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Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura. Read More

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Kamakura Blog

Jan 27

Written by: Donald van Deventer
1/27/2011 1:42 AM 

One of the hazards of the risk management profession is the need to spend long hours on airplanes. Man cannot survive by the collected works of Robert Merton alone, so I often turn to Rex Stout detective novels, featuring the detective Nero Wolfe and his faithful side-kick Archie Goodwin.  Much to my surprise, Rex Stout through his characters had a lot to say that’s useful to risk managers.  Here are a few of my favorite quotes.

“To assert dignity is to lose it.”
Rex Stout, League of Frightened Men,1935

In the risk management business, the parallel sin to this quote is to defend a risk measurement technique, not by citing its virtues in accurately measuring risk, but by claiming it’s “industry standard.” When one hears this defense, one should immediately conclude that the technique is no longer “best practice.”  Perhaps the widest use of the “industry standard” defense has been associated with techniques like the Nelson-Siegel yield curve smoothing technique, the copula and related methods for simulated correlated defaults in a credit portfolio or in a collateralized debt obligation, or Merton model default probabilities.  It’s now very widely recognized that these techniques are seriously flawed, yet die-hard users choose to avert their eyes instead of looking at the evidence that the techniques don’t work as well as many of us once thought.  These blogs provide a guide to the evidence that these techniques and many others that were once “industry standard” are no longer best practice.

“All genius is distorted. Including my own.”
Rex Stout, League of Frightened Men,1935

There is nothing as dangerous as a head trader or a head of risk management whose intellect is so respected or feared that there are no effective checks and balances. Tens of billions of losses would have been avoided in the CDO market if senior management had simply called for a second opinion regarding the strategies put in place by genius traders and then, quite often, blessed by genius risk managers.  A house call by an outsider with no conflict of interest is essential in protecting the shareholders’ interests. 

“To be broke is not a disgrace, it is only a catastrophe.”
Rex Stout, League of Frightened Men,1935

In the risk management context, it is not a disgrace to make a mistake in managing risk. We’ve all done it.  That being said, some mistakes are big enough to be labeled catastrophes and it’s better to avoid them when one can.

“If you eat the apple before it’s ripe, your only reward is a bellyache.”
Rex Stout, League of Frightened Men,1935

Mack McQuown, the “M” in legacy risk vendor KMV, once said, “This business is like surfing.  If you get too far out in front of the wave, you fall off the board and get crushed.  If you get too far back into the tube, you get knocked off the board and get crushed.” One of the reasons so many of the losses in the 2007-2010 credit crisis were concentrated among very large banks is their resistance to new technology, the real focus of Mack’s quote. Big banks lag best practice considerably because of the difficulty, say, of getting consensus among the risk managers buried in the 300,000 employees of Bank of America. Another barrier is the high “switch costs” in dumping a vendor whose product has not aged gracefully, if many other data sources and political processes have been tied to that vendor.  Often, the only way progress is made is when a very senior manager has the insight and power to tell the working level that they’re using archaic technology and that a change has to be made.

“I love to make a mistake, it is the only assurance that I cannot reasonably be expected to assume the burden of omniscience.”
Rex Stout, League of Frightened Men,1935

We’ve all made a ton of mistakes and we’ll continue to do that.  Each mistake unveils something new about the world that we didn’t clearly understand previously. These mistakes aren’t “black swans,” they’re simply assumptions about the world made by us that turned out not to be true.

“I have all the simplicities, including that of brusqueness.”
Rex Stout, League of Frightened Men,1935

In many places in these blogs, we’ve talked about troubled institutions where the risk manager is put in an awkward position: either the risk manager has to be brusque and tell management and the board that a mistake is being made, or the risk manager has to put his head down and hope that, when the dice roll, the result will not be too horrible.  No one wants to end up in this position, but most readers of past blogs have agreed that telling the truth in a loud voice is the best option, even if one loses his job because of it. Those who lose their job in this way get rehired in a hurry.  Those who wait for the dice to roll, saying nothing, have a much harder time when snake eyes are the result.

“A desperate fool is still a fool.”
Rex Stout, League of Frightened Men, Chapter 16, 1935

What happens when an unsophisticated risk manager makes a mistake?  A recent  example is a risk manager who assumes that home prices in the United States will not fall.  When a big mistake has been made, senior management should be especially careful that the foolish risk manager does not become a desperately foolish risk manager, someone who either wants to ignore or hide the mistakes that have been made. Tales of these “desperate fools” would take up a lot of blog entries!

“…if only men could be depended upon to base their decisions on reason.  Alas, there are only three or four of us in the world, and even we will bear watching.”
Rex Stout, League of Frightened Men, Chapter 18, 1935
We’ve mentioned above how common it is for risk managers to deny evidence that there’s a better way to do things.  In a rational world, one looks at the facts and changes one’s mind when the evidence indicates there’s a better way to manage risk. Darwin described the process by which these unfit risk managers are ultimately replaced in a “survival of the fittest.” As mentioned by Nero Wolfe above, though, every risk manager should be carefully watched, with their strategies and calculations audited by third parties on a regular basis.

“The truth is, only a few things are possible, pitiably few.”
Rex Stout, League of Frightened Men,1935

I once sat in a room while 20 PhDs argued long and loud that a particularly technique, which is now widely recognized as best practice for default probability estimation, was much too simple to be appropriate for that organization.  That firm did nothing and later was rescued at huge cost to the US taxpayers.  As Nero Wolfe says, only a few things were possible: use the technique or don’t use it, but if one doesn’t use it something else has to be put in its place.  Often senior management needs to bang heads to make progress in a situation like this.

“But using a gun, especially in a crowd, is always bad management unless you have to…”
Rex Stout, “Fourth of July Picnic,” Chapter 6, reprinted in And Four to Go, 1956

As the prior quote indicates, sometimes senior management has to use a “gun,” i.e. to forcefully demand progress in risk management to avoid disaster for the firm.  It’s much too easy for progress to stall because of mid-level staff politics and irrational allegiance to techniques or vendors that don’t represent best practice.  When this is happening, “using a gun, especially in a crowd,” may be necessary.

If you decide to spend time with Nero Wolfe and Archie Goodwin, say “Howzit” for me.

Donald R. van Deventer
Kamakura Corporation
Honolulu, January 27, 2011