Risk Management at Investment Banks

September 10, 2008
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“Risk comes from not knowing what you’re doing.” – Warren Buffett.   

Today’s news about Lehman Brothers’ large loss, and yesterday’s post on the Fannie Mae and Freddie Mac takeovers, reminded me of an old post at a blog by Rick Bookstaber, the author of A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation.

The Wall Street Journal had this to say about his book. “Like many pessimistic observers, Richard Bookstaber thinks financial derivatives, Wall Street innovation and hedge funds will lead to a financial meltdown. What sets Mr. Bookstaber apart is that he has spent his career designing derivatives, working on Wall Street and running a hedge fund.”

In his post, Bookstaber imagines a conversation at a high-powered investment bank between a hot-shot trader of a complex financial derivative called a CDO (Collateralized Debt Obligation) and the risk manager for the firm. This conversation illustrates the conflict between generating high trading profits and the danger of taking on additional risk.

For your reading enjoyment  (and to understand the rest of my commentary) …

Talk about being the proverbial fly on the wall!

Take note of his conclusion:

…the real risk manager should not have people management and report generation responsibilities. He should be able to have the time and space to question and think. He should be able to use all the risk data as an input and demand other types of analysis he deems necessary, but then have the time to sit back and think. In this respect, his role would not look much different than any number of very successful portfolio managers.

Taking Risk Seriously

Bookstaber emphasized, that in a conflict situation, top management must back the risk manager.

It seems to me that at some firms, like J.P. Morgan Chase and Goldman Sachs for example, top management “got it” and took risk seriously. They did an excellent job of managing their exposure, prudently. Other investment banking firms, such as Bear Stearns, Citigroup, Lehman, etc., apparently didn’t understand the risks they were taking. Making things worse, it appears that they leveraged (used borrowed money) considerably more than they should have.

What a pity for their respective stockholders.

Comments

3 Responses to “Risk Management at Investment Banks”

  1. Sue Massey on September 10th, 2008 1:30 pm

    I must say this is a great article i enjoyed reading it keep the good work :)

  2. Cheryl Krueger on September 16th, 2008 10:26 am

    Roger – AMEN!!! I remember when insurance companies were first getting on the ERM (Enterprise Risk Management) bandwagon. I got a real kick out of one of the young ERM actuaries who had a poster on his door with a great ERM quote, and when you read the small print, it was from a risk manager at ENRON, of all places! It’s absolutely about the attitude of senior management. It’s not enough to just have a risk management function in place that’s seen as a “must do” rather than an integral part of managing the business. Risk management can put the breaks on an overly risky project, or tweak a good idea into being a more prudently executed idea. But it’s complex and the will to say “no” to a quick profit has to come from the top.

  3. Roger on September 17th, 2008 12:02 pm

    Cheryl,

    Thanks for stopping by.

    With your insurance background, what is your opinion of the risk management of AIG? Was top management up to the job?

    Roger