Financial Risk Management

<body bgcolor="#E8FFF0"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table18"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table19"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table20"> <tr> <td> <p align="center" class="header_green"><map name="FPMap4"> <area target="5" href="../../blog101906_post.htm" shape="rect" coords="0, 0, 149, 29"> </map>A Right Way and a Wrong Way</td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../../../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table21"> <tr> <td align="left" valign="top" bgcolor="#E8FFF0"> <p class="blog_body" align="center"> October 19, 2006  <font size="2"> <a target="_top" href="http://www.glynholton.com/link/blog101906.htm">permalink</a></font>  <a target="5" href="../../blog101906_post.htm"> comment</a>  <a href="mailto:glyn@contingencyanalysis.com?subject=Blog Feedback"> e-mail</a></td> </tr> </table> </td> </tr> </table> <p class="blog_body">Not long ago, I was sitting on a trading floor, helping a trader figure out the intricacies of volatility surfaces. The firm's head of risk management strolled by, and the trader grunted an expletive under his breath. I was taken aback by the trader's vehemence. Not only did he dislike the head of risk management, it was visceral. </p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table22"> <tr> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="blog_body">In many firms—most, perhaps—there is conflict between trading (the "front office") and risk management (the "middle office"). At its most harmless, this takes the form of collegial banter and humorous put-downs. At its worst, it is a blood sport, complete with backstabbing, hoarding of information and political intrigue. </p> <p class="blog_body">Sooner or later, every firm has a budding rogue trader. Only one in a thousand is ever reported in the newspaper. The vast majority are discovered before they can do much damage and are quietly let go. In organizations where risk management works well, bad apples are easy to spot. They are the one or two traders who are evasive in their dealings with risk management. But those bad apples won't stand out if there is a cold war raging between the front and middle offices. In a context where every trader is evasive towards risk management, the bad apples don't stand out. There are plenty of reasons to avoid conflict, but this one alone is sufficient. </p> <p class="blog_body">So how do we avoid conflict? Over the years, I have come to identify two competing models for how financial risk management should work. No organization implements either model in its pure form. Rather, the two models are extremes. Organizations more or less blend the two. However, as pure concepts, the two models can help us understand what works and what doesn't work in financial risk management. I have given the two models names. These are technical terms, so I wouldn't want you reading too much into them, but one model is called the Wrong Model and the other is called the Right Model. </p> <p class="blog_body">To understand the two models, it is useful to distinguish between strategic risk takers and tactical risk takers. These labels take on different meanings in different contexts. For now, strategic risk takers will be board members and senior management of a corporation. They make strategic decisions that place the corporation's assets at risk. Tactical risk takers will be traders, credit officers, salespeople and middle managers. They make tactical decisions that place the corporations assets at risk. </p> <p class="blog_body">Presumably, we want there to be some link between the decisions of one group and the decisions of the other. This requires two-way communication. Strategic risk takers communicate down in the organization with a business plan and formal policies and procedures. These explain to tactical risk takers what tactical risks they should be taking. They also detail the manners in which those risks should be taken. Tactical risk takers communicate up in the organization with reports (which may be prepared by others with their input). The reports allow senior risk takers to monitor tactical risk taking to ensure it is consistent with the vision they presented in the business plan. It also allows them to assess what is working and what is not—so they can make changes to the business plan, as necessary. Tactical risk takers also communicate up in the organization with requests for changes to procedures. Because these are usually prompted by developments—either within the organization or in the organization's business environment—such requests are a formal vehicle for strategic risk takers to become aware of such developments. </p> <p class="blog_body">There is nothing particularly new about any of this. It is how corporations have operated for decades, if not centuries. So where does financial risk management fit into the picture? The two competing models offer very different answers. </p> <p class="blog_body">According to the Wrong Model, strategic and tactical risk takers aren't very good at assessing risk. They need help, and that is where risk managers come in. Under this model, risk managers are like super risk takers. They advise strategic risk takers on whether to enter a market of expand into a new territory. They recommend whether currency exposures should be hedged or not. They monitor the activities of tactical risk takers—and intervene when risk gets out of hand. </p> <p class="blog_body">There are many problems with the Wrong Model. First of all, it addresses a problem that shouldn't even exist. It is the role of strategic and tactical risk takers to take risk. They should be experts at it. If they are not, the solution is not to hire some super risk taker to help them. It is to fire them and replace them with people who are more competent. </p> <p class="blog_body">A second problem is the fact that the Wrong Model holds no one accountable. If a CEO decides to take a particular risk based on the advice of a risk manager, who is accountable when the risk turns bad? Will it be the CEO's fault or the risk manager's? Accountability is about one person taking responsibility. If two people are accountable for the same decision, no one is really accountable. </p> <p class="blog_body">Wherever the Wrong Model predominates, this problem of ambiguous accountability causes conflict between the front and middle offices. Traders' compensation and careers depend on their trading performance. Having to share accountability with some risk manager threatens their reputation and livelihood. For example, if a trader has a successful quarter, does she deserve the credit? Or do we credit the risk manager whose oversight presumably kept her from taking inappropriate risks? </p> <p class="blog_body">Traders are not the sorts of people to let grass grow under their feet. When they feel threatened by risk managers, they respond. They deny the risk managers information or feed them misinformation. They undermine the risk managers within the organization and generally promote a perception of the risk managers as "Keystone Cops" who are incapable of contributing anything meaningful to their trading decisions. Where the Wrong Model predominates, there is conflict between the front and middle offices. It is pretty much inevitable. </p> <p class="blog_body">The Right Model is profoundly different. It assumes that an organization hires experts at taking strategic risk to serve as strategic risk takers. It assumes that an organization hires experts at taking tactical risk to serve as tactical risk takers. Risk managers don't assist, advise or oversee any of these experts in doing their jobs. Rather, risk managers facilitate the risk taking process. Risk managers facilitate the drafting by strategic risk takers of business plans, policies and procedures, and they ensure that these are communicated to tactical risk takers. They facilitate the preparation of risk reports and see that these are communicated to strategic risk takers. They monitor to ensure that policies and procedures are followed. To aid in that process, they facilitate requests for changes to procedures whenever tactical risk takers identify a need. In a nutshell, effective risk taking requires a constant flow of information up and down the organization, and it is the role of financial risk management to facilitate this information flow. </p> <p class="blog_body">Under the Right Model, a better name for "risk managers" would be "risk facilitators." Risk facilitators do not take risk. They do not advise on risk. They have no opinions about risks. All they do is ensure that strategic and tactical risk takers have all the information they need to do their jobs. A risk facilitator may tell a senior risk taker that a portfolio's value-at-risk is USD 750,000, but it is up to the strategic risk taker to decide if that is acceptable or not. As soon as a risk facilitator expresses an opinion on whether a given risk is acceptable or not, that individual is contributing to the risk taking process—and contributing to a blurring of accountability. A key strength of the Right Model is that it promotes accountability by putting one person's name on each risk. </p> <p class="blog_body">Under the Right Model, conflict between the front and middle offices is rare. When it does arise, it is usually a warning signal that traders are engaged in activities they don't want strategic risk takers knowing about. Otherwise, risk facilitators provide a valuable service to traders, ensuring that they receive clear strategic vision from the top and that their efforts are fairly and accurately communicated to management. So long as traders now that risk facilitators cannot and will not encroach on their own decision making, there is every reason for traders and risk facilitators to work together collegially toward the common goals detailed in the strategic risk takers' business plans. </p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table23"> <tr> <td align="right" width="9"> </td> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="blog_body">It is impossible to facilitate a process and simultaneously be a participant in that process. This is why the Wrong Model fails. The Right Model maintains a clear separation between risk taking and risk facilitation roles. Risk takers take risk. Risk facilitators do not. For risk facilitators, this is not a glamorous role, but it is a profoundly important role. </p> <p class="blog_body">Unfortunately, the Wrong Model predominates in many organizations. It is sort of the default model people gravitate towards without giving the matter much thought. The Right Model is more subtle. It has to be explained to people, and they often aren't ready to embrace it until they have experienced the failings of the Wrong Model first hand. </p> <p class="blog_body">Look around your own organization. Does the Wrong Model predominate? If it does, the first step towards a solution is to educate people. Explain the two competing models to them. Change people's titles, so "risk managers" become "risk facilitators." Enforce clear separation between risk taking and risk facilitation roles.</p> <p class="blog_body">If you are a risk manager yourself, there is something else you can do. The next time someone asks you whether a particular risk is worth taking, answer them with "I don't have an opinion on that."</p>  <p class="blog_body" align="center"> Glyn A. Holton</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table24"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table25"> <tr> <td width="100%"> <p align="center"><map name="FPMap0"> <area target="5" href="../../blog101906_post.htm" shape="rect" coords="0, 0, 149, 29"> </map> <img border="0" src="../images/button_comment.gif" usemap="#FPMap4" width="150" height="30"><p align="center"> </td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../../../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table26"> <tr> <td align="left" valign="top" bgcolor="#E8FFF0">  </td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table27"> <tr> <td bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" bgcolor="#E8FFF0" id="table28"> <tr> <td width="100%" bgcolor="#E8FFF0"> <p align="center" style="margin-top: 18"><map name="FPMap2"> <area target="_top" href="http://www.glynholton.com" shape="rect" coords="0, 0, 192, 76"> </map> <img border="0" src="../images/logo_blog_green.gif" width="193" height="77" usemap="#FPMap2"></p> <p align="center"><span class="verdana10"> <a href="http://www.riskglossary.com/main/disclaimer.htm" target="_self"> Disclaimer</a></span></p> <p align="center">website: <a target="_top" href="http://www.contingencyanalysis.com"> <font size="2" face="Verdana, Arial, Helvetica" color="#003300">http://www.contingencyanalysis.com</font></a><br> blog direct link: <font size="2" face="Verdana, Arial, Helvetica" color="#663366"> <a target="_top" href="http://www.glynholton.com"><font color="#003300"> http://www.glynholton.com</font></a></font><br> copyright © Contingency Analysis, 2006 - current<p align="center"> <map name="FPMap3"> <area target="_top" href="http://www.contingencyanalysis.com" shape="rect" coords="0, 0, 240, 88"> </map> <img border="0" src="../images/logo_ca_green.gif" width="241" height="89" usemap="#FPMap3"></td> </tr> </table> </td> </tr> </table> </td> <td>  </td> </tr> </table> </div>  </body>