Money and Finance

Confessions of a risk manager

Why did banks become so overexposed in the run-up to the credit crunch? A risk manager at a large global bank—someone whose job it was to make sure that the firm did not take unnecessary risks—explains in his own words

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The pressure on the risk department to keep up and approve transactions was immense. Psychology played a big part. The risk department had a separate reporting line to the board to preserve its independence. This had been reinforced by the regulators who believed it was essential for objective risk analysis and assessment. However, this separation hurt our relationship with the bankers and traders we were supposed to monitor.

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Spoilsports

In their eyes, we were not earning money for the bank. Worse, we had the power to say no and therefore prevent business from being done. Traders saw us as obstructive and a hindrance to their ability to earn higher bonuses. They did not take kindly to this. Sometimes the relationship between the risk department and the business lines ended in arguments. I often had calls from my own risk managers forewarning me that a senior trader was about to call me to complain about a declined transaction. Most of the time the business line would simply not take no for an answer, especially if the profits were big enough. We, of course, were suspicious, because bigger margins usually meant higher risk. Criticisms that we were being “non-commercial”, “unconstructive” and “obstinate” were not uncommon. It has to be said that the risk department did not always help its cause. Our risk managers, although they had strong analytical skills, were not necessarily good communicators and salesmen. Tactfully explaining why we said no was not our forte. Traders were often exasperated as much by how they were told as by what they were told.
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At the root of it all, however, was—and still is—a deeply ingrained flaw in the decision-making process. In contrast to the law, where two sides make an equal-and-opposite argument that is fairly judged, in banks there is always a bias towards one side of the argument. The business line was more focused on getting a transaction approved than on identifying the risks in what it was proposing. The risk factors were a small part of the presentation and always “mitigated”. This made it hard to discourage transactions. If a risk manager said no, he was immediately on a collision course with the business line. The risk thinking therefore leaned towards giving the benefit of the doubt to the risk-takers.
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Collective common sense suffered as a result. Often in meetings, our gut reactions as risk managers were negative. But it was difficult to come up with hard-and-fast arguments for why you should decline a transaction, especially when you were sitting opposite a team that had worked for weeks on a proposal, which you had received an hour before the meeting started. In the end, with pressure for earnings and a calm market environment, we reluctantly agreed to marginal transactions.
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Over time we accumulated a balance-sheet of traded assets which allowed for very little margin of error. We owned a large portfolio of “very low-risk” assets which turned out to be high-risk. A small price movement on billions of dollars’ worth of securities would translate into large mark-to-market losses. We thought that we had focused correctly on the non-investment-grade paper, of which we held little. We had not paid enough attention to the ever-growing mountain of highly rated but potentially illiquid assets. We had not fully appreciated that 20% of a very large number can inflict far greater losses than 80% of a small number.

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Related Books:

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation

Fiasco: The Inside Story of a Wall Street Trader

The Black Swan: The Impact of the Highly Improbable

Manias, Panics, and Crashes: A History of Financial Crises

Speculative Contagion: An Antidote for Speculative Epidemics

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