How- and How Not To Manage Risk

Yesterday, on CNBC, one of their on-air guests uttered some of the worst ideas yet on risk management and regulation thereof. If I'm not mistaken, the guest was former Clinton-era economic advisor, Laura Tyson.

Ms. Tyson's bright idea was to have more detailed audits of each financial service company's risk management procedures by regulators.

Unfortunately, she seems not to have any working knowledge of how risk is really managed in the trenches of a modern investment, or even commercial bank.

For examples, look no further than Kidder Peabody last decade, or Merrill Lynch several years ago. In both cases, risk managers who dissented from business managers' desires to heighten exposures were either intimidated, as in the case of Kidder, or simply fired, as in the case of Merrill Lynch.

I happen to have actually known the risk manager of the unit which was responsible for the losses which Kidder suffered, thanks to Joe Jett's government instruments trading, while part of GE. His explanation of what happened, between squash games one night, was that, upon discovering positions which exceeded risk limits, he was simply told to shut up, or leave. Being subordinate to the operating unit's management, he had little choice. He looked the other way.

At Merrill Lynch only a few years ago, veterans Jeff Kronthal's and Doug DeMartin's forced departures solved the problems of risk management for business managers in the fixed income unit which was busily increasing the firm's exposure to newly-minted mortgages and their securitized final products.

Laura Tyson's bromides are worthless. It's not the printed risk management policies that matter at a financial institution.

Rather, it's how the risk management organization is structured, and to whom it reports. I don't know the details of Goldman's current risk management organization. But I have read several different accounts which confirm that the company puts a premium on objective, independently-housed risk management challenges to each trading and investment business. Risk and business managers swap jobs, in order to imbue each business manager with a fresh and recent perspective on the importance and practice of the risk management function.

Of course, it helped enormously when investment banks were private partnerships. Never so much as when their own money was at risk have investment banks practiced effective risk management.

However, like their commercial banking brethren, once becoming listed public entities, even investment banks learned that taking on excessive risk paid them, as employees and managers, while leaving shareholders owning any imprudent and, ultimately fatal exposure.

In my opinion, there is simply no substitute for risk managers being equal with business managers, capable of vetoing business decisions, and reporting up through a separate command chain to a Chief Risk Manager who reports to the CEO or CFO. To execute prudent, objective risk management, the function has to be separated, organizationally, from the businesses to which they are assigned.

Anything less will eventually become corrupted, no matter what the former Clinton economic official might see in her visit to an investment bank to audit their risk management policies, procedures and operations.