Thursday, December 11, 2008

Dos and Don'ts of Risk Management

There's one question that keeps getting asked again and again in the ongoing crisis: how did the best minds and the fanciest models fail so badly? How could some of the biggest players in the business have messed up risk management so thoroughly?

I'd venture to suggest that it was not so much a problem of flawed mathematical models or faulty assumptions being fed into models. Models do fail in situations of extreme stress but that is hardly the whole of the problem or even the biggest part of the problem.

The problem was that a few people at the top took the basic decisions on risk and that information on risk exposures was not shared widely enough. In other words, autocratic decision-making was a big factor in the downfall of mighty financial firms. Even the boards of these firms did not know- and did not care to ask. I dwell on this in my ET column, Managing risk in today's world and spell out some dos and donts.

My point is that risk management is a governance issue and is a matter of sound management and regulation- it's not just about models and rocket scientists. You need to get the whole culture of and incentives in a bank right for risk management to succeed. Wide dissemination of information on risk exposures and participation of a large number of people are crucial to risk management.

This last is where Indian public sector banks score. They have officer as well as staff representatives on the board. These people are watching managers all the time. They not only know about lending decisions but also about the lifestyles of managers. When the chairman throws a wedding party, employees are watching- how lavish it is, who attends, what is the body language, what sort of gifts are exchanged. They talk about these things. This sort of employee watchfulness is an excellent risk management tool. Because very often it is not lack of knowledge, but mala fide intent, that underlies bad business decisions.


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Vikram said...

Many more factors to why banks and other big US brokerage houses suffered heavy losses, global slowdown, US and European markets choppy, India too facing the brunt. Its like US sneezes and India catches cold. But fortunately some recovery to be seen in US markets lately, hopefully this will continue. FIIS should pump in money like they did last yr now they don't wanna burn their fingers. hopefully better global cues in near future.
I personally feel that the failure of their risk management programs did not cause all this damage, that might have off course but nominal and not much could have helped following the risk management technique, as everything was going wrong and all negative news everywhere. I feel the uncertainty in the markets and fear of recession may be the reason for the crash as it was already predicted b4(i think sir warren buffet did)

Krishnan said...

I remember hearing the word "derivative" being used to describe/model transactions on Wall Street - and then read news about PhD's in Physics/Engineering migrating to Wall Street to tweak/run/massage complex models that only the originator of such models seemed to know. When the going was good, no one asked questions and gave credit to such complex models. Boards, regulatory authorities did not bother to ask if the models did accurately reflect the realities and how they were being manipulated.

We see something very similar about Global Warming - levels of CO2, temperature change patterns and so on. James Hansen of NASA started this several years ago and slowly reports are trickling out of programming code mischief that is generating results that people want to see and not accurately model climate changes, climate events. Many people, like Al Gore, have had too much invested in their predictions of climate doom/gloom that they are ignoring fundamental principles of modeling and scientific fidelity.

Wall Street is finding out that one cannot keep massaging models, reality will come back to bite. I hope sufficient numbers of scientists wake up to realize the fraud that is being perpetrated by alarmists about the effect of man on any climate change.