Ask a practitioner of the origins of financial risk management, and he might say it emerged in response to financial blow-ups of the early 1990s. Or he might say it emerged out of efforts by the Basel Committee to standardize bank capital requirements globally. Or he might say it emerged from efforts by banks to understand their own risks—RAROC and RiskMetrics being the two most obvious initiatives. All these explanations would have financial risk management emerging during the period 1985-1995. But what exactly emerged?
For many years, I have defined financial risk management as “the process whereby an organization optimizes the manner in which it takes financial risk.” Note that it is not about optimizing risk; it is about optimizing the manner in which risk is taken, but this is a topic for another posting. For now, let’s note that other definitions have been offered over the years, but most tend to be as general as my own. There is little that links them to the specific events of 1985-1995. Organizations have struggled to optimize, in some sense, the manner in which they take financial risk, for as long as they have faced financial risk. This places the origins of financial risk management in the shadows of prehistory. Financial risk management would include everything from installing cash registers that ring when the drawer opens to credit analysis and the entire field of financial accounting.
Processes for optimizing risk taking have existed and evolved over millennia. What happened during 1985-1995 was that a new buzzword was applied to a body of techniques, some of which were just emerging. It was the second time in 20 years that this had happened. During 1975-1985, the new buzzword was asset-liability management (ALM), which was applied to duration matching, gap analysis and other related techniques. Now the buzzword was financial risk management, and it was applied to value-at-risk (VaR), risk-adjusted performance measures (RAPMs) and still other related techniques.
ALM failed to prevent the Savings & Loan crisis. Based on that track record, I would say that ALM has proven itself useful but inadequate. The report card for financial risk management has been even worse. It failed to prevent
- the Asian crisis
- repeated blow-ups at hedge funds, starting with LTCM
- the 2000 dot-com bubble
- electricity trading abuses that were, at least partly, responsible for bankrupting PG&E and caused rolling blackouts in California
- spectacular corporate failures, including Enron and Worldcom
- a host of abuses at investment banks relating to equity analysts, IPOs and bundling of loans with investment banking services
- the “market timing” scandal at mutual funds
- the executive stock option back-dating scandal.
This all transpired during the ten years following the Group of 30 report and JP Morgan’s introduction of RiskMetrics. Some might conclude that financial risk management has been an unmitigated disaster. I would respond that things would have been worse without financial risk management, but it is hard to argue about hypotheticals. It is indisputable that, just as ALM proved an inadequate solution, so has financial risk management. It either needs to be transformed or supplemented with a new new buzzword and associated techniques.
Back in the mid-1990s, financial risk management was the darling of Wall Street. Banks embraced it as an industry alternative to proposed regulation of the emerging OTC derivatives markets. That battle was won, and the OTC derivatives markets avoided the feared regulation. No longer Wall Street’s darling, financial risk management is mostly trotted out to help close derivatives sales or to satisfy regulators. It is also embraced by third parties who sell software, courses, books and such. Mostly, it has become an unwanted “cost center.” Thousands of bright, dedicated professionals labor away in these cost centers, but they receive little acclaim from those they serve. New ideas percolate into financial risk management from bank regulatory initiatives or financial engineering. Otherwise, innovation and debate have largely dried up. The heady days of 1995 are long gone.
Today, I am launching a blog about risk generally and about financial risk management specifically. My goal is to reignite innovation and debate. I intend to be novel, provocative and even controversial. I am writing to make a difference, but I will accomplish nothing without your involvement. I hope you will join me. There is functionality for commenting on my postings. Just click the comment button that appears at the end of each posting. You can also reply to other people’s comments by clicking on the reply button that appears within each comment. I hope to post about once a week. With your involvement, we should get quite a discussion going.