Regulation – risk management at a cultural crossroad

Regulators and central banks are starting to look at new and amended controls. Investors and their lawyers are looking at whom to sue: banks, fund advisors and auditors being on their list of targets. Everyone is looking at ways to ensure those who creamed off high bonuses, whilst putting their banks on the rocks, do not benefit – or at least that no one will speak to them in the pub.

Where does all this leave risk management? To use an American Football analogy, the defence is currently on the field, but the offense are working on a new playbook to put into practice when their turn comes.

The defence is concentrating on the allocation of blame: did risk management practices fail, or were risk management practices ignored? The answer will probably be a bit of both. Current practices will be overhauled and the Basel Committee will improve the Basel II playbook. Risk committees will start to appear, and CEOs will ignore these at their peril.

But defence will soon be replaced by the offense. What will dictate the style when the offense starts playing? The big question is – can risk in financial institutions ever be measured to a degree sufficient to be useful? In other words, are you a VAR-believing quantitative risk analyst, or are you an advocate of rule-based controls that you will apply with pragmatism?

There may be a middle ground but one of these two cultures will dominate the future of risk management. Will we continue to seek to improve the models, developing new and more effective ones, with their implementation tempered by qualitative oversight: or will we concentrate of sound controls based on experience and foresight, and use quantitative modelling as a tool for local and short-term analysis? What is the best route into risk management: a PhD in economics, or twenty years in banking practice?

The battle for the leadership is becoming polarised. In one corner we have probability theories, Gaussian bell curves and long tails, most of the academics and probably all the economists. The heroes are Ramsey and Savage, contempories of Keynes and Knight in the 20s and 30s*, JP Morgan and RiskMetrics, Robert Merton and Myron Scholes, and many other winners of the Nobel Prize in Economics.

In opposition are historians and the writers of case studies, many bankers and financial analysts and most of the operational risk community. The patron saints are more diverse but include Keynes and Knight, and, more recently, John Kay at the Financial Times, Danny Blanchflower at the Bank of England’s MPC, and the popular iconoclast, Nassim Taleb with his Black Swans.

Recent statements from authorities seem to indicate that Jean-Claude Trichet, President of the European Central Bank, is in the first camp when he talks of the underpricing of the unit of risk and the underestimation of the quantity of risk, whereas Adair Turner, Chairman of the FSA, talks about macro prudential analysis, the danger of innovation and the need to take action on remuneration and incentives.

It matters who will win because the winners will dictate the risk managers’ behaviour and training for years to come. We all agree that risk management needs to raise its profile, be a strategic decision maker rather that a simple reporter of statistics, and gain that seat on the board. But will that board member be a 35-year old mathematics genius from Harvard, or will he be a 55-year old banker, with legal or accounting training, who has worked in every department in the bank?

Who do you believe will come out on top? The answer will impact career decisions, the recruitment of banks, the investment of vendors.

(I have given links to relevant articles or presentations by those mentioned.
* For an overview on the debate in the 20s and 30s on risk and probability, read Glyn Holton’s 2004 paper, Defining Risk).