SPECULATIONS ON THE ROLE OF THE

RISK MANAGER POST-CRISISPresented by Barry Schachter

GARP student chapter European Business School, London

11 November 2010

Crisis is a Catalyst for Change “...life as crisis is a condition in which

man holds only...the lack of feeling certain about anything important...[and is] handed over to the chaos of pure circumstance...”José OrtegaMan and Crisis, New York: W.W. Norton (1958) pp. 87-88.

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Risk Management and the Crisis

Much criticized, both measurement & management of risk

Several examples of failure to cite, e.g.,Mortgage-related losses (e.g., UBS)Lehman BrothersBernie MadoffJerome Kerviel (SocGen)

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Analysis of Failures are Many Senior Supervisors Group, Turner

Report, IMF, IIF, IOSCO, Lehman Examiner’s report, UBS report to shareholders, and many, many research articles (e.g., Stulz, Golub, Jorion)

These include taxonomies of what when wrong and how to fix it

Risk Management Lessons

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UBS Report is Illustrative

Gaps in risk management expertise / experience at the IB Senior Business Management level

Insufficient discussion of or actions upon concerns surrounding Subprime

Absence of Front-desk limit structure

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UBS on Risk Management Failure [Independent] Risk Control framework

was insufficiently robust (see next slide) historical data used for VaR and Stress

“did not attribute adequate weight to the significant growth...” “...hindsight suggests...”

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UBS Risk Control Failures

No loss limits tuned to risk of US housing market

Over-reliance on VaR, Stress, Ratings Insufficient granularity on positions /

risks reported to senior management

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What is Risk Management? My evolutionary view:

It is an adaptation for enhancing individual firm survival

My muddied evolutionary view: It is a proxy tool for supervisory control of systemic risk and protection against moral hazard of public guarantees (e.g., deposit insurance and too-big-to-fail)

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How does this Adaptation Function? Enterprise-wide risk appetite Executive level decisions on risk

allocation Risk taking culture Risk information (measurement) Distribution of authority over risk taking

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What Role Does Risk Manager Play?

In general perception, this is the “independent” risk manager

In part evolved from regulatory mandates

Heavily involved in risk informationdelegated authority over risk taking

Risk Information: Forecasting or Fortune-telling?

Science, Scientism, or Mysticism?

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Analogy to Weather Forecasts

What does “40% chance of rain” mean? Prob. of Precip. = C x A,

where "C" = confidence that precipitation will occur somewhere area, and "A" = percent of area that will receive measureable precipitation, if it occurs at all.Source: US National Weather Servicehttp://www.srh.noaa.gov/ffc/?n=pop

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Historical Note

Hallenbeck first true probability-based precipitation forecasts (for New Mexico, USA) Monthly Weather Review (November 1920)

“Empirical” probabilities similar to method of Historical Simulation VaR

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Statistical Forecasts

Can we forecast low frequency events?ability to modelavailability of data

Relaxing the normality assumption (where it is used)

More fundamental epistemological questions

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Non-Statistical Risk Information

Stress TestingWhat-if scenariosFactor sensitivities

Ideas from network theoryMeasures of connectedness“Latent” correlation identification

Ideas from complexity/game theorypositive feedback & illiquidityconcentration of risk

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After the Crisis: Improving Risk Info

More general VaR models New approaches to stress testing (e.g.,

reverse stress tests) Better data New regulator-required measures New risk metrics Caveat: perfection is unattainable,

but perfection is the benchmark – after the fact

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Authority Over Risk Taking Benefits of Independent Oversight

Second set of eyesMonitoring of potential moral hazard

Risks of Independent OversightRisk assessment is separated from return

assessmentRisk manager as adversary to risk taker

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After the Crisis

Regulatory responseGreater independence from risk takersGreater voice on the board

Market responseFire the old CROs, hire new onesLook for meaningful lessons, don’t confuse

risk management “failures” with “facts of life”

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New Risk Challenges for Risk Managers lower liquidity (e.g., new position limits) greater counterparty risk concentration fewer low correlation trades

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New Opportunities for Risk Managers Increased focus by banks on “asset

management” versus proprietary risk taking

Disintermediation of Funds of Hedge Funds

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In SumNext Generation of Risk Managers

More authority Bigger voice at senior management

level Broader implementation of independent

risk management function (e.g., by institutional investors)

More qualitative requirements New quantitative techniques (more

research)

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In SumRisks to Gen-R Bigger compliance role Less innovation Return to the old normal corporate

culture