One of the principles ingrained in me is that risk management should be kept separate from the area or individuals taking the risk. The argument is that there is a conflict of interest: if those responsible for making money also handle risk management, their motivation for profit may overshadow everything else, taking us to a place we don’t want to be.
This model became an industry standard after the Nick Leeson incident, leading to Barings Bank's collapse. Consequently, banks were mandated to establish independent risk management to assess front-office activities. While this separation has clear benefits, it also presents a potential problem: it may signal to traders that risk is not their concern as long as they operate within set limits.
An example is when dealers adopt an "it's not my problem" attitude when given credit limits.
They utilise these limits without questioning the broader implications, assuming that as long as they remain within their boundaries, all is well. This can be even though the credit market is pricing a particular credit risk differently. This mindset is potentially dangerous and can lead to things being overlooked.
Another example arises from collateral management where a withdrawal of market liquidity leads to sudden and large price change. Traders know this can and does happen and if it’s not factored into your oversight, you will be in for a nasty surprise.
We are talking about situations where there is no right or wrong approach, one clear benefit of segregating risk management is that it removes the personal motive for gain from risk-taking, ensuring that institutional values are upheld. However, this can also mean that valuable insights about risk, which traders possess due to their close market interactions, may go unnoticed.
To address these issues, fostering a culture of mutual respect and open dialogue between risk managers and traders is crucial.
Risk managers should understand what it is like to be a dealer or trader—the pressure to generate P&L, the job's complexity, and market nuances not captured in reporting.
For example, they should be aware of what happens when markets “gap” and what this can mean for spread and basis risks, as well as practical advice such as "if you can't price it, don't do it." Understanding hedge rebalancing from convexity and risk pricing at extremes (e.g., deep out-of-the-money options and volatility smiles) is also vital; we need to speak the same language and respect each other's expertise.
Management should encourage an open culture where risks are discussed both formally and informally. This involves creating an environment where traders and risk managers can collaborate on their understanding of the exposures. It is also important to recognise that great outcomes do not always imply good decision-making and poor outcomes do not always imply weak decision-making. The focus should be on how the decisions themselves are arrived at and whether they are thought through.
What can help?
Rewards influence actions and should be skewed towards long-term performance, encouraging staff to see beyond a one-year horizon and ensuring they see the benefit of making prudent decisions. Conversely, attempts to make a quick profit should be discouraged unless you have known skills in this domain.
Recording who says what and documenting decision-making processes ensure transparency and provide a basis for learning. The focus should be on whether decisions were well thought out and if the potential risks were adequately considered.
Simple oversight tools can bridge the gap between risk management and traders. Metrics like deltas can provide insights into how small changes in interest rates or credit spreads (e.g., 0.01%) affect valuation, P&L, and liquidity. Subjecting these deltas to tail risk scenarios by asking "what if" questions can help prepare for extreme events. For instance, during the LDI problem, a simple delta analysis based on a significant shift in the gilt market would have highlighted the leverage and potential cash needs arising from derivative trades.
Incorporating AI can provide a broader range of scenarios allowing risk managers and traders to evaluate outcomes and develop contingency plans.
Whilst I recognise the value of separate lines of defence, risk management should be something everyone is engaged in - because we all have different views and opinions the collective discussion will be valuable.
If you liked this sign-up for regular posts
Comments