Performance Perspectives Blog

Risk management in name only?

by | Mar 15, 2010

We spend a great deal of time debating the value of various risk measures, arguing, for example, whether it’s appropriate for the Global Investment Performance Standards (GIPS(R)) to require the disclosure of the 3-year annualized standard deviation or whether value at risk has any value. But perhaps more time needs to be spent on the management of risk, as this seems to be what has often led to the crises we’ve witnessed. In his exceptional treatise, When Genius Failed, on Long-Term Capital Management, Roger Lowenstein discussed how LTCM regularly reviewed their risks but never put the brakes on any of their investing, in spite of the apparent risks they were facing. Seeing the risks, being aware of the risks, but not doing anything about them, shows an institution that is void of risk management.

In a more recent book, The Quants by Scott Patterson, we read that “risk management is about avoiding the mistake of betting so much you can lose it all.” Patterson further states that this was “the mistake made by nearly every bank and hedge fund that ran into trouble in 2007 and 2008.”

In this past weekend’s Financial Times we are presented with a rather abridged version of the recently published 2,200 page expos√© on Lehman’s actions, that highlights quite a lot. For example, that the firm’s risk officer “resisted an increase in the limit [of risk] from $2.3bn to $3.3bn but was overruled.” and that “by the end of 2007, it was $4bn.” Further, that certain assets, such as a “$2.3bn bridge loan…was never included in the risk usage calculation, although that single transaction [for example] would have put Lehman over its already enlarged risk limit.” What exactly was the role of their risk officer? Patterson’s claim that “the banks and hedge funds blowing up didn’t know how to manage risk” seems, at least in Lehman’s case, to be accurate.

The use of derivatives, short sales, and complex models are often cited as contributors to the market disaster that we’re slowly making our way out of. However, risk management needs to be fully assessed as it appears that its absence from many of the trading rooms and investment houses surely was a huge factor. Henry Paulson was no doubt unaware of Lehman’s risk management issues when he penned On the Brink, though he does speak in a rather disparaging way the (broad) management of AIG, and so not only risk management but management in general needs to be reviewed by those charged with providing oversight.

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