Wednesday, September 16, 2009

A case study in risk management

The credit crisis of 2008, or the Great Recession as it is now famous as, has had many many books written on it. Writers from across the ideological spectrum have written about why the crisis occured and how their brand of ideology could have prevented the crisis. Which is why I was skeptical when I came across this piece which seemed to rehash the story of the collapse of Lehman. I was pleasantly surprised that this article was about one element that has been whispered off and on, but not very convincingly: about risk management based on common sense. (The reader needs to get past the title and the opening blurb, though. The title seems to suggest the credit crisis would have never taken place if Goldman Sachs hadn't spotted the game early enough. That is plain ridiculous. The leveraging of the economy + the decline in lending standards created a ticking time-bomb. But I digress.)

The article is not about having some fancy risk management metrics or why our models are wrong or why we should not trust a Ph.D that offers to build a model for you. (Of course, all of these elements contributed to why the crisis was ignored for all these years.) Instead, the article recounts a real-life meeting that took place in Goldman Sachs at the end of 2006. The meeting was convened by Goldman CFO, David Viniar, based on some seemingly innocuous happenings. The company had been losing money on its mortgage backed securities for 10 days in a row. The resulting deep-dive into the details of the trades pointed to a sense of unease about the mortgage market. Which then caused Goldman to famously back-off from the market.

I'll leave the reading to you to get more details of what happened. But some thoughts on what contribute to effective risk management practices.

- A real-life feel for the business. You can't be just into the models, you need to be savvy enough to understand how the models you build interact with the real world outside. And it is an appreciation of this interaction that cause the hairs to stand at the back of your neck when you encounter something that just doesn't seem right.
- Proper role of risk management in the decision making hierarchy. Effective risk management takes place when the risk governance has the authority to put the brakes on risk takers (i.e., the traders, in this case). In Goldman, there were a number of enablers for this type of interaction to take place effectively. Most importantly, risk management reported to the CFO, i.e. high enough in the corporate heirarchy. Second, investment decisions needed a go-ahead from both the risk takers and risk governance.
- Mutual respect between risk governance and risk takers. Goldman encourages a collaborative style of decision making. This allows multiple conflicting opinions to be present at the table. Minority opinions are encouraged and appreciated. Over time, this fosters a culture that genuinely tolerates dissonance of opinions. This also allows the CFO to be influenced by the comptroller group as much as he typically would by the trading group.
- Finally, a certain intellectual probity to acknowledge what it does not know or understand. During the meeting, the Goldman team was not able to pinpoint what their source of unease was. But they were able to honestly admit that they didn't really understand what was going on, but that it was also most appropriate to bring the ship to harbour, given their blindspot about what they didn't know. It takes courage to back-off from an investing decision, saying "I don't understand this well enough" in the alpha-male investment banking culture.

All in all, a really interesting read.

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