Politics and Risk Management

The intersection of politics and risk management came together in a big way recently with the crash of the financial markets. Politicians from both parties could not help themselves from using the collapse of the economy to point blame and feed at the trough of public funding. It is clear that there is little consensus in how to address the problem and worst yet little willingness to work together to come to a common framework.

If the past track record of governmental intervention is any prologue for what can be expected the politicians will be more interested in posturing than real systemic remedies. On a recent Sunday morning talk show politicians and the CEO of the US Chamber of Commerce showed that the status quo will be very difficult to change course. Wrapped up in all of the acrimony is a lesson on the very basics of risk management. If we take a step back to look at the role of government how it performs oversight has changed significantly. Depending on your political perspective you may come to different conclusions.

However, by taking an independent view, I would propose that the very essence of government and the role it should play may determine if risk management is part of the responsibility of government. I don't mean to say that government should intervene in ways that restrict the free flow of goods and services or the risk taking that is embedded in the American way of doing business. What I am proposing is that there may be a role for government to play in large systemic risk events. The role of government should be to understand the threats to financial systems and develop mechanisms to mitigate systemic risks that threaten the viability of our economy and financial markets.

Whoa, you say! That sounds like some form of socialism! The government does not understand business and does a terrible job of managing its own resources efficiently, you say! Why would we want government to manage business risks? Let me be clear, I am not advocating for governmental involvement in managing business risks. However, what I am advocating for are policies, legislation, and systemic controls that monitor risks across industries and act on key indicators when threats to markets reach levels that force politicians to mitigate these risks before they occur.

Sounds like a tall order! It is and the consequences of not doing so are playing out in the economy today! Here is how it would work. First, there is no need to change the governance and oversight committees that exist in Washington, D.C. today. What would be different is regular and consistent dialogue about risks in financial markets gathered from existing regulatory bodies or a central regulator who looks across all markets for systemic breaks that threaten individual or linked markets. The difference is that the key risk indicators and the policy and legislation that is promulgated from these reports could not be influenced by lobbyist or political contributions. Risks to our way of life should be free of narrow political interest groups or powerful individuals with the ability to ignore these threats.

What are the mechanics? Setting limits on the level of margin or leverage used, the net capital needed, the efficient operation of markets, such as the settlement of derivative contracts are but a few examples! The arbiters of these key risk metrics would be the regulators themselves and not congress. Congressional committees would simply take the appropriate risk mitigation steps that must be established in advance and acted upon once the thresholds are breached. By setting up prearranged checks and balances and making the actions automatic you begin to pro-active manage systemic risks as they increase in severity.

When there are multiple systemic risks or large scale failures these same committees would have scenario plans in place that would act on their contingency plans for "fat tail" events. This approach does not prevent risk taking it simply acts as a "governor" to reduce the types of large scale systemic failures that we are experiencing today!

Idealistic!? Yes, but why not dream big! Its only our future and the future of our children that we are attempting to fix.

$1 trillion in operational losses and growing

How could this happen? Did all the smart money go to sleep on Wall Street and let the unthinkable occur, the answer is more complicated than you think. First of all, let's start by asking whether the product of mortgage-backed securities is good for investors. The original idea of "securitization" is a great risk management concept. Package up a diverse pool of mortgages originated across the country or in strong regional locations and re-sell the tranches to institutional and retail clients looking for increased income.

So far so good! The pool of mortgages helps to diversify the risks of default. Bankers and/or loan originators gain liquidity for more mortgages and homeowners get the homes that were increasingly out of reach. The cycle started an economic boom the likes and length America had not experienced before. So what went wrong and why didn't the smartest people on wall street not see it coming.

To describe the concept, I will use a term called the "herding model" to best illustrate what happened. When the early innovators of mortgage backed securities pools began to package and sell these products to sophisticated investors the product worked as advertised. However, once the imitators began to follow the lead of the early innovators into the market the quality of the deals and the margins began to shrink. The "herd" killed the market for these products because of increased competition for deals. The early signals were plenty. Newspapers, conferences, blogs, even Joe Lunch-Bucket saw the end in sight however no one wanted or believed the inevitable would happen. Why? Regulators never stepped in aggressively to put curbs on the practice and market participants continued to crowd the field.

Risk practices across all of Wall Street have a difficult time measuring risks of new phenomena. Modeling the unknown is fraught with inadequate assumptions making predictive models unreliable. Risk models are much better at predicting cycles or patterns that are constant or cyclical. New risks are hard to predict and revenue generating incentives are very difficult to contain. So why did some firms suffer when others did not? Experience, common sense, luck?

All of the above. The few firms who were relatively unscathed never lost there conservative approach to investing and deal making. Money clouds the senses. Common sense told us all that the real estate market and financial boom times could not sustain itself given consumer debt however no one wanted to step off the money train first. The "herd" finds safety in numbers because "everyone can't be wrong, right?" Risk management is the art of seeing through the "herding" model of investing and developing data that gives you directional signal. The ability to have the hard conversation about risks can be politically volatile in many firms because the big producers of revenue do not want the gravy train to stop.

The wealth destruction that is going on today is the result of panic that the economic models really were flawed. The original concepts were valid however! Like most things in business and in life good execution is fundamental to success. The next time that you say to yourself that this feels to good to be true...... remember it probably is.

All things Risk and Compliance

Risk Matters will be devoted to the community of risk management and compliance professionals looking for a way to share best practices, approaches and thoughts on improving risk and compliance programs globally.

Topics will include survival skills for risk and compliance professionals as well as a repository for sharing tricks of the trade and tools that may help others. Because of the diversity of practices in risk and compliance the areas of focus may require specialization and sub-groups over time.

My personal area of specialty includes the broker/dealer and asset management industry. I focus on operational risk for an asset management firm across a broad range of complex financial services and products. However, this site will be equally useful for practitioners in health care, basic industry, manufacturing, insurance, etc. My goal is that this blog becomes a "One-Stop" shop for all Risk Matters. Thus the name.

Please visit the site as often as you like to make suggestions and to add postings yourself. I am new to the blog-o-sphere so any advice and feedback will only make the site better over time. I am so excited about creating a forum for risk and compliance experts around the world.