In Sunday's NY Times Magazine, Joe Nocera wrote about Value at Risk (VaR) and the role it might have played in the current financial crisis. Was that tool an aid to dealing with the situations facing its users or did it contribute to their problems? How should we understand its impact? Several important questions are raised by the Nocera interviews. How should responsibility be apportioned between human behavior and measures like VaR? What do measures like VaR mean? And, what dangers must be addressed in the design of such measures?
Many of those Nocera spoke with saw the problem as rooted in human behavior, rather than financial measures or tools. Consider this assertion made by Greg Berman, one of the founding partners of RiskMetrics. "But I do think that this was much more a failure of management than of risk management."
What does Mr. Berman take the "management" part of "risk management" to mean? We get a clue as we read on. "I think that blaming models for this would be very unfortunate because you are placing blame on a mathematical equation. You can't blame math." He seems to think of risk management as the application of mathematical tools to assessing risk, rather than the actual activity of managing it.
But of course you can blame math, just as you can blame the design of a clock that does not show the proper time or an automobile that performs poorly. Financial instruments, including VaR, are designs. They are human artifacts intended to serve a purpose. If you need convincing that mathematics is, like clocks and automobiles, the product of human design, I recommend George Lackoff and Rafael Nunez’s Where Mathematics Comes From: How the Embodied Mind Brings Mathematics into Being.
Others subscribed to similar dichotomies between models (or specifically VaR) and the people who use them. In speaking about the failure of Long Term Capital Management, Nocera noted "…firms took to rationalizing away the fall of L.T.C.M.; they viewed it as a human failure rather than a failure of risk modeling." This is a common strategy for diverting blame. Rather than question the design of the instrument or system its advocates assert "the user is at fault." But part of the activity of designing something involves insuring that it is not likely to be widely misused. Power tools have safety guards.
Assumptions play a critical role in thinking about models and many of those using VaR overlooked them. "Indeed, so sure were the firm’s partners that the market would revert to "normal"—which is what their model insisted would happen— that they continued to take on exposures that would destroy the firm as the crisis worsened." Pay particular attention to that phrase between the hyphens "what their model insisted would happen." This suggests that a return to normal was considered an output from the model. But the model did not say that things would return to normal; rather it assumed that they do.
An important, indeed the defining, characteristic of VaR is that it is a scaler; that is, a single measure, a number. As the article points out it is a number that got a lot of legitimacy by being marketed, standardized, and regulated. It came to have "meaning."
Every semester, I ask MBA students to consider why we might want to beware of single measures. What kinds of problems do they bring with them? And every semester, bright students propose that measures are often incomplete, that any particular one might not capture all that we really want to know, that each will have particular assumptions embedded within it. And usually after they have been thinking about it for oh, ten minutes or so, one of them says something like "people will game any simple number." So, listen now to this, from Nocera’s narrative:
"Guildimann, the great VaR proselytizer, sounded almost mournful when he talked about what he saw as another of VaR's shortcomings. To him, the big problem was that it turned out that VaR could be gamed. That is what happened when banks began reporting their VaRs. To motivate managers, the banks began to compensate them not just for making big profits but also for making profits with low risks. That sounds good in principle, but managers began to manipulate the VaR by loading up on what Guildimann calls 'asymmetric risk positions.' These are products or contracts that, in general, generate small gains and very rarely have losses. But when they do have losses, they are huge. The positions made a manager’s VaR look good because VaR ignored the slim likelihood of giant losses, which could only come about in the event of a true catastrophe. A good example was a credit-default swap, which is essentially insurance that a company won’t default. The gains made from selling credit-default swaps are small and steady—and the chance of ever having to pay off that insurance are assumed to be miniscule."
Create a single measure of anything, and clever people will find ways to work it. When I was a student, Professor Jim Emery told us about a time when he and his colleagues at Proctor & Gamble created a measure to reward workers for factory floor safety. The measure "days since an accident" was displayed over the door. And when a man cut his thumb one day he was encouraged by his co-workers to have it treated on his way home from work, since bonuses were linked to the measure and a visit to the in-house clinic would reset the counter. As Jim pointed out, no one wanted to induce that behavior, but they did nonetheless. Single measures will be gamed. Keep that in mind all you financial instrument and incentives designers.
I don't expect that advice to be widely followed, though. Commenting on the widespread use of VaR, Christopher Donohue, who manages research at the Global Association of Risk Professionals, said that because it relates so directly to money people "attach a meaning to it." And a former risk manager that Nocera spoke with considers it part of the human condition that "People like to have one number they can believe in."
With all of this there was a heroic story in Nocera's narrative. It came relatively early in the financial crisis when people at Goldman Sachs began to notice irregularities in the VaR. David Viniar, Goldman’s chief financial officer brought together about 15 people who met for three hours during which they "poured over everything. They examined their VaR numbers, and their other risk models. They talked about how the mortgage-backed securities market ‘felt’ [italics added]." This heroic episode is the story of people using irregularities in one measure as a clue guiding them to look at others, of using feeling to complement thinking, of using talking to make meaning within a complex situation they had never faced before. It is the story of a leader calling on his people to stop and think ("But who has time to stop in the middle of a crisis?" I hear many of the executives I have taught over the years crying out.). And it is the story of tragedy averted, at least for a bit. Goldman Sachs acted on what they learned in those three hours and avoided much of the pain suffered by Bear Stearns, Merrill Lynch, Lehman Brothers, and others.
There are several lessons for the design of financial instruments that follow from the stories Nocera has collected together. First, our financial systems involve humans and as such are complicated. No single measure can address all of the complexities that will be encountered in such complex systems. Second, meaning in complex social systems is not a matter of universal laws (as it is in physics, say); rather meanings are socially negotiated. And finally, because tools such as VaRs are the product of design, the extent to which design methods and attitudes are understood and employed will impact their utility and resilience.
Related Stories: | Topics:Management, Design, financial crisis, Value at Risk, Joe Nocera, Joe Nocera, Economic Crisis, Economic Issues, Business, Financial Markets |
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Recent Comments | 7 Total
January 11, 2009 at 12:38pm by Ilya Bodner
On the other side of this article are the real people that got hurt by the chaos. Yes, it is digital but what we must remember is that no matter how systematic a company can react - the families at home all suffer. Oddly enough this has been a high season for small business buy out - probably because execs are being laid off.
This article provides the view on the instability of teachings, and I think everyone should be reminded that it is time to adjust with the times. As a small business owner myself I would like things to stop going down and remind all other business owners to focus on alternative choices. Try searching for "strong business credit" (just like that in quotes) if you are in the need of more credit. Check out the latest issue of Entrepreneur for free gadgets online. Do something!
Sincerely,
Ilya Bodner
Small Business Owner
Initial Underwriting Group
January 25, 2009 at 5:49pm by Joe Schmid
Using the term “risk management” in the context of the plethora of derivatives on which Mr. Nocera’s article is based is meaningless. The VaR metric was flawed from the get-go in that it saw the future as an extrapolation of the present. The over reliance on or anointment of a single measure, as your conclusion well points out, was even more tragically flawed.
There is a huge difference between chance taking and managing risk. The financial markets and “players” were fraught with chance taking – not risk management. Students of financial markets ought to take a hard look at how risk is managed in the industries and technologies that produce and govern the perils of highly hazardous/dangerous situations to life and/or property. First, there is an array of metrics continuously monitored and integrated. Second the metrics are used to analyze the entire spectrum from inputs, through process and outputs, to results.
The broader lesson is for those responsible for the creation of these financial forms of so-called “toxic securities” and the quants who develop metrics to play them, to see outside the “trader” culture matrix of values and into the realm of the human impact of their work, and the real meaning of risk management.
February 2, 2009 at 9:11am by Fred Collopy
I like your suggestion (to have students of finance looking at highly hazardous/dangerous situations), Joe. My instinct is that it won't gain wide traction in the teaching of finance. I think finance professors will argue that they have too much to teach students as it is.
February 3, 2009 at 7:33am by Joe Schmid
Try having your students / colleagues consider this. There has been a flood of liquidity into the global financial markets but it is being tied up in a knot by the fear to risk and or aversion to it. If what financial institutions have been doing by way of mitigating / managing risk isn’t working (a.k.a. conventional industry wisdom), those institutions need to change what they’re doing.
In the short term, government becoming the insurer of risk only gets us back to not much different then what we had before this mess. SO what is going to be done and put in place so we know why we don’t get right back into the debacle of financial risk management that got us to today? The path to the answer starts getting the problem defined correctly. So what is the problem? What are the processes that delivered the outcome? What was the thinking behind them; and who owns those processes that matrix the financial and support the financial systems? What were the owners thinking; and how should that thinking change? The immediate cause for the financial meltdown at first inspection might be judged as the institutionalizing of chance taking (not risk management). Is the fix that simple? Lower lending to 30% of collateral? But what is the root cause? What is the systemic cause?
NIH is part of the genetic code any profession. A central question is whether the financial think tanks are willing to look beyond and outside of themselves. Analogy is a powerful teaching and learning tool. The daydream of a snake biting on its own tail was the breakthrough from conventional “linear” thinking that allowed the understanding of the benzene molecule.
Where else does risk reside? Who manages risk well?? What are their thinking processes and discipline collaborative systems they use? If NO RISK was the answer, we wouldn’t have the technical commodities like plastics, chemicals, etc. or nuclear power, or solar panels, refrigeration or clean water that define our standards of living today. How do these inherently dangerous and risk filled industries that provide these benefits pull it off? What can be learned? If the financial industry had used just one of the simple tools these industries use (e.g. Fault Tree Analysis - FTA) the probability of the financial meltdown most certainly would have been reduced if not avoided entirely.
February 16, 2009 at 8:37am by CNV Krishnan
The problem, to my mind, is not so much risk management technology as agency cost. As Fred writes, “Create a single measure of anything, and clever people will find ways to work it.” I would go a step further and modify this statement to “People will always find a way to game any measure devised.” This line of thinking is based on Michael Jensen’s “Rational, Evaluative and Maximizing” model, in which people (managers) are inherently selfish and will always find a way to maximize their “managerial surplus”. Indeed, this line of thinking is well-entrenched in corporate finance. Managers care about maximizing compensation, consumption of perquisites; they care about entrenchment and empire building. And they often behave selfishly and myopically to do so. Well known examples of agency cost include Tyco, Adelphia, Worldcom, Global Crossings and Enron (especially in the context of their energy trading activities).
Agency examples abound in trading activities as well. Rogue traders galore. France's Société Générale, a global powerhouse in the derivatives-trading business, disclosed a $7 billion loss from rogue trading by a single employee, Jerome Kerviel, in 2008. The trader "had taken massive fraudulent directional positions on future movements of European stock indices without his supervisors' knowledge” the bank said. Because he had previously worked in the trading unit's back office, he had "in-depth knowledge of the control procedures" and evaded them by creating fictitious transactions to conceal his activity. Nick Leeson brought down venerable British bank Barings Bank in 1995, again by having similar control over back-office operations to conceal his bets. Sumitomo’s Hamanaka was a legend in trading circles. This quiet 48-year-old worked with other brokers would buy copper to drive prices up, sell to bring them down, forcing competitors to follow his lead. But, for nearly a decade, Hamanaka falsified company records to cover his losses, finally leading to a loss of about $4 billion for Sumitomo. Maintaining strict separation between trading activities and back-office controls is a key requirement of risk management. When this is violated by “maximizing” managers, agency costs are exacerbated.
So, when Fred asks “How should responsibility be apportioned between human behavior and measures like VaR?”, my answer would be most of blame falls on the people. “Don’t blame the gun, blame the person firing the gun” is an adage that is well suited to this context. In a recent issue of Newsweek, Robert Shiller, top economist, and an expert in financial innovation and risk management, argues that derivative products are a solution rather than a problem. Derivatives allow for risk hedging, can lower costs of capital and indeed can promote market efficiency. The problem lies, to a large extent on the people using derivatives and apparently “managing risk”.
Agency theory can also explain why “credit rating agencies is a story of colossal failure", to use the words of Representative Henry Waxman. According to Andrew Taylor, writing for AP, the committee released internal documents showing that executives of the rating agencies were "well aware that there was little basis for giving AAA ratings to thousands of increasingly complex mortgage-related securities but the companies vouched for them anyway." How did this happen? Perhaps because the rating agencies are paid by the corporations, whose products they are rating. This leads to agency problems similar to the ones investment banks were allegedly involved a little while ago: issuing inflated analyst recommendations on firms from whom they were to get future business.
To conclude, Risk Management is perhaps a Design Problem. Thinking “out of the box” on agency costs is the way to go, in my opinion. We need to think innovatively on human behavior, and on incentives and incentive contracts design.
February 16, 2009 at 9:49pm by Fred Collopy
I concur that there are important issues of agency at work in this situation and that as you suggest, given what we know about the behavior of people acting as agents, there is some likelihood that even complex systems will be gamed. But simple scaler measures are much more likely to be subject to such abuses than more sophisticated and comprehensive ones. Further, because risk is inherently complex, a measure like VaR flatten it beyond acceptable limits for understanding what is really going on (something that is no longer arguable; VaR clearly did not capture the real risk involved). One of the arguments of some of those quoted in Nocera’s article was that VaR functioned as the incentive system. So, your call for “thinking out of the box” on agency costs and for thinking through more comprehensive designs for incentives based on actual human behavior seems very well placed.
I must make a comment on your reliance of the framed gun analogy. I hear this often in discussions about limits on the role of designers in the creation of (particularly) abstract artifacts. People rush to defend any design as acceptable, placing the blame for whatever happens on the users of the artifact. They then point out as you do that guns represent a parallel case of the difference between the thing and its use. But designers must often assume responsibility for the safety of their artifacts. I prefer thinking of VaR, credit default swaps (CDSs) and other financial devices as more akin to power tools than guns. It is irresponsible to create a power saw without reasonable safety guards. For that matter, even modern guns are designed with safeties.
February 18, 2009 at 3:01pm by Joe Schmid
Agency cost may be the most apparent symptom but layers of derivatives hedging hedges with the presumption that this mitigates risk and in turn subjugates due diligence is closer to the root cause behind the failure. I don’t agree with Shiller. The thinking behind and over reliance on VaR is naïve and reckless. Regardless whether bad people or people behaving badly the whole risk management culture and the “technology” of derivatives produced this. I’d suggest that if someone examined stripping derivatives out of the system and then apply some serious design thinking that the study would lead to a better future. If we’d take Mr. Waxman’s advice, I’m sure we’d most probably end up with more of the same, with the ultimate hedge being government bailout. Somewhere along the line rather than creating financial instruments to take risk out, maybe the best course of action is to put more risk back in. After all, the closer to the fire the more careful you are.