Concurrent Session 3E

"Stories of Risk Culture: the Good, the Bad, the Ugly"

Presenters: John Wengler of Hess and Dragana Pilipovic of Energy Risk WorkDesk

John:
Blame VaR/models/numbers for the crisis? NO. Don't blame the breaks, blame the driver. "St. Francis of Assisi" vision of a risk manager, i.e., highly moral (and associated with martyrdom.) Risk manager should NOT be the most moral person in the organization; he should be like everyone else in the organization.

There's nothing inherently wrong with speculation. We have to have bottom-feeders and vultures, etc. That's how we get functioning markets. See slide 6 for his matrix of the types of risk culture. Individuality versus Community and Order versus Chaos. From this we get "the Accountants," "the Hollywood Agents," "the Commanded and Controlled," and "the Flock" (respectively mapping to: IO, IC, CO, CC.) Then you create a distribution of the organization according to where each person in the organization falls on these axes. The core represents the culture of the organization, but you should have people who go against the core as well, as these people can drive innovation.

Dragana:
Risk management culture needs to be tied to the way the company makes its money. So then the question is: who is motivated naturally within the organization to achieve high-quality risk management? Someone who will stay at the company long-term, who understands the key factors that create success for the company, who answers to the shareholders. Is it about ethics or personality? How does corporate culture motivate? The same person can behave very differently in a different environment.

Focus is on trading. Market making is theoretically risk-neutral (as compared to speculation where you deliberately leave your position unhedged.)  Arbitrage as a strategy does NOT usually mean pure arbitrage (this doesn't happen enough to make enough money.) Statistical arbitrage aims to make money over time. In this case, you do hedge by buying the option and the underlying stock. If you're right about the actual price, eventually you will make money. Finally there's a strategy to just invest in risk-free rates.

In some cases, people say they're doing statistical arbitrage, but when the underlying thing you're betting on is itself risky, it starts to look like speculation. In general, the best traders I've seen have been the best risk managers; in fact, they are risk managers first and traders second.

Natural choices for risk managers include the C-suite and consultants (operation in a competitive consulting market.)

Success stories:

Story 1: Speculative trading shop taking substantial risks. Top trader with decades of experience was not particularly quantitative but did have a good instinctual feel for distributions. He would review the company's book periodically and if he didn't agree with another trader's trade, he would literally take the opposite position in his own book. His focus was on the risk for the total company being at an acceptable level, even if he personally took losses to accomplish that. This shop then had ridiculously stable returns, unlike anything I've ever seen.

Story 2: Volatility arbitrage firm with a head trader who had a quant background, but not a deep understanding. But he valued quants and had as many quants as traders. In this shops, the quants were viewed as the profit-makers, above the traders. Traders were only allowed based on the quants' estimates of volatilities subject to a certain spread. Again a very successful shop.

Story 3: Energy company where CEO and CFO were the top risk managers. Culture started with them and permeated the company. Maintained an appropriate level of trading (under Treasury function) given their level of expertise.

Who is *not* motivated to help the company? Rogue traders, people who just don't realize they lack expertise, C-suites motivated by short-term gains or who are addicted to high returns, or consultants who are loyal to one person and not the company as a whole (because that one person will feed them more business.)

Failure stories:

Story 1: Speculation - Rogue trader takes advantage of "chaos" in the firm to mark his books to his advantage. Really this is a management failure - chaos must be dealt with.

Story 2: StatArb - Assumed mortgage pre-payment rate was fixed, then it suddenly changed. Perhaps couldn't be hedged, but the size of the position could have been managed. In this case, everyone was reviewing and following the model, but this assumption was missed. Consider when assumptions might change.

Story 3: Asset arbitrage failed at a firm where the C-suite (same company as success story!) decided to chase higher returns without acquiring the appropriate in-house expertise. Failed and exited the new business.

Story 4: Market-making - sales-driven organization ended up with negative MTM value on numerous deals. Possible due to IT system.

Story 5: C-suite addiction to higher returns happens frequently. They don't ask how the money is being made. Natural gas spreads, ignoring market liquidity. C-suite approved blowing through the VaR limit multiple times.

Responses to questions from the audience:

John: I don't even like the title CRO, because is implies that risk is a separate function rather than embedded throughout the organization. The best, most thoughtful manager of risk should NOT be the risk manager, it should be the CEO and head trader.

Dragana: The capital issues during the financial crisis were aggravated rather than solved by TBTF. Not that it would have prevented the crisis, but the clean-up would have been more efficient had it been allowed to happen in the free market. Then again it might have prevented it if the risk had been owned by the market (instead of by Fanny/Freddy/gov't.) It may not have made a difference, honestly, if C-levels were caught up in the huge returns. The data was there, showing the risk, but it was ignored.

John: Greenberg at AIG valued the AAA credit rating above all else. After he left, the attitude became "why isn't AA good enough?" But the collateral demands on a AAA versus a AA company are significant. They lost their access to easy credit in addition to having to post margins for losses and collateral on loans. You need to recognize where you're vulnerable. That and you need to recognize when you've been lucky.

Is risk management contrary to human nature?

John: There are some members of the tribe who think long-term, who are managing risk. At the same time, there are cowboys out there.

End session.