June 28, 2010

How Risk Management Works In Practice

Lack of transparency has often been quoted as one of the big issues in terms of regulating financial institutions. But the lack of transparency is not only a problem for regulators, it is a potentially bigger problem for executives in the ivory towers of our largest financial institutions. The so-called black boxes in the trading floors of the big investment banks and trading houses are not only spooky to us. Aside from a few rocket scientists who may only operate within the realm of balancing complex equations, the executives who make final risk management decisions often don’t have a clue of what is going on inside of these boxes either.  In addition, communication issues can fog understanding of risk further. Ergo, the institutions we entrust our money with sometimes operate on this basis: The left hand doesn’t know what the right hand is doing...

This story from the popular Blog: Macro Man is point in case.  Because it is so exemplary, I’d like to quote it verbatim.

Another story starts with a chap from a bank's product control department visiting a trading desk and asking them why they are losing money on client trades. The trader replies that the head of sales had told him that the desk needs to be aggressive in its pricing so that business can be won for the bank in "more-profitable" areas, such as exotics. At this point, the risk manager remembers that one of the exotics desks he is responsible for has just started posting some very large losses which he was going to investigate that very afternoon. So he goes to the exotics desk and asks the trader why they are losing all this money, who replies because of xyz there was a big correlation breakdown, the markets jumped and there was no way to hedge the risk. The risk guy replies "But I've been sending you these reports each day with all your correlation risk etc. Why didn't you take this into account?". The exotics guy replies "well, the head of exotics sales told us we had to be aggressive in our pricing to win business and warehouse the risk, the head of trading was fine with it". So the risk guy goes to find the head of trading and asks him why he was fine with them having all this risk? The head of trading replies "huh?". After a brief conversation it turns out that the head of trading doesn't understand the risk the exotics desk were running and thought everything was OK. Net result: flow desk loses money, exotics desk loses money, both flow sales & exotic sales get a big bonus.

Good luck and good trading!

No comments: