A little more on risk mismanagement

The NYT just published an interesting analysis of the role played by modern financial models in the current meltdown [http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?_r=1&partner=permalink&exprod=permalink&pagewanted=all]. The article highlights the particular role played by VaR models and the institutionalized and improper reliance on that kind of models.

I have blogged about this in the past. It's common knowledge - although also commonly ignored - that mathematical models are just that - models. They operate under sets of assumptions that need to be understood to be applied.

But as pointed out earlier [http://architectguy.blogspot.com/2008/12/financial-instruments-systems-analysis.html], the key problem from a technical standpoint is that no real system analysis has been attempted on the complex combination of financial instruments being put to work. No exception or error propagation analysis, no interface consistency analysis, etc. These are all words that are foreign to the daily practice of these instruments. Quants are not system analysts.

To the industry's credit, it may well be that the sheer complexity that the systems analysis entails is such that it is practically unfeasible. If that ends up being the case, regulation-based restrictions on these instruments in the largest financial markets may help reign in the complexity - at the cost of reduced creativity. The current meltdown can explain how it is that such a move would probably be positive in the short to medium term - and would avoid having the tax payers foot a huge bill to bail out an already highly rewarded and ultimately irresponsible industry.

If the financial industry wants to avoid over-regulation, it will have to prove it can control its risk, through a combination of better overall systems analysis and better understanding of the decisions made.

Decision management is gradually including the relevant aspect of systems analysis, and will turn to be an unavoidable piece of the core processes that use the complex financial industries. You need to be prepared to deal with the unexpected and understand the impact of the decisions you make.