This Is the End


Markets, Risk and Human Interaction

October 12, 2007

Risk Management and Shake-up Time at the Investment Banks

What a mess. With multi-billion dollar trading losses, we are starting to see heads roll. Citigroup is losing its long-time fixed income head Tom Maheras and several of his lieutenants. Merrill is continuing in its approach to managing human capital, bringing in new blood and losing experienced hands in the fixed income business. Oh, and they are putting someone into a Chief Risk Officer role. Talk about closing the barn door….

Other firms have fared very poorly but so far without executing any of the troops. Morgan Stanley layered a heart-stopping $390MM one-day loss in its prop trading desk on top of far bigger losses on leveraged loans and the like. This loss in Process Driven Trading was similar in timing to the losses at Goldman’s Global Alpha fund, AQR and other quant hedge funds. Which pretty much tells us that what this secretive group at Morgan Stanley was up to was a not-so-secretive strategy: They had a lot of capital riding on the same sort of momentum and value versus growth quant equity strategies as the rest of the gang.

What I don’t understand in all of this is that for all the mention in the press of the risk takers, there is not a single mention I have found of the people who are supposed to be overseeing the risk. If you are the Chief Risk Officer and everything blows up, don’t you bear some responsibility?

To get the idea of the CRO job, let me tell you a bit about myself. Although I am older and have a slight build, I am an Olympic athlete. My event is the shot put. I consider myself a top notch athlete in this event. I work out like the other competitors, follow a high protein diet, steer clear of performance enhancing drugs and train at the local track. The only trouble I have is when the Olympics roll around every four years, because it turns out that for an Olympic athlete, I am not very good. But then, that is only an occasional blip in my otherwise Olympic-worthy regimen.

In the CRO job 99% of the days there is nothing going wrong. The only test you get of how well you are doing – short of pouring out risk reports and looking ponderous and prudent in meetings – is what happens to the firm during times of market crisis. Every few years something calamitous happens in the market; if the firm gets blown away, that suggests you did not do a very good job.

What about the job of the risk taker? Well, a risk taker does, after all, take risk. He tries to do so intelligently, that is, he tries to put on positions that he hopes have a high return per unit of risk. But how much risk he takes and where he takes it has to be dictated by someone. You can’t just say “take risk, and good luck”.

The job of the risk manager at these firms is to convey the risk parameters to the risk takers, to define the boundaries. And that should involve more than simply running a value at risk calculation on the computer. If that is all you want, you don’t need a guy making a few million a year and employing a staff of hundreds. Before I would be so harsh on Tom Maheras and his compatriots, I would be calling to task the people who allowed that risk level to be taken in the first place.