The Limitations of Risk Management

I’m just back from a week of splendid isolation, fly-fishing in Scotland and free from mobile phone networks and Internet connections. Amazingly the weather was dry every day, highly unusual for May. Bright weather doesn’t make for good fishing but personally I’d rather sacrifice the fishing for pleasant weather.  

My only link with business was reading a copy of the Economist from May 17 which happened to carry an interesting analysis of the recent financial meltdown from a risk management perspective.  

This article entitled “Professionally gloomy” makes a number of good points. Value-at-risk measures look backwards not forwards. So the longer things go smoothly, the better the situation looks. But we all know that a downturn becomes more likely. Risk models also create an illusion that we can quantify and regulate all risks, but it’s simply not true. We can’t anticipate the unexpected. And we have no historical data for new products.

It’s also hard to see the big picture of aggregate risk. “We have all the leaves on the tree but not the tree” as one risk manager puts it. Put simply, risk management is highly immature. We have a long way to go to develop techniques and models that are truly fit for purpose.   

Excessive leverage means that misjudgements can be especially dangerous. Good risk management is therefore becoming more crucial to longer-term survival. The smarter banks detected the problem earlier and started to steer away from the problem in late 2006. That’s probably one reason why executive search agencies report that good risk managers are currently in heavy demand.