C&B Notes

A Qualitative View of Risk Management

It is enticing to attempt to distill risk down to easily consumable metrics, but a strong culture is by far the most important ingredient for effective risk management and compliance.

Early in his career, Mr. Breit figured out that models for markets aren’t like those for physics. They don’t come from nature. It was necessary to know the math, if only so that he couldn’t be intimidated by the quantitative analysts.  But the numbers more often disguise risk than reveal it.  “I went down the statistical path,” he said.  He built one of the first value-at-risk models, or VaR, a mathematical formula that is supposed to distill how much risk a firm is running at any given point.

The only thing from capital markets math he came to embrace was this immutable law of nature: Investors make money by taking risk.  “If it’s profitable and seems riskless, it’s a business you don’t understand,” he told me.  Instead of fixating on models, risk managers need to develop what spies call “humint” — human intelligence from flesh and blood sources.  They need to build networks of people who will trust them enough to report when things seem off, before they become spectacular problems.  Mr. Breit, who attributes this approach to his mentor, Daniel Napoli, the former head of risk at Merrill Lynch, took people out drinking to get them to open up.  He cultivated junior accountants.  “They see things first,” he said. “Almost every trading debacle was sitting on some accountant’s desk.”

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Yes, a big market move might reveal a fatally flawed trade, but that volatility is not the root cause of an oversized loss.  The problem, as Mr. Breit sees it, is that this has nothing to do with how risk management is practiced today, or what the regulators encourage.  Regulators have reduced risk managers to box checkers, making sure they take every measure of risk and report it dutifully on extensive forms.  “It just consumes more and more staff, turning them into accountants and rotting brains.”

Take VaR.  In Mr. Breit’s view, Wall Street firms, encouraged by regulators, are on a fool’s mission to enhance their models to more reliably detect risky trades.  Mr. Breit finds VaR, a commonly used measure, useful only as a contrary indicator.  If VaR isn’t flashing a warning signal for a profitable trade, that may well mean there is a hidden bomb.  He despises the concept of “risk-weighted assets,” where banks put up capital based on the perceived riskiness of the assets.  Inevitably, he argues, banks will “pile into” the same types of supposedly safe investments, creating bubbles that make the risks far more severe than the initial perceptions.  Paradoxically, risk-weighting can leave banks setting aside the least capital to cover the biggest dangers.  “I could not be more disappointed,” he said.  “The cynic in me thinks this is all in the interests of senior management and regulators to avoid blame.  They may not think they can prevent the next crisis, but they then can blame the statistics.”  Instead, Mr. Breit says he believes that regulators should encourage firms when they reach different conclusions on what is risky and what is safe.  That creates a diverse ecosystem, more resilient to any one pestilence.