The New Role of Risk Management: Rebuilding the Model
I recommend reading this Q/A. If you’re running tight on time read the excerpts below.
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Article Introduction (Via Knowledge @ Wharton)
Risk managers armed with the most sophisticated quantitative tools available did not foresee the biggest development in a generation — the systematic breakdown and global contagion of financial markets. In an interview with Knowledge@Wharton, John Drzik, president and CEO of the Oliver Wyman Group, Richard J. Herring, a finance professor at Wharton, and Francis X. Diebold, a Wharton professor of economics, finance and statistics, discussed how to build a more informed risk management model. All three took part in the recent Wharton Financial Institutions Center and Oliver Wyman Institute 12th Annual Financial Risk Roundtable 2009.
Excerpts Of The Q/A (Via Knowledge @ Wharton)
Q. I want to start with a very simple question. Can you really measure risk accurately?
A. I think the last year shows that we can’t, that there are lots of things we can’t quantify very successfully and that we became overconfident in the things we could quantify. We’ve made great strides in risk analysis, risk measurement, and aggregating risk. But we’ve tended to focus most of those efforts on things that are relatively easy to manage. And even some of those relations broke down. We simply didn’t have enough data. Our techniques were not good enough. We weren’t using enough forward information and, unfortunately, this crisis has blame that can be shared across the entire spectrum of participants, from regulators to participants in securitizations and even to risk managers themselves.
“And the thing is, ironically and somewhat depressingly, it’s not the easier-to-model risks in many cases, but the harder-to-model risks that really bring firms down as opposed to just swing earnings by 3% or 5% a year. So we need to be humble, but we have made progress.”
“The dirty little secret of diversification is that it disappears when you need it most. The only thing that rises in falling markets is correlations.”
“So the old ways had a sort of overconfidence about them, which was unwarranted and seemed to justify taking on risks that in retrospect we know were too much. So that leaves us with the known unknowns, or the unknown knowns?”
