From the Desk of Risk: Back to Basics in Risk Management

It is both natural and desirable to continually seek improvement, to enhance current processes. But if those processes are the guidelines governing behavior and action, a reference point is also necessary. If that reference point is fungible, credibility will suffer. If that reference point is viewed as fungible, confidence may wane. Stability instills confidence, provides an anchor. Stable risk management processes instill confidence, provide an anchor.

“VaR models change almost every time we talk.” Jamie Dimon, J.P. Morgan Chase CEO, as quoted by Bloomberg News, October 12, 2012

This statement – spoken in the context of the 2012 “London Whale” incident – probably revealed more of the regard given to internal risk management than the entirety of the investigation. If the model and benchmark for risk measurement continually change, by what basis can it instill confidence? Many pointed fingers at management within JP Morgan for the apparently little regard given to internal risk management. But I would lay the blame elsewhere – with risk management itself. Too many PhDs entering this profession have failed to realize that what matters is not the sophistication of the method, it is the credibility of the process. Confidence only comes through credibility, and inconsistency and variability rarely will instill that confidence.

Yes, we can always devise a better model, a more realistic abstraction of reality. (Or should we say “abstraction from reality”?) But it is the simple models that last. It is the simple models that gain wide acceptance. For example, consider the Black-Scholes option pricing model originally published in 1973. It is well known that this model makes a number of assumptions that are gross simplifications of reality. And yet it is still the benchmark used over 40 years later. Why? Because market participants know all its deficiencies but still know how to make it work. Because it provides a common valuation metric that is understood and accepted by all market participants. Are there better option-pricing models out there? Absolutely. But name one that has greater market awareness than Black-Scholes.

What too many fail to realize (or admit) is that parameter uncertainty and dynamic markets will almost invariably overwhelm incremental model enhancements.

So what principles should underlie a firm’s risk management process?

  1. As much as possible, risk measures should reflect current market conditions and be based on actual returns rather than model-based abstractions.
  2. Risk management should allow management and portfolio managers “enough rope” to hang themselves, but not the client. And never the firm. Risk managers should clearly define the final line of defense, as well as assist, encourage, and measure tighter safeguards. But, at the same time, the risk manager should know what really matters and stand aside unless absolutely necessary.
  3. Risk measures and processes should rarely change. Refinements are certainly required from time to time; however, the vetting process for fine-tuning should be quite rigorous.
  4. Finally, the risk measures used need to be quite visible, transparent, and clearly understood. This should never be sacrificed simply to satisfy the deities of model enhancement.

One final point should be made. Risk management should never be viewed as more than what it is. Greater returns come with greater risk and the presence of a robust risk management culture will never change this. The key is that the risk undertaken is intentional, understood, and tied directly to the desired outcome.

 

 

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