No, your machine does not work

[Welcome, alea readers!]

One of the most compelling points (in my view) about Luhmann’s systems theory of risk is his assertion of the futility of “managing” risk in complex systems solely by calculation. It’s hard to imagine that anyone takes claims of calculation-based risk management all that seriously anymore after recent events. To take just one example, I found this in my research into the market component of the food crisis. It’s from a breathless 2006 BusinessWeek article titled “Inside Wall Street’s Culture of Risk,” an article that is clearly from another age:

On the 31st floor of a skyscraper overlooking Times Square one recent spring day, a dozen or so of Lehman Brothers Inc.’s (LEH ) top executives filed into a conference room to run through risks, relive past financial crises, and worry about new ones. They analyzed how much money the firm might lose if the markets were buffeted like they were after the terrorist attacks of 2001. They pored over complicated risk models showing how tens of thousands of trading positions and financial contracts with clients would fare in the event of an Avian flu epidemic. They tested all conceivable scenarios that might put Lehman in harm’s way. “We are in the business of risk management 24/7, 365 days a year,” says Chief Administrative Officer David Goldfarb.

This one is even better:

“Right now everything on my screen is flashing red,” said Michael Alix, chief risk officer at Bear, Stearns & Co. (BSC ), on May 11, the day after Federal Reserve Chairman Ben S. Bernanke raised interest rates, sending the market gauges he was looking at tumbling. But “that doesn’t make me nervous,” says Alix. The bank has built such powerful computing systems that Alix can reevaluate every day the risks of thousands of positions across the firm’s trading businesses under various stressful scenarios to be sure the firm doesn’t hold too much of any risky investment at any one time. That type of analysis used to take a week to complete. “The machine works,” he says. The degree to which risk management has evolved in the past few decades is astonishing, say analysts.

Astonishing is one word for it.

Judgment, on the other hand, is something else entirely. My cynicism about calculations of risk is rooted in the same experience of working with dozens of fund managers that has given me tremendous respect for those (and they most certainly are out there) with the market sense and insight to understand that the best models in the world are no substitute for effective decision-making. In that vein, I have Amar Bhidé’s A Call for Judgment waiting for August vacation reading, and am thoroughly looking forward to it.

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3 Responses to No, your machine does not work

  1. a says:

    mark to market > mark to model

    • Anchard says:

      I am 50% in complete agreement, if that makes sense. To the extent that you’re talking about valuing an existing portfolio (and establishing whatever present and ex-post risk metrics are possible from that) then absolutely, mark to market is the way to go. Cue private equity whinging in 3….2….1….

      But in the case of risk management, which is inescapably an ex ante exercise, it’s less clear what mark to market even means. My problem with the calculation obsession is the notion that by using past market prices and assumptions about the future that a firm or team has “managed” anything, when in truth all they have done is to come up with a number. The paradox is that this kind of calculation is entirely necessary to proper risk management, though unfortunately we seem stuck in an age where having a number is viewed as having a solution.

  2. Danny says:

    The issue with mark to market is the built-in positive feedback. One day you have ever increasing asset prices and suddenly you are in a death spiral and thats for more or less liquid assets. I would also highlight credit ratings triggers as another feedback cause.

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