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Risk Management's Existential Crisis

Despite strong methodologies and supporting technology, risk management failures continue aplenty. Fortunately, structural changes can help.

Risk management is entering its third decade as a formal discipline – its methodologies and supporting technologies have never been stronger, yet major risk management debacles keep occurring. High-profile examples include not only banking firms, but also energy companies and other firms that engage in commodities trading. Are risk management practices fulfilling their purpose for utilities and other companies in the power and gas industries?

Recent risk management debacles share some common themes, which suggests risk management systems and methodologies haven’t evolved to prevent such failures. In many trading shops, risk management is a junior partner to commercial personnel who have asymmetrical incentives, that is, to “over-risk” the firm in pursuit of large bonuses instead of adhering to the firm’s stated risk appetite. As a result of this uneven balance of power and distorting incentives, risk management as a discipline has, to-date, not fulfilled its mandate. The best solution might not be to write new policies and standards, but instead to change the structural incentives for risk management professionals.

Recent Risk Management Failures

On April 30, Jamie Dimon, CEO and chairman of the board of JP Morgan (JPM), bellowed at his subordinates. He had just reviewed position reports that showed losses up to $5 billion.1 10 days later JPM – a firm with a reputation as a world class risk manager which sailed through the 2008 mortgage crisis relatively unscathed – announced losses of between $2 and $5 billion, caused by what’s now widely considered as a badly executed and poorly managed hedge. [1] JPM’s stock slid 18 percent in the next 10 days erasing $27 billion of market value and its debt was downgraded from A plus to A minus. The Department of Justice, FBI and Congress initiated investigations. The full extent of JP Morgan’s losses still aren’t known, but the estimate has risen well beyond $5 billion.

Fig. 1: What Happened to the Top 10 Energy Traders by Volume in 2000

Source of Ranking: Platt's Gas Daily

On Dec. 8, 2011, Jon Corzine, a man rich with honors and accolades – including being ex-CEO of Goldman Sachs, a former U.S. senator and governor – sat testifying before a U.S. congressional committee trying to explain why his current firm, MF Global was bankrupt and over $1.2 billion of customer money was missing.

On Oct. 6 2008, Lehman Brothers CEO Dick Fuld testified before the United States House Committee on Oversight and Government Reform regarding the causes of the bankruptcy of his 158-year-old firm.

And in July 2007, Bear Stearns CEO James Cayne busied himself playing in a bridge tournament without a cell phone or email device as his firm began to collapse, sparking the start of the 2008 global credit crisis [2].

Each of these once highly respected leaders was pummeled by risk management failures, and their firms lost billions of shareholder dollars. But they are by no means alone. The rise of derivative trading has been shadowed by a corresponding and ever-growing graveyard of the unlucky with poor risk management practices.

The Maginot Line of Risk Management

The power in trading shops lies with the traders. Risk managers, regardless what the policies say, do not hold equal stroke to

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