Risk Models: A timeless “classic” tale

The following extract is from a NYT article written over 2 years ago (September 2008) and why, when we hear reports of the acronym B.A.U. (business as usual) in common parlance amongst the many survivors.

They survive, unpunished, unbowed to perpetrate the same abuses against the same people with a fresh batch of victims’ money!

Same people, same culture, same outcomes…

Top bankers couldn’t simply ignore the computer models, because after the last round of big financial losses, regulators now require them to monitor their risk positions. Indeed, if the models say a firm’s risk has increased, the firm must either reduce its bets or set aside more capital as a cushion in case things go wrong.

In other words, the computer is supposed to monitor the temperature of the party and drain the punch bowl as things get hot. And just as drunken revelers may want to put the thermostat in the freezer, Wall Street executives had lots of incentives to make sure their risk systems didn’t see much risk.

“There was a willful designing of the systems to measure the risks in a certain way that would not necessarily pick up all the right risks,” said Gregg Berman, the co-head of the risk-management group at RiskMetrics, a software company spun out of JPMorgan. “They wanted to keep their capital base as stable as possible so that the limits they imposed on their trading desks and portfolio managers would be stable.”

One way they did this, Mr. Berman said, was to make sure the computer models looked at several years of trading history instead of just the last few months. The most important models calculate a measure known as Value at Risk — the amount of money you might lose in the worst plausible situation. They try to figure out what that worst case is by looking at how volatile markets have been in the past.

But since the markets were placid for several years (as mortgage bankers busily lent money to anyone with a pulse), the computers were slow to say that risk had increased as defaults started to rise.

It was like a weather forecaster in Houston last weekend talking about the onset of Hurricane Ike by giving the average wind speed for the previous month.

But many on Wall Street did even worse, as Mr. Berman describes it. They continued to trade very complex securities concocted by their most creative bankers even though their risk management systems weren’t able to understand the details of what they owned.

A lot of deals were nonstandard in many ways, “so you really had to go through the entire prospectus and read every single line to pick up all the nuances,” Mr. Berman said. “And that slows down the process when mortgage yields looked very attractive.

How Wall Street Lied to Its Computers

2 Responses to Risk Models: A timeless “classic” tale

  1. Geary Sikich says:

    Good piece. Risk needs to be redefined and globalized for a better assessment capability. It seems that everyone is suddenly doing risk management. A colleague informed me that he was doing risk assessments – he works in health and safety – is he really doing risk assessments that will adequately communicate risk to decision makers?

    • Hi Geary,
      I know it is unbelievable how something so, apparently, ineffective is going to be made better by people who know less that current “experts”!!!

      OK, so, undoubtedly there is scope for some “old school” knowledge and assumptions to be unlearnt but this is taking things too far. Nest thing you know it’ll be sexy to be a “Risk Manager”…even some of those guys on Wall Street, FSA, SEC or The Fed might fancy trying it out!

      Sorry, that’s probably taking it too far.

      Seriously though, thanks for the kind words it is very much appreciated.


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