Eyes wide shut: Are finance managers looking but don’t see?

By Shane Murray

In the wake of poor returns or worse, substantial loss of wealth, Financial Managers wear the blame. Like a phoenix born from the ashes of ruin, the angry mob emerges and sprays charge at the financial sector, labelling their behaviour as reckless, their knowledge of financial markets absent and their understanding of risk as infantile. In my opinion this is a justified resolve as from inception, Financial Managers have been monitoring risk with their eyes wide shut. The inherent flaws of contemporary risk models used by Financial Institutions are well known, as too are the means of manipulating portfolios to accumulate risk not captured by their estimates. Such behaviour is reckless and wholly undermines why risk is quantified in the first place. But what choice do Traders have? Year after year shareholders demand bigger and better returns and Financial Managers find themselves in a precarious situation. Should they be reducing the exposures when the mutters of disaster begin to surface, or do they turn a blind eye and rely on their risk metrics as an appropriate scapegoat? After all, taking the safer approach, reducing risk and yielding a lesser return spell certain crucifixion at the hands of the same angry mob. So it seems the problem is twofold. Thankfully, with so much on the line, a collaborative approach to risk supervision is emerging through the Basel accords which aim to dispel such irresponsible behaviour. Unfortunately such endeavours are yet to curb the insatiable desires of the mob, which Financial Managers seem more than willing to oblige.

In prosperous times when the bull market is charging upwards and onwards shareholders are happy. Returns are solid and little thought is made to the effect of a market reversal. This has been observed time and time again: in the late 1990’s with the dot-com bubble; and more recently with the GFC. But who is to blame when the music stops? Some say Financial Managers are at fault through the failings of their risk models which under quantify the actual risks being accumulated. One in favour of such accusation is Nassim Taleb, the author best known for his book The Black Swan, who passionately faults Financial Institutions use of value-at-risk (VaR) as their risk metric of choice. Mr Taleb criticises the assumptions commonly applied when computing VaR estimates, labelling the practice irresponsible, since these very assumptions are known to be wanting. Yet, Financial Managers charge ahead, ignoring the fact that the risk metrics they monitor so very closely possibly only represent the shadow cast by the actual exposure.

Underestimation as such is particularly worrying considering the VaR metric provides only a measure of the minimum loss to be incurred, at a given confidence, over a period. As the observation suggests, when this metric is exceeded it could be by a dollar or it could be by a trillion! With this in mind one would expect a rational person to be weary of increasing such a minimum loss exposure. Interestingly enough, earlier this year, just a few short years after the devastation of the GFC, JPMorgan Chase reported a two billion dollar loss fuelled by leveraged positions taken on to bolster earning in the wake of poor shareholder returns. So it seems Financial Managers have learnt nothing from the crisis and are still blindly treating their VaR as a limit they must adhere to, not a warning of what might be lost. Again, reckless and absent minded behaviour prevails.

While some might argue that the inconsistencies the VaR model presents through its assumptions make it hard to place too much faith in the metric, the widely accepted CAPM and the Black-Scholes (BS) Option Pricing Model are not too dissimilar. In 2003 Elton McGoun1 noted that while the CAPM cannot be empirically confirmed (due to the model being purely expectations based) and the BS model is known to be flawed through the normality of returns assumption (similar to the VaR model when the same assumption is applied) both are still held in high esteem. The reason for such acceptance is that regardless of their deficiencies, both still provide an unquestionably robust framework for financial analysis which aligns seamlessly to modern finance theory. So while these financial models, the VaR model included, have their flaws, they still provide valuable insight. So the value these models provide comes from appropriately interpreting the results, not simply using them to form hard limits as assurance risk is under control as Financial Managers are blindly doing with their VaR measures.
In further defence of the VaR model, a number of measures can be adopted to improve its applicability. One such variation is to incorporate a more suitable returns distribution that more pertinently reflects the likelihood of larger negative return events. While this may improve the quantification of the likely returns, it also has implications for the portfolio return. In this situation, since the risk estimate is inflated, investment cannot be made as strongly and the portfolio return is impeded. Of course, this is not favoured by investors who demand the best return possible. Unfortunately, until all Financial Managers adopt more prudent approaches, shareholders will simply move from the more diligent Managers to one who offers a better return for the same risk…or so their model says. In an open market, Financial Managers have little choice but to turn a blind eye to the estimates of more robust risk modelling if they wish to stay in business, which is a sobering truth indeed.

Fortunately, all is not lost. While governments have established regulatory requirements to monitor such flagrant practice internally, the financial system is evermore becoming one of a global entity and so similar governance has been adopted on a broader scale. The Basel Accords outline minimum capital requirements banks trading internationally must adhere to based on the amount of risk they hold. While the original accord focused solely on exposures pertaining to credit risk, subsequent revisions now also consider, amongst others, exposures to market and operational risks with the methodology for their quantification ever evolving and improving. Such an approach to risk management is encouraging and so it should be of no surprise that it has been met with strong resistance by the financial sector. In only 2009, former UK Trade Minister, Lord Davies, and the Bankers Association for Foreign Trade (BAFT), in unison with Financial Managers worldwide expressed strong disapproval for the revision of the Basel II accord, which seeks to do no more than ensure the stability of individual institutions and the financial sector as a whole. A similar proclamation of their endeavours is of course made by the BAFT and Financial Managers, though it seems they again may not be seeing clearly.

The perpetual ignorance towards risk quantification on behalf of Financial Managers seems to be a compounding issue. While improvement to risk quantification methods are made each day and regulatory bodies are working to re-enforce the stability of financial markets as a whole, Financial Managers appear to be doing all they can to halt progress. Unfortunately, it seems Financial Managers are content to undermine risk practices and manage risk with eyes wide shut, giving the mob what they want through the good times and wearing the blame through the bad.

1McGouin, Elton G. 2003. “Financial models as metaphors.” International Review of Financial Analysis Vol 12, Issue 4: pp.421-433.

Shane Murray is a Master of Applied Finance student at Queensland University of Technology.

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