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Letter to the editor

'Risk management' failures keep piling up

By STEVEN PEARLSTEIN, Washington Post
Published November 30, 2007

WASHINGTON - Vince Kaminski has seen firsthand how sophisticated companies systematically underestimate and ignore the financial risks they take on until it's too late.

He was at Salomon Brothers when a rogue trader used false bids at Treasury auctions to corner the market in some government bonds, a scandal from which the venerable investment bank never really recovered.

At Enron, he was one of the few who tried to warn top management of the financial house of cards created by Andy Fastow's off-book partnerships and the inadequate capital the energy company had to support its extensive trading operations.

So I was curious about what he might have to say about the credit crisis engulfing Wall Street's banks and investment houses.

"Let's just say that all the demons of Enron have not been exorcised," said Kaminski, who is writing a book and teaching part time at Rice University. "In many ways, it is the same story all over again."

Kaminski hardly fits the mold of the corporate gadfly. He is a careful man with a Ph.D. in economics, an MBA and a nearly completed degree in mathematics. His expertise is in the relatively new field of risk management, in which sophisticated quantitative techniques are used to measure and model a business' risks. It is this "science" of risk management that supposedly gives management the ability to foresee and prevent the kind of things that brought down Enron and that now befall Citi, Merrill, HSBC and the rest. And it is this "science" regulators rely on to protect the banking system.

So why doesn't it work?

As Kaminski sees it, the first problem is that the models these systems are based on, while potentially useful, have limitations that are too often ignored.

The data that go into them, he says, are so aggregated and "averaged" that they disregard outliers and abnormalities that turn out to be important. There are also risks - like risk to reputation - that are ignored because there is no data by which to quantify them.

Moreover, by relying heavily on past patterns of behavior, they are often useless in dealing with new products and new markets, most often the source of the trouble.

Most important, Kaminski says, the models have been unable to capture the cascading effect as problems spread, confidence is undermined and people start to act irrationally.

"You cannot model behavior of humans under conditions of extreme stress," Kaminski says.

But even if the models were better able to predict calamities, risk management would likely fail, he says, because risk managers are routinely ignored or overruled.

"Many times I have been sitting across the table from an energy trader and I would say, 'Your portfolio will implode if this specific situation happens.' And the trader would start yelling at me and telling me I'm an idiot, that such a situation would never happen," he says. "The problem is that, on one side, you have a rainmaker who is making lots of money for the company and is treated like a superstar, and on the other side you have an introverted nerd. So who do you think wins?"

[Last modified November 30, 2007, 00:53:49]