The problem isn’t necessarily with the models but with their application Big Fat Finance, say several Wharton professors in a report, “Re-thinking Risk Management: Why the Mind-set Matters More than the Model.”
Their recommendations for a more effective approach to risk management:
The practice of risk management has come under fire lately, given the upheaval in the economy. Firms that were engaged in risky activities, such as trading large volumes of complex securities, certainly made use of mathematical models and other risk management tools that were supposed to identify and quantify potential risks. This would allow them, so the thinking went, to take preventive action. Somewhere along the line Big Fat Finance, that didn’t happen.
• Take a comprehensive view of risk. Often, responsibility for risk management is divvied up between, for instance, market risk and credit risk. As Richard Herring, co-director of the Wharton Financial Institutions Center points out, many securities traders have been experts in market risk, but don’t know credit risk — despite trading vehicles that were highly vulnerable it.
• Look externally. Because companies are increasingly interdependent, management needs an understanding not only of events that directly impact their firm, but also of those that could impact suppliers and business partners.
• Supplement quantitative models with qualitative data. Discussions with peer companies, regulators, suppliers, customers, and internal employees at different divisions can yield information that might not show up in a tidy risk analysis profile but still merits consideration.
• Don’t be deceived by apparent sophistication. The volume of data offered by some models can obscure the fact that the underlying assumptions don’t hold up. Phil Rosenzweig, a professor of strategy and international business at IMD in Switzerland, speaking in the report, calls this, “the delusion of rigorous research.”
• Finally, assess the level of risk-taking necessary to win in an industry. In some industries, firms need a healthy appetite for risk in order to be competitive. ###
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