Magazine article Risk Management

Converging Risk, Part II: The Human Element. (End Analysis)

Magazine article Risk Management

Converging Risk, Part II: The Human Element. (End Analysis)

Article excerpt

Last month, we looked at how risk management comes in two distinctly different strains--the quantitative and analytical financial risk management and the hard-headed and business-minded operational risk management. In recent years, however, the distinction between these two types of risk management has begun to fade. Much of the momentum behind this trend has come from the financial arena, where models, although recognized as valuable, no longer dominate the practice of risk management.

There are a number of reasons for this, the most prominent being a string of embarrassing disasters that served as reminders for financial institutions that operational risk management is just as important as financial risk management. (See "Earning from Mistakes," RM, October 2000). Modelers are also starting to accept that forecasting the behavior of financial markets and companies is not like forecasting the weather: The weather does not change because its audience hopes it will; the same cannot be said of the financial markets.

Modeling the Human Mind

In finance, individual human actions dissolve into statistical insignificance much of the time; individual investors usually cannot make much difference to the direction of the stock market; and there is no serious threat to a bank if an individual borrower runs out on a debt. But collectively, humans can change the nature of the financial game dramatically; and sometimes, as illustrated most terribly by the events of September 11, even the actions of a few individuals can make an enormous, and enormously unpredictable, difference.

"When you propose a financial model, you're pretending you can guess another person's mind," observes Emanuel Derman, a quantitative researcher at Goldman Sachs, in a January 2001 working paper. That guesswork can fail, and so, therefore, do the model's predictions.

The most infamous example is the summer 1998 demise of Long Term Capital Management (LTCM), the hedge fund that was founded by legendary Salomon Brothers trader John Meriweather, with Nobel Laureates Myron Scholes and Robert Merton on its payroll.

LTCM represented the zenith of models-based finance, using state-of-the-art analytical tools to find valuable and supposedly low-risk trading opportunities. …

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