The September 2008 issue of Harvard Business Review has two excellent articles on risk management, both written by consultants at McKinsey. The first one, entitled "The New Arsenal of Risk Management", provides a fascinating historical perspective on risk management in finance and beyond. I'll discuss it here, and keep the second article on "Owning the Right Risks" for my next post.
In this first article, the authors identify the 1973 option-pricing model developed by Fischer Black and Myron Scholes, as well as Robert Merton, as a watershed moment in risk management, and tie the underlying ideas to the concept of real options, i.e., options on capital investment (such as renting or buying a new warehouse, cancelling a project, postponing a product launch, etc). The advantage of real options is that they "put a value on managerial flexibility", in contrast with Net-Present-Value calculations, which lead to only one number and don't capture the array of decisions available to the manager. I found the exhibit on the evolution of risk management from the 1950s on particularly illuminating.
The authors then describe the parallel trajectories of the risk management techniques and computational tools available over the last few decades. It is easy to forget now that hand-held electronic calculators have not always been around, and that there was a time where you couldn't run business simulations off a PC using Crystal Ball or @Risk. Even now, the fact that one needs an Excel add-on to generate most random variables meaningful in real life speaks volumes about the public's lack of understanding of simulation tools and their importance to practitioners (otherwise, industry licenses wouldn't cost thousands of dollars a piece.)
After connecting the debt-to-equity ratio with the probability the company will suffer losses, and discussing how to mitigate risk in high-level terms, the authors focus on risk in financial services, with a number of one-sentence anecdotes that will make many readers look up details of each case on the Internet (the collapse of the Herstatt bank in 1974, illustrating settlement risk in foreign-exchange transactions, and the 1991 failure of the Bank of New England come to mind. The BNE case is eerily similar to recent developments at Washington Mutual.)
They point out the main issues in the mortgage crisis, such as the fact that "the ability to estimate credit-risk exposure has not kept pace with the growth in credit-risk instruments" and the creation of "counterparty credit risk" when companies trade risk with each other. (Baltimore's City Paper has an entertaining example of counterparty risk that illustrates the challenge created by derivatives quite humorously. For August predictions on counterparty risk that turned up true this week, read this article from Wall Street Journal's Market Beat.)
The New York Times explains in its article about Washington Mutual that "The government has dealt with troubled financial institutions differently. Lehman Brothers and Washington Mutual, which were less entangled with the rest of the financial system, were allowed to collapse. But the government took emergency measures to stabilize Goldman Sachs, Morgan Stanley and the American International Group, the insurance giant." We could call this the "jump off the bridge" principle. People are always more motivated to stop someone from jumping off a bridge when that person is threatening to take down innocent bystanders with him. Maybe Lehman and WaMu hadn't made themselves necessary enough - a sad end to impressive success stories. Ironically, their demise might be due to the fact that they weren't troublemakers enough.
The Harvard Business Review comments in some detail on Goldman Sachs, today "essentially in the business of managing risk" and gives four factors explaining the company's success: (1) recruiting quantitative professionals (the article names Fischer Black, hired from MIT, Emanuel Derman, now at Columbia, and Bob Litterman, "a codeveloper of the Black-Litterman global asset allocation model", that one of my former students praised just a few days ago, (2) strong oversight ("daily risk reports detail the firm's exposure with [...] stress tests showing potential losses under a variety of scenarios"), (3) partnership heritage (the idea that employees own part of the firm), and (4) business principles, and in particular the emphasis on behaving in a way that maintains the company's good reputation rather than being afraid to lose the company's money.
The article ends with a discussion of the energy sector and its attempts at risk transfer through energy futures markets, and a warning from the companies that have "stayed on the sidelines" and thus avoided the crisis: this behavior "has also prevented them from growing as quickly as they might have." The authors explain how risk techniques can be used by any industry practitioner in their second article, which will be the topic of my next post.