Risk Management – What Really Matters

This a summary of a keynote speech I gave to a conference of African Central bankers in Johannesburg, looking at what really matters in risk management.

A central question when developing a risk management strategy has to be: “Do you manage risk or just measure it?” Ironically, risk management could be said to have been one of the major contributors to the financial crisis, through the concept that financiers believed they could take on additional risk because their risk management systems had become so much more sophisticated. The more mathematical or formulaic approach to risk management has simply proven that models can never replace personal judgment.

The key to risk management is risk ‘identification’ which proposes that instead of using ever more mathematical concepts commonplace in finance one should rather look at what finance can learn from other disciplines. While diversification is a central theme of any reserves management programme, regulators may have given insufficient consideration to the fact that globalisation, hitherto typically seen as a positive factor had in fact produced some important negative factors such as unexpected convergences. These potentially include convergence of regulators and rating agencies, the commoditisation of information systems and of information providers. De facto, this results in not as much diversification occurring as central banks or fund managers had anticipated.

It results in narrowed thinking – if everyone uses the same analytics and systems, they are probably all coming up with the same trading strategies which has the effect of increasing risk when users think they are lessening it. It brings about unexpected correlations across unrelated markets. In effect, it reinforces the ‘herd instinct’ at critical times of crisis, when it is least wanted. In fact, growing regulation tends to worsen this factor: new Basel rules may simply be bringing about new levels of herd mentality and potentially increasing volatility rather than reducing it.

What experience has taught is that as connectivity increases systems become more resilient – but only up to an optimum point. As things become too connected (as today) the resilience tends to decrease in the absence of ‘fire breaks’ in systems. This in turn increases turbulence and volatility. The serious systemic risks of such a highly connected world are often invisible and unexpected. Each new crash is completely unheralded and all the vigilance in the world has hitherto not been able to prevent them. What it requires is a close look at all the linkages in the system, otherwise known as Complexity Science – thinking outside the box at linkages and the various networks organisations have.

The answer may be for risk management to become less formulaic and more judgmental. Central banks establishing risk management systems should by all means employ the traditional tools always used – but not omit personal judgment. African central banks may benefit from the mistakes made by their colleagues in developed countries – but one rule to learn well as don’t over-rely on tools.