
A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.
. Which of the following statements is incorrect with respect to the relationship between risk factors?
A. The risk/reward trade-off is easier to consider for individual stocks than for private equity investments.
B. Risk management conflicts of interest can be easily mitigated through stockbased compensation.
C. Risk managers should consider granular loss drivers.
D. Risk management conflicts of interest can be mitigated through periodic internal audits.
LO 1.e: Describe and differentiate between the key classes of risks, explain how each type of risk can arise, and assess the potential impact of each type of risk on an organization.
All irms face risks. These risks can be subcategorized as market risks, credit risks, liquidity risks, operational risks, legal and regulatory risks, business and strategic risks, and reputation risks.
Market risk refers to the fact that market prices and rates are continually in a state of change. The four key subtypes of market risk are interest rate risk, equity price risk, foreign exchange risk, and commodity price risk. The key to mitigating these risks is to understand the relationship between positions. As these relationships change, risk management methods need to change as well.
Interest rate risk refers to uncertainty lowing from changes in interest rate levels. If market interest rates rise, the value of bonds will decrease. Another form of interest rate risk is the potential for change in the shape of (or a parallel shift in) the yield curve. Interest rate risk may arise from having positions that are either completely or partially unhedged. This occurs when underlying transactions do not fully offset. In this instance, the loss could be attributed to basis risk, which means that the presumed correlation between the price of a bond and the price of the hedging vehicle used to hedge that bond has changed unfavorably.
Equity price risk refers to the volatility of stock prices. It can be broken up into two parts: (1) general market risk, which is the sensitivity of the price of a stock to changes in broad market indices, and (2) speci ic risk, which is the sensitivity of the price of a stock due to company-speci ic factors (e.g., rising cost of inputs, strategic weaknesses, etc.). General market risk cannot be diversi ied away, while speci ic risk can be mitigated by holding assets with less than perfect correlations.
Foreign exchange risk refers to monetary losses that arise from either fully or partially unhedged foreign currency positions. Foreign exchange risk results from imperfect correlations in currency price movements as well as changes in
international interest rates. Potentially large losses could reduce an entity’s competitive edge relative to its foreign competitors.
Commodity price risk refers to the price volatility of commodities (e.g., precious metals, base metals, agricultural products, energy) due to the concentration of speci ic commodities in the hands of relatively few market participants. The resulting lack of trading liquidity tends to increase the amount of price volatility compared to inancial securities. In addition, commodities may face signi icant price discontinuities (i.e., prices suddenly jump from one level to another).
Credit risk refers to a loss suffered by a party whereby the counterparty fails to meet its contractual obligations. Credit risk may arise if there is an increasing risk of default by the counterparty throughout the duration of the contract. There are four subtypes of credit risk: (1) default risk, (2) bankruptcy risk, (3) downgrade risk, and (4) settlement risk.
Default risk refers to potential nonpayment of interest and/or principal on a loan by the borrower. The PD is central to risk management.
Bankruptcy risk is the chance that a counterparty will stop operating completely. The risk management concern is that the liquidation value of any collateral might be insuf icient to recover a loss lowing from a default.
Downgrade risk considers the decreased creditworthiness of a counterparty. A creditor may subsequently charge the downgraded entity a higher lending rate to compensate for the increased risk. For a creditor, downgrade risk may eventually lead to default risk.
Settlement risk could be illustrated using a derivatives transaction between two counterparties. At the settlement date, one of them is in a net gain (“winning”) position and the other is in a net loss (“losing”) position. The position that is losing may simply refuse to pay and ful ill its obligations. This risk is also known as counterparty risk (or Herstatt risk1).
Consider an example where one investor’s net gain on a futures contract is $500,000 at settlement. The counterparty must pay this amount, but they have encountered inancial dif iculty and are only able to pay $400,000. This estimated payment is called the recovery value, and the $100,000 that will be lost is known as the loss given default (LGD). Expressed in percentages, the recovery rate is 80% and the LGD is 20%. If the recovery rate was 0%, then the counterparty would be in complete default and possibly in a bankruptcy scenario.
Risk managers use sophisticated modeling to properly consider credit risk. Following is a list of some very important considerations relative to this risk identi ication process: Is the interest rate charged on the instrument commensurate with the risk taken? Is a portfolio of instruments diversi ied both geographically and by industry? Have correlations between instruments and other known risk factors been properly considered?
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is to say, four-fifths of all these steamers will belong to England. This will give to us a fleet of ocean steamers outnumbering those of all the rest of the world combined; and these will always be at our disposal for, to say the least, the transport of troops, and of the materials of war. Of the remaining fifth a large proportion will be built in this country, as our resources and arrangements for the construction of iron ships and marine engines are superior to those of any other country.
If, then, it should prove that this forecast of the advantages of the Canal to us in war is correct, it would seem to follow that, in time of war, we should be under the necessity of holding it ourselves; or, at all events, of occupying its two extremities. We should be obliged to take care that neither an enemy blocked it up, nor a friend permitted it to go out of repair.
Beatus qui intelligit. Book of Psalms, V .
No one can see anything in Egypt except what he takes with him the power of seeing. The mysterious river, the sight of which carries away thought to the unknown interior of the great Continent, where solar heat, evaporation, and condensation are working at their highest power, giving birth abundantly to forms of vegetable and animal life with which the eye of civilized man has yet to be delighted, and instructed; the lifeless desert which has had so much effect in shaping, and colouring, human life in that part of the world; the grand monuments which embody so much of early thought and earnestness; the contrast of that artistically grand, morally purposed, and wise past with the Egypt of to-day; the graceful palm, and the old-world camel, so unlike the forms of Europe; the winter climate without a chill, and almost without a cloud; all these are certainly inducements enough to take one to Egypt; but how differently are they seen and interpreted at the time by the different members of the same party of travellers; and with what widely different after-thoughts in each!
And just as many of us are dissatisfied with life’s journey itself, if we can find no object in it, so are we with the travel to which a fraction of it may have been devoted, if it be resultless. Should we, when we look back upon it, be unable to see that it has had any issues which reach into our future thought and work, it seems like a part of life wasted. For, whatever a man may have felt at the time, he cannot, afterwards, think it is enough that he has been amused, when the excitement of passing through new scenes is over, and he is again in his home,—that one spot on earth where he becomes most conscious of the divinity that is stirring within and around him, and finds that he must commune closely with it.
But as to particulars: that which is most on the surface of what Egypt may teach the English traveller is the variety of Nature. It has not the aspects of the tropics, in which the dark primæval forest, and tangly jungle, are the predominant features; yet its green palmtufted plain, and drab life-repelling desert, are a great contrast to our still hedge-divided corn-fields, and meadows; to our downs, and heaths, and hills, and streams; and so are its clear sky, and dry atmosphere to our clouds and humidity. To see, and understand something about such things ought, in these days, to be part of the education of all who can afford the time and money requisite for making themselves acquainted with the riches of Nature; which is the truest, indeed the only, way to make them our own. In saying this, I do not at all wish to suggest the idea that in variety, and picturesqueness of natural beauty, the scene in Egypt is superior to what we have at home. The reverse is, emphatically, the case. Every day I look upon pleasanter scenes than any Egypt can show: scenes that please the eye, and touch the heart more. Nature’s form and garb are both better here. So, too, is even the colour of her garb. To have become familiar, then, with the outer aspects of Egypt, is not only good in itself, as an addition to our mental gallery of the scenes of Nature, but it is good also in the particular consequence of enabling us to appreciate more highly the variety and the beauty of our own sea-girt home.
Of course, however, the source of deepest interest in any scene is not to be found in its outer aspect, but in its connexion with man. If we regard it with the thought of the way in which man has used, modified, and shaped it, and of how, reversely, it has modified, and shaped man, how it has ministered to his wants, and affected the form, and character of his life; or if we can in any way associate it with man, then we contemplate it from quite another point of view, and with quite different feelings. Indeed it would almost seem as if this was the real source of the interest we take even in what we call the sublime and beautiful in nature. Man was only repelled from snow-capped mountains, and stormy oceans, till he had learnt to look upon them as the works of Intelligent Mind akin to his own. Conscious of intelligence within himself, he began to regard as grand and beautiful, what he had at length come to believe Supreme Intelligence had designed should possess these characteristics. This
is, perhaps, the source of the sentiments of awe, and admiration, instead of the old horror, and repugnance, with which we now contemplate cold and inaccessible barrier Alps, and angry dividing Seas. To Homer’s contemporaries, who believed not that the gods had created the visible scene, but that, contrariwise, they were posterior to it, and in some sort an emanation from it, the ocean was only noisy, pitiless, and barren. And the modern feeling on these subjects has, of late, been greatly intensified, and become almost a kind of religion, since men have come to think that they have discovered that these grand objects were brought into being by the slow and unfailing operation of certain general laws which they have themselves ascertained. So that now, to some extent, they have begun to feel as though they had themselves assisted at their creation: they stood by, in imagination, as spectators, knowing, beforehand, the whole process by which Alps and Oceans were being formed. That they were able to discover the laws and the steps by which Omnipotent Intelligence had brought it all about, alone and sufficiently demonstrates the kindredness of their own intelligence. It is the association of these ideas with natural objects that causes the present enthusiastic feeling—almost a kind of devotion—they awaken within us, and which would have been incomprehensible to the ancients, and even, in a great measure, to our forefathers. They seem like our own works. They were formed by what is, in human degree and fashion, within ourselves. We know all about them; almost as if we had made them ourselves.
Regarded, then, in this way, it is not the object itself merely that interests, but the associations connected with it. Not so much what is seen, as what is suggested by what is seen. The object itself affects us little, and in one way; the interpretation the mind puts upon it affects us much, and in quite a different way. In this view there are reasons why the general landscape here, at home, should be more pleasing to us than it is in Egypt. It is associated with hope, and with the incidents and pictures of a better life than there is, or ever has been, in Egypt. I have already said that the natural features are not so varied and attractive there as here; their value to us, in this respect, consisting in their difference. But what I now have in my
mind is the thought of the landscape as associated with man; and in this other respect also I think the inferiority of Egypt great.
The two pre-eminently grand and interesting scenes on this kind in Egypt, where our Egyptian associations with man’s history culminate, I have already endeavoured to present to the imagination of the reader. They are the scene that is before the traveller when he stands somewhere to the south-east of the Great Pyramid, looking towards Memphis, and commanding the Necropolis in which the old Primæval Monarchy is buried, the green valley, the river, and the two bounding ranges; or, to take it reversely, as it appears when looked at from the Citadel of Cairo; and the scene, for this is the other one, which is presented to the eye, again acting in combination with the historical imagination, from the Temple-Palace of the great Rameses at Thebes, where you have around and before you the Necropolis, and the glories of the New Monarchy.
What, then, are the thoughts that arise in the mind at the contemplation of these scenes? That is precisely the question I have been endeavouring to answer throughout the greater part of the preceding pages. My object now, as I bring them to a close, is somewhat different; it is to look at what we have found is to be seen in Egypt from an English point of view; with the hope that we may thus be brought to a better understanding, in some matters, both of old Egypt and of the England of to-day. This will best be done by comparing with the Egyptian scenes, which are now familiar to us, the English scene which in its historical character, and the elements of human interest it contains, occupies, at this day, a position analogous to that which they held formerly. These are subjects that are made interesting, and we may say intelligible, more readily and completely by comparisons of this kind than by any other method. Anatomical and philological comparisons do this for anatomy and philology, and historical comparisons will do the same for history. We shall come to understand Egypt not by looking at Egypt singly and alone, but by having in our minds, at the time we are looking at it, a knowledge of Israel, Greece, Rome, and of the modern world. Each must be set by the side of Egypt.
We will come to ourselves presently We will take Israel first. It proposed to itself the same object as Egypt, that of building up the State on moral foundations, only it had to do its work under enormous disadvantages. Considering, however, the circumstances, it attained its aims with astonishing success. We must bear in mind how in the two the methods of procedure differed. So did their respective circumstances. Egypt had the security which enabled it freely and fully to develop and mature its ideas and its system. This precious period of quiet was no part of the lot which fell to Israel. It had to maintain itself and grow up to maturity under such crushing disadvantages as would have extinguished the vitality of any other people, except perhaps of the Greeks, the periods, however, of whose adolescence and manhood were also very different from those of Israel. At those epochs of their national life they had freedom, sunshine, and success. Israel, on the contrary, had then, and almost uninterruptedly throughout, storm and tempest; overthrows and scatterings. The people never were long without feeling the foot of the oppressor on their necks. Still they held on without bating one jot of hope or heart; and by so doing made the world their debtors, just as did the Egyptians, the Greeks, and the Romans. Regarding the point historically, we cannot say that one did this more than another; for, where all are necessary, it would be illogical to affirm that one is greater or less than another. Neither the seeing nor the hearing, we are told, can boast that it is of more importance than the other; for, were it not for the seeing, where would be the hearing? and, were it not for the hearing, where would be the seeing? In the progress of man the ideas, and principles, and experience contributed by each of these constituent peoples of humanity were necessary: and if the contribution of any one had been wanting, we should not be what actually we are; and that something that we should be then would be very inferior to what we are now. We could not dispense with the gift of any one of the four. Egypt gave letters, and the demonstration of the fact that morality can, within certain limits, be deliberately and designedly shaped and made instinctive. Greece taught the value of the free development of the intellect. Rome contributed the idea of the brotherhood of mankind, not designedly, it is true, but only incidentally, though yet
with a glimmering that this was its mission. Without Rome we might not yet have reached this point. Israel taught us that, if the aims of a State are distinctly moral, morality may then be able to maintain itself, no matter how great the disadvantages, both from within and from without, under which the community has to labour; and even when morality is unsustained by the thought of future rewards and punishments: a lesson which has thrown more light on the power the moral sentiments have over man’s heart than perhaps any other fact in the history of our race.
I bow down before the memory of the old Israelite with every feeling of the deepest respect, when I remember that he abstained from evil from no fear of future punishment, and that he laid down his life for truth and justice without any calculation of a future heaven. In this view the history of the world can show no such single-minded, self-devoted, heroic teachers as the long line of Hebrew Prophets. They stand in an order quite by themselves. Socrates believed that it would be well with him hereafter. They did not touch that question. Sufficient unto them was the consciousness that they were denouncing what was false and wrong, and that they were proclaiming and doing what was true and right.
We will now turn to the Greeks. The interest with which they contemplated the antique, massive, foursquare wisdom of Egypt is well worthy of consideration. It is true they did not get much from Egypt, either in the sphere of speculation or of practice: still for them it always possessed a powerful attraction. The reason why it was so is not far to seek. The Egyptians had done great things; and they had a doctrine, a philosophy of human life. This was that philosopher’s stone the Greek mind was in search of. And they inferred from the great things done by the Egyptians (and this was not a paralogism) that there must be something in their doctrine. In fact, however, they learnt little from Egypt: for if it was the cradle, Greece itself was the Holy Land of Mind. Nor was it possible that they could learn much from it, for the two peoples looked upon society and the world from quite different points of view. Greece acted on the idea that in political organization, and in the well-being of the individual, man is the arbiter and the architect of his own
fortune. Egypt acted on the supposition that these things rested on an once-for-all heaven-ordained system. Greece believed that truth was to be discovered by man himself, and that it would, when discovered, set all things right; and that freedom, investigation, and discussion were the means for enabling men to make the needed discovery. Egypt thought that truth had been already communicated; and that freedom, investigation, and discussion could only issue in its overthrow. What Greece regarded as constructive, Egypt regarded as destructive. It could not therefore learn much from Egypt.
Rome we will now set by the side of Egypt. It will bring the two into one view sufficiently for our purpose, if we endeavour to make out what Germanicus must have thought of old Egypt, when he was at Thebes. He must often have compared it with Rome; in doing which he could, of course, only view it with the eyes of a Roman. And the time for such a comparison had arrived, for the work of Rome, and the form and pressure of that work upon the world, were then manifesting themselves with sufficient distinctness. What he was in search of was light that would aid him in governing the Roman world. Probably he came to the conclusion that the wisdom of Egypt could be but of very little use to him. The aim of Egypt had been allembracing social order, maintained by morality, compacting the whole community into a single organism, in which every individual had his allotted place and work, neither of which he could see any possibility of his ever abandoning, or even feel any desire to abandon. Egyptian society had thus been brought, through every class and member, to do its work with the regularity, the smoothness, the ease, the combined action of all its parts, and the singleness of purpose of a machine. I need hardly repeat that they had understood that the morality by which their social order was to be maintained must be instinctive, and that they had made it so. The difference between them and other people in this matter was, that they had understood distinctly both what they wanted for their purpose, and how to create what they had wanted. Germanicus must have been aware, if he had seen this point clearly, that no government could frame the general morality of the Roman Empire; and that the single moral instinct upon which he would have to depend, if he could
create it, must be the base and degrading one of obedience and submission brought about by fear. No attempt could be made, in the world he expected to be called to govern, to cultivate an allembracing scheme of noble and generous, or even of serviceable, morality. Much, indeed, of what was best would have to be repressed, and stamped out, as hostile and subversive; as, for instance, the sentiment of freedom, and the consciousness that the free and full development of a mans inner being (in a sense the Athenian and the Christian idea) is the highest duty. He would have to provide not for what would encourage his future subjects to think for themselves, and to make themselves men, but for what would indispose them to think for themselves, and would make them only submissive subjects. He had to consider how many abundant and virulent elements of disorder, discontent, and corruption could be kept down: under such a system an impossible task. These evil growths of society had, each of them, been reduced to a manageable minimum, spontaneously, by the working of the Egyptian system; but, under the circumstances of the Roman world, they were inevitably fostered and developed. The application, however, of the Egyptian system to that world was out of the question and inconceivable. So, here, Egypt could give him no help. It could not show him how he could eliminate or regulate these evils. He would not be able to get rid of the elements of discord and discontent in the Egyptian fashion, by creating such instincts of order and submission as would dispose every man to accept the position in which he found himself as the irreversible appointment of Nature. Nor, again, would he be able to counteract social corruption, in the Egyptian fashion, by making virtue the aim of the state, of religion, and of human life.
There were also two other problems to the solution of which he would have to attend. How was the ring of barbarians that beleaguered the Empire to be kept in check? and how was the enormous military force that must be maintained for the internal, as well as the external, defence of the Empire to be prevented from knowing, at all events from using for its own purposes, its irresistible, unbalanceable power? For doing every thing of every kind he had to do, he had but one instrument, and that was force, law being
degraded into the machinery through which that force was to act; and being also itself at discord with much that was becoming the conscience of mankind, that is, at discord with its own proper object. He could make no use of the Egyptian instruments, those, namely, of general morality, of religion, and of fixed social order. The task, therefore, that was before him, however strong the hand and clear the head might be which would have to carry it out, was ultimately hopeless. For one of two things must happen: either men must rebel against the order he would have to maintain, and overthrow it, or it must corrupt and degrade men. For, in the long run, nothing but law and religion, both in conformity with right reason, and aiming at moral growth, can govern men; that is to say, government must aim at human objects, to be attained by human means. Men, of course, can be controlled otherwise, as, for instance, by armed force, the only means that would be at the disposal of Germanicus; but then the product is worthless. Egypt, therefore, could give him no assistance. It could only tell him that the task before him was to him an unattainable one. It was not the one the Egyptians had taken in hand, nor could it be carried out by Egyptian means. A great fight had to be fought out in the bosom of Roman society, and under such conditions that its progress and issue would be the ruin and overthrow of society, as then constituted.
We all know that the man who, in a period of dearth, withholds his corn for a time, is thinking only of himself, though it eventually turns out that what he did was done unintentionally for the benefit of the community: a law, above and beyond him, had been working through him, and shaping his selfish act so that it should contribute to the general good. So was it with the Roman Empire. It subjugated and welded together all people merely to satisfy its own greed, but in so doing it had further unfolded and advanced the world-drama of human history. When it had played out its part, it was seen that that part could not have been dispensed with, because, though so hard for those times, it was essential to the great plot, for it was that that had given birth to, and brought to maturity, the sentiment of the unity and brotherhood of mankind.
And now at last we come to ourselves. All, including Egypt, have become teachers to us. We are the inheritors of the work of all. To us —and how pleasant is it to know this—the wisdom even of old Egypt is not quite a Dead Sea apple, something pretty to look at, but inside only the dust of what had been the materials of life. We can feel our connexion with Egypt, and that we are in its debt; and we shall not be unworthy of the connexion, and of the debt (a true debt, for we are benefited through what they did), if we so make use of them as that those who shall come after us shall have reason to feel that they, too, are, in like manner, debtors to ourselves. Inquiries of this kind enable us to discover what are the historical, which means the natural and actual, bases of our own existing civilization.
What we now have to do is to compare ourselves with old Egypt. Things of this kind become more intelligible when made palpable to sense by being taken in the concrete. We have looked on the scenes in Egypt which are invested with an interest that can never die, because it is an interest that belongs to the history of humanity. By the side of them we must set the scene in the England of to-day, which holds the analogous position. Of course it must be in London. And as it must be in London I know no better point at which we can place ourselves than on the bridge over the Serpentine, with our back upon Kensington, so that we may look over the water, the green turf, and the trees to the towers of the old Abbey and of the Palace of Westminster. The view here presented to us is one which obliges us, while looking at it, to combine with what is actually seen what we know is lying behind and beyond it. It is not a scene for which an otiose glance will suffice, because it is precisely the connexion between what is before the eye, and what is to be understood, that gives it its distinguishing interest.
What is immediately before you, in its green luxuriance of turf and leaf, is peculiarly English; you might imagine yourself miles away from any city, and yet you are standing in the midst of the largest collection of human beings ever brought together upon the earth: what is around you is hardly more the capital of England than of the world. Strange is it to find yourself in the midst of such an incomprehensible mass of humanity, and yet at the same time in the
midst of a most ornate scene of natural objects—water, trees, turf. Just as in the Egyptian scenes, where the interests of its history are brought to a focus, the preponderant objects presented to the eye are graves and temples in the desert, which tell us of how religious and sombre a cast was the thought of the Egyptians, who could see nothing in the world but God, and could regard life only in connexion with death; so here, too, we find, as we take our stand in the midst of this English world-capital, that we can see nothing of it; that it is hid from our eyes by the country enclosed within it. This alone tells us something about the people. It intimates to us that those who have built this world-wonder have not their heart in it; that it is against the grain for them to be here: they do not love it: they do not care to make it beautiful: that, unlike their Latin neighbours, they are not a city-loving people; that the first and strongest of their affections are for the green fields, the wavy trees, and the running streams; and that they have, therefore, reproduced them, as far as they could, in the midst of the central home of their political life, to remind them of what they regard as the pleasanter and the better life. But it is strange that this very fondness for rural life is one of the causes that have contributed to the greatness of this city. It has been the love of Nature, and the hardihood of mind and body the people have acquired in their country life, which have disposed them to go forth to occupy the great waste places of the earth; and so have helped in enabling the Nature-and-country-loving English race to build up an Empire, out of which has grown this vast, but from the spot where we are standing in the midst of it invisible, city.
Each also of the two great buildings, whose towers are seen above the trees, has much to tell us about ourselves. There is the old Abbey, reminding us of the power religion has had and will ever have over us, though not now in the Egyptian fashion of something that has been imposed upon us, but rather of something that is accepted by us; and of our determination that it shall not be constructed out of the ideas and fixed for ever in the forms which belong to ages that, in comparison with our own really older and riper times, had something to learn, and not everything to teach. It is precisely the attempt to invest Christianity with Egyptian aims and claims, fixity and forms, which is arraying men’s minds and hearts
against it; and, in some parts of Christendom, making the action of society itself hostile to it. It is this attempt which is in a great measure depriving it of the attractiveness and power it possessed in its early days when it was rightly understood: though then it was, necessarily, not only a private care, but one that had also to strive hard to maintain its existence against the fierce and contemptuous antagonism of the collective force of the old pagan form and order of society. If men are now turning away from what they once gladly received, it can only be because what is now offered to them has ceased to be what it was then—the interpretation, and expression, and the right ordering, of all that they knew, and of the aspirations of their better nature. The phenomenon is explained, if we have reason for believing that men then regarded Christianity as an honest organization of knowledge, thought, and morality, for the single purpose of raising and bettering human life, but now regard it as, in some measure, their priestly organization for the purpose, primarily, of maintaining priestly domination, through the maintenance of a system which was the growth of widely different times and circumstances.
It cannot be seen too clearly, or repeated too often, that Christianity did not originate in any sense in priestly thought, but was, on the contrary, a double protest against it, first in its own actual inception, which included a protest against priest-perverted Judaism, and antecedently in the primary conception of the previous dispensation, which included a protest against priestly Egyptianism; so that neither in itself, nor in its main historical source, could it originally have had any priestly or ecclesiastical, but only broadly human and honestly moral aims.
This will, by the way, assist us in forming a right estimate of the character of that argumentum ad ignorantiam we have heard so much of lately, that Protestantism is only a negation of truth, and an inspiration of the Principle of Mischief. Looking back along the line of our own religion, we find that Moses, speaking historically, was the first Protestant; and that the Saviour of the World was, in this respect also, like unto him. As, indeed, have been, and will be, more or less, in the corrupt, but though corrupt, yet still, on the whole, advancing
currents of this world, all who are wise and good, and who have the courage of their wisdom and goodness. It will also assist us to understand that religion does not mean systematic Theology and organized priestly domination, which are its degeneration, and into which the ignorance and carelessness of the mass of mankind, and the short-sightedness of some, and self-seeking of others, of its constituted expounders are tending always to corrupt it; but that it means, above all things, the ideal theory of perfect morality and virtue, combined with the attempt to work it out practically in human life, so far as is possible, under the difficulties and hindrances of this world, supported by the good hope of its actual complete realization in a better world to come.
The history of old Egypt is very much the history of the character, working, and fate of the priestly perversion (as we must regard it now) of religion, even when the attempt is made, as it was in that case, honestly, and without any violation or contradiction of the original principles and aims of the religion. As respects the modern world, the lamentable and dangerous consequences of this perversion of religion are to be traced, in some form or other, in the actual moral and intellectual condition of perhaps every part of Christendom. We see indications of them amongst ourselves in individuals, and even in classes. The legitimate action of religion has been in many cases not merely neutralized and lost, but directly reversed. It ought to generate the instincts that contribute to the order, the unity, the building up of society; whereas, by aiming at ecclesiasticism, and endeavouring to retain what is at variance with its own true purpose, it has given rise to unavowed repugnances, to fierce antagonisms, to repulsion of class from class, and even among some of hatred to the very order of Society; that is to say, it has produced instincts that contribute, and that most energetically, to disorder, disunion, and the overthrow of Society; proving the truth of the saying that nothing is so bad as the corruption of that which is best. Religion is the summa philosophia which interprets, harmonizes, systematizes, and directs to the right ordering of Society, and of the individual, all knowledge from whatever source derived, all true and honest thought, all noble aspirations, all good affections. Development and growth ever have been, and ever must
be, a law of its existence: nothing else can maintain its continuity And as, notwithstanding this necessity of development, its end and aim must all the while, and for ever, be one and the same, development and growth do not and cannot mean the overthrow of religion, as some have told us, and will continue to tell us, but, on the contrary, the enlargement and strengthening of its foundations, and the better ordering and furnishing of the superstructure.
The very name of the building before us—The Abbey—reminds us that, as far as we ourselves are concerned, we have accepted and acted on the principle of development, adaptation, and correction in our religion. The old name, belonging to a past order of things, is evidence that this principle has once been applied; and so it supplies us with a ground for hope that it will be applied again, whenever a similar necessity may arise. History, indeed, assures us that this must be done always, sooner or later, for in all ages and places the religion of any people has ever been, in the end, what the knowledge of the people made it; but it makes a great difference whether what has to be done be done soon, or whether it be done late. If the former, then the continuity of growth and development is not interrupted. If the latter, then there intervenes a long period of intellectual and moral anarchy, of religious and irreligious conflict. The consequences and the scars of the conflict are seen in what is established eventually. It is found that some things that were good have perished; and that some that are not good have become inevitable.
By the side of the old Abbey rise the towers of the Palace of Westminster—a new structure on an old site. That which first occurs to the beholder, who has old Egypt in his thoughts, is its inferiority in artistic effect to the stupendous but simple grandeur of the Egyptian Priests’ House of Parliament in the hypostyle Hall of Karnak, with its entourage of awe-inspiring temples, its vast outer court, and its lofty propylons. In that hall he had felt that its great characteristic was not so much its grandeur as its truthfulness to its purpose, of which there is not one trace to be found in the home of our great National Council, which one might survey carefully, both internally and externally, without obtaining the slightest clue for enabling him to
guess for what purpose it was designed. But how grand, I hesitate to say how much grander, is the history which the site, at all events, of the building we are looking at brings into our thoughts. It has not indeed numbered the years of the Egyptian Panegyries. They might have counted theirs by thousands, while our Assembly counts its by hundreds. And we must also remember that they assisted at the birth, and watched by the cradle, of political wisdom. True they swathed the infant in the bands of a fixed religious system; but, then, they could not have done otherwise; and what they did, under the restrictions and limitations which times and circumstances imposed upon them, was, notwithstanding, good and precious work; and we comparing that work of theirs with much that has since been done, and is now doing, see that, though it was crippled and distorted at every step by their evil necessities, it was done wisely, and well, by men who clearly understood what they wanted to do, and how it was to be done. Our Parliament had to do its work under very different and even opposite conditions. This island—indeed, this part of the world—was not an Egypt where none but corporations of priests and despotic rulers could be strong. We could not, on the contrary, be without chieftains’ strongholds, and strong towns, too. While, therefore, with us the armed possessors of these strong places accepted religion, they could resist and forbid ecclesiastical encroachments, and could thus save Society, through saving the State, from ecclesiastical domination. They were strong and free, and so could nurture freedom, instead of standing by and looking on while it was strangled and buried out of sight. They were, too, the heirs of Israelite, Greek, Roman, and German traditions; and these they could keep alive, even without quite understanding them, until the day came when they might be carried out more fully and harmoniously; and more might be made of them than had been possible even in the days, and in the countries, which had given them birth. That has been the slow but glorious rôle in human history of these English Parliaments, of which that Palace of Westminster at which you are looking is the shrine: a spot most sacred in human history, and which will be closely interesting to the generations that are to come when time shall have forgot the great Hall of the Panegyries of Egypt; for the History of the freedom of Religion, of
Speech, and of the Press, of Commerce, and of political and almost of human freedom itself, is the History of these English Parliaments.
The History, then, of these two buildings throws much useful light on the history of the later phases of the progressive relations to each other of the State and of the Church; and of the rights, the duties, the proper field, and the legitimate work of each. The questions involved in these points have been answered very differently at different times, in accordance with the varying conditions of society: but the answers given have, on the whole, been such as to assist us in understanding two particulars of importance: first, that the character of the relation of the two to each other among any given people, and at any given time, is dependent on the conditions of society, then and there; on the point knowledge has reached; the degree to which it has been disseminated; and on the course antecedent events have taken. (The relation, at any time established, does, of course, re-act on the conditions which gave rise to it, and so has some effect in shaping, and colouring, their character in the proximate future.) And, in the second place, that there is observable, throughout History, if its whole range be included in our view, a regular evolution and evergrowing solution of the great question itself.
All the peculiarities, and particulars of the history, of these two buildings, such, for instance, as that they stand side by side, and yet are quite distinct from one another; that the Ecclesiastical building is very old, very ornate, and imposing, and was very costly; and that the Civil building is modern, but on an old site; that it too was costly, and is very ornate and imposing, and in its ornamentation and aspects affects somewhat the Ecclesiastical style; that they are in the hands of distinct orders of men belonging to the same community; that the work carried on in them is quite distinct, and yet that ultimately their respective work is meant to contribute, by different paths, and with different sanctions, to the same end, that is to say, the bettering of man’s estate—all this symbolizes with sufficient exactness the history and character of the conflicts, and of the relations, past and present, of the Church and of the State amongst ourselves.
I am here taking the word Church in its widest, most intelligible, and only useful sense—and which is the interpretation history puts on the phenomena the word stands for—that of the conscious organization of the moral and intellectual forces and resources of humanity for a higher life than that which the State requires and enforces. It is untrue, and as mischievous as untrue, to talk of Religion—that is, the effect on men’s lives of the doctrine which the Church has elaborated—as if it were something apart, something outside the natural order of things, something up in the air, something of yesterday, which has no root in man’s nature, and the history of which is, therefore, not coincident with the history of man. Like every thing else of which we have any knowledge, it is the result of certain causes. And in the case of this effect, of which the Church is the personal embodiment, the affiliation is distinct and palpable. Poetry and Philosophy are as much manifestations of it, as what we call Religion, when we are employing the word in its popular, restricted signification. They do, indeed, so entirely belong to it that there could be no advance in Religion, I might almost say no Religion at all, without them. And, conversely, Religion supplies to the bulk of mankind all the Poetry and Philosophy that will ever be within their reach. Poetry (which uses Art as one of its instruments of expression), dealing with things both objectively, as they appear to address themselves to us, and subjectively, as they are seen through the medium of our own sentiments; and Philosophy, dealing with the ensemble of things as they are in themselves—the two, working in these ways, and endeavouring to organize sentiment and knowledge, or, in other words, human thought and the world of external facts, for the sovereign purpose of nurturing and developing our moral being, if they do not give rise to Religion, yet have, at all events, largely contributed towards expanding, purifying, and shaping it. Every one can see how Philosophy and Poetry contributed each its part to the construction of the Old Dispensation. It is equally plain that Christianity originally rested on a profoundly philosophical view of the Old Dispensation, considered in connexion with the then new conditions of the world. And it was, precisely, because the view taken was so profound, because it went so completely to the bottom of all that then and there had to be dealt
with, that it was felt and seen to be thoroughly true. For the same reason it was as simple as it was true. And it was because it was so entirely in accord with man’s nature and history, and with the conditions on which the world had then entered, that it was understood to be, and received as, a Revelation from God. This was the internal evidence. And in the old Classic world, which we can now contemplate ab extra, and without prepossession, we see that the only teachers of Religion were first Poetry, and then Philosophy: at first mainly the former, and afterwards mainly the latter. And thus were they the means by which the outer world, at all events, was prepared for Christianity.
If, then, we take the word Church in the sense I am now proposing (and I am concerned here only with the interpretation History gives of the phenomenon), it will help us to understand how it happens that every Church, at certain stages in its career, comes into conflict with the State, or the State with the Church; and, too, how it happens that, at certain conjunctures, the action of the State, as it is, is to restrict and to thwart the action of the Church, as it should be; and why it is that, in the end, the latter must always carry the day. It will also lead us to think that in the future the Clergy will not have the entire decision of religious questions; but that, strange as it may sound to us, the Poet, the Historian, and the Philosopher will, sooner or later, be able to make their ideas felt in the discussion and shaping of these matters. It has been so in the past; and we may suppose that it will be so again in the future. Even now the lay Prophet has no insignificant auditory, and it is one that it is growing rapidly in every element of influence. We have no reason for believing that the world will be content to leave, for ever, its own highest affair in the hands of those only whose function, as understood and interpreted, at present, by the majority of themselves, is to witness to what were the thoughts of their own order, in an age when that order thought for mankind; and did so, sometimes, not in complete accordance with the common heart, conscience, and aspirations of mankind, certainly not with what they are now, but rather with what the Church supposed would complete and strengthen its own system; at all events, always in accordance with the insufficient knowledge, sometimes even with the mistaken
ideas, of times when the materials supplied by the then existing conditions of society, and by the then state of knowledge, for the solution of the problem, were not the same as those supplied by our own day.
In old Egypt—under the circumstances it could not possibly have been otherwise—the Church administered, and was, the State: the State was contained within it. The distinction between things civil and things religious had not emerged yet. This fact deeply modified the whole being of the Church. Its resultant colour thus came to be compounded of its own natural colour and of that of the State. This primæval phase can never again recur. The increase and dissemination of knowledge; the idea and the fact of civil as opposed to ecclesiastical, we may almost say of human as opposed to divine legislation, and the now thoroughly well ascertained advantage of the maintenance of civil order by civil legislation, have made the primæval phase, henceforth, impossible among Europeans, and all people of European descent. We may add, that it has, furthermore, become impossible now on account of the higher conception that has been formed of the duty and of the work of the Church itself.
The Middle Ages present to our contemplation the curious and instructive picture of a long-sustained effort, made under circumstances in many respects favourable to the attempt, and which was attended by a very considerable amount of success, to revert to and to re-establish the old Egyptian unspecialized identity of the two. This effort was in direct contradiction to the relation in which the early Christian Church had placed itself to the State; though, of course, it was countenanced, apparently, by the early history of the Hebrew Church, which, like that of Egypt, had necessarily embraced, and contained within itself, the State, in the form and fashion that had belonged to the requirements of those times. That it had been so with it, however, only shows, when we regard the fact, as we can now, historically, that society, there and then, was in so rudimentary a condition, that its two great organs of order, progress, and life had not yet been specialized; the ideas and means requisite for this advance not having been at that time, among the Hebrews, in existence.