Risk Management Lessons from The Current CrisisBarry Schachter

For presentation to the Society of Quantitative AnalystsJune 11, 2009 (New York)

Outline and Summary Paradise is exactly like where you are right

nowOnly much, much better. Laurie Anderson, “Language is a Virus” (1986)

Popular and consensus views about risk management

Why are these views off-target Another look at risk management lessons

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Popular and Consensus Views about Risk Management

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The Model of a Modern Risk Manager (Not)

I’m very well acquainted, too, with matters mathematical/ I understand equations, both the simple and quadratical/ About binomial theorem I'm teeming with a lot o' news;

With many cheerful facts about the square of the hypotenuse./I'm very good at integral and differential calculus/ I know the scientific names of beings animalculous/ I am the very model of a modern Major-General.William Gilbert (lyrics), “A Modern Major General”4

Signs of Risk Management Failure (Not) Negative Accounting Earnings Bankruptcy Forecast Errors Inability to Predict the Future Inability to weigh all data, both available and

not, exactly as it subsequently would be weighed with hindsight

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The World is Normal “Risk-management models used in banks

were generally based on the simplified assumption that markets fluctuated randomly following a “normal” statistical distribution. This implied very low probabilities of extreme losses, ignoring financial history.”

Shahid Chaudhri and Richard Griffiths, The Times (London), March 9, 2009 - founding partners of Innovation4Now, a risk-management consultancy

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The World is Normal (Not) - 9/15/08

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The Six Failures of Risk Management 1. Mismeasurement of known risks. 2. Failure to take risks into account. 3. Failure in communicating the risks to top

management. 4. Failure in monitoring risks. 5. Failure in managing risks. 6. Failure to use appropriate risk metrics.

“Understanding Risk Management Failures” by Rene Stulz Relying on historical data; focusing on narrow

measures; overlooking knowable risks; overlooking concealed risks; failing to communicate; not managing in real time; “Six Ways Companies Mismanage Risk” by Rene Stulz

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The Current Risk Management Debate Based on these perceptions, action items

have already been identified Cultural Change (3, 5)

Greater independence of the Risk Manager More knowledgeable and involved “NEDs”

Methodological Change (1, 2, 4, 6) New risk measurements More transparency

The paradigm from which the action items come is yet to be examined, however.

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The Current Paradigm Paradigm elements

Risk management failures are firm-specific Firms can be viewed as independent actors Systemic problems have a cause at the firm level

Implications No strategic behaviors or feedback loops No systemic consequences of regulatory framework No endogenous sources of change in risk management

technologies Systemic crises arise from exogenous factors

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A Different Starting Point

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Where to find the Lessons to be Learned

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The crisis cannot be understood solely in terms of failures of risk management Adverse selection – informational asymmetries Incentives (perverse and not) Undirected emergent properties of a complex

adaptive system Some of the aforementioned Big 6 failures

may be more accurately described as facts of life

A different paradigm highlights different potential problems (and solutions)

An Evolutionary/Networked Paradigm Firms pursue idiosyncratic strategies with the goal of

survival Risk management is one adaptation by individual

firms in pursuit of that goal (a combination of physical and social “technologies”)

Firms interact with each other and macro economic behavior, e.g., price dynamics, growth in GDP, employment are “emergent” properties of the system

A crisis may arise from an exogenous shock or endogenously as a result of a feedback loop

Risk management practices with a greater survival probability will tend to propagate, while others are dropped

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Credit Crisis: The Network Movie The Spread of the

Credit Crisis: View from a Stock Correlation Network Reginald D. Smith (Feb ‘09)

S&P500 stock correlations estimated over 8/1/07 to 10/8/08, a distance metric computed from the correlations, and a minimal spanning tree estimated.

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Two Questions to Ask

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Are there signs that Risk Management is an “ill fit” adaptation?

Are there signs that elements of Risk Management contributed to the positive feedback in the network?

The “Fitness” of Risk Management in the Crisis

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American International Group I was recently widely reported that at AIG the

corporate risk staff were limited in their direct interaction with the Financial Products group.

Senior Supervisors’ Group has noted the crisis has rewarded firms with a more integrated approach to risk in decision making.

Too much separateness of the risk management function may be a problematic adaptation.

Risk Management and Positive Feedback

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LTCM crisis generated discussion of positive feedback effects arising from widespread use of VaR trading limits that might exacerbate crises.

“It is arguable that regulators have actually promoted herding through risk management systems. They may also have done so in their zeal for disclosure of bank positions and central bank reserves.” Avinash Persaud (Sending the Herd off the Cliff

Edge (World Economics 1(4): 15-26, 2000))

We May Be Engaged over the Wrong Issues Too much focus on risk measurement

Amaranth example of risk taking culture Ratings-driven instrument design VaR models required by regulators

Too much focus on firm-level issues Too much focus on making sure this particular

event doesn’t happen again Regulators are, largely, exempted from the

examination We are engaged in a search for the

unattainable

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The Problem Of The Two Cultures A barrier exists between the “scientific” and

“literary” cultures – a product of the Enlightenment

Clash of the weltanschauungen “knowledge is power”

Francis Bacon (Meditationes Sacrae (1597)) “If our sciences are futile in the objects they propose,

they are no less dangerous in the effects they produce.” Rousseau (Discours sur les sciences et les arts (1750))

“…scientists can give bad advice and decision-makers can’t know whether it is good or bad.” C. P. Snow (1960)

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Risk Management and the 2 Cultures

Many methods of Risk Management lie within the “Scientific” culture

Risk Management regularly crosses the dividing line between the two cultures

Action under uncertainty is at the core of division

“None of our beliefs are quite true; all have at least a penumbra of vagueness and error.” Bertrand Russell (“Free Thought and Official

Propaganda” (1922))

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Meme vs. Gene in the Two Cultures

Risk Management (Scientific)

General Public, Regulators, BoDs

(Literary)

Bad Decisions; Lack of Trust; Conflict

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Another Look at Risk Management Lessons

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Action Items Revisited – Culture Change Greater independence for risk managers

Increased authority over risk Outside the business – report directly to the Board

Increased power to and expectations of NEDs

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The Independence Issue – Summary The claim: effective independent Risk management viewed as an oversight

function Assumes the problem is not enough oversight One solution is to impose a regulation on the

organizational structure of the risk function, something that is identified with greater independence

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The Independence Issue – Another View

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Risk management (i.e., how firms make risk-relevant decisions) is an adaptation by firms for survivability

It consists of various “technologies”, physical and social (e.g., risk measurement, risk governance)

Like any adaptation, it may exhibit significant variation across firms, as it arises organically, endogenously in each firm

Independence is not necessarily a universal characteristic (nor is it necessarily a dominant survival characteristic)

Regulation of organizational structure is (at best) an indirect means to an end

Adaptation and Variety Let a hundred flowers bloom;

Let a hundred schools of thought compete. Mao Zedong (speech, 1956)

Unlike banks, insurance, and securities firms we can find a wide variety of adaptations for risk management in hedge funds.

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Possible adverse impacts “the main impact of political interference…is

to slow down evolution’s clock speed.” Eric Beinhocker (The Origin of Wealth (2006))

Limiting firms’ ability to adapt organizational structure to business needs may hinder endogenously generated improvements in risk management

Imposing uniformity in organizational structure may increase sensitivity to systemic failures by reducing diversity.

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Action Items Revisited – Methodology New Risk measurement

“CoVaR” “Reverse” stress testing

Additional Transparency

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The Methodology Issue – Summary The claim: Risk measurement problems led to

the crisis Assumes the problem is deficient risk

measurement One solution is to impose a (revised)

regulation on the types of risk measurement required.

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The Methodology Issue – Another View

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Risk measurement, a set of physical technologies, is only a part of the risk management adaptations employed by firms

Risk management adaptations incorporate the organization’s risk measurement “known unknowns.”

Methodologies that are more “fit” will enhance firm survivability and propagate endogenously.

Externally imposed methodologies may inhibit future adaptability and will reduce diversity.

The impact on systemic risk will depend on the features of the system dynamics.

New Risk Measurements CoVaR

The value at risk (VaR) of a financial institution conditional on other institutions being in distress. E.g., Adrian and Brunnermeier (September, 2008)

Contains elements of positive feedback effects Does not embed the type of price dynamics in a

strategic trading model, such as Morris and Shin (“Market Risk with Interdependent Choice” (2000)).

Reverse Stress Tests Identify the scenarios that correspond to a level of

loss sufficiently severe to threaten the institution’s viability. E.g., Financial Services Authority CP 08/24 (December,

2008)

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The Sticky Problem of Intervention “…the dread of disturbance and the love of well being

insensibly lead democratic nations to increase the functions of central government as the only power which appears to be intrinsically sufficiently strong, enlightened, and secure to protect them from anarchy…the particular circumstances which tend to make the state of a democratic community agitated and precarious enhance this general propensity and lead private persons more and more to sacrifice their rights to their tranquility.” (de Tocqueville, 1835)

“Rahm Emanuel reportedly has a doctrine: Never let a serious crisis go to waste. His point is a good one - vested interests usually block change across a wide range of important issues in the US, and a major financial/economic crisis provides an opportunity to bypass or breakthrough those interests in order to introduce meaningful and substantial change.” (The Baseline Scenario blog, May 26, 2009)

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Conclusion The crisis has led to much healthy self-examination of

the performance of risk management and identified weaknesses

From the viewpoint of the standard paradigm, these need to be addressed through new regulatory requirements directed at the organization and operation of risk management at the individual firm level

Viewed from a different, evolutionary and network perspective both the prescriptions and the prescriptive approach are subject to question.

The alternative view is not synonymous with a hands-off approach, but rather one that recognizes the importance of endogenous adaptation and variety in reducing systemic risks.

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