Risk and Reward Column: The Invisible Problem of Risk Blindness

As the semester begins to wind down, many classes (mine included) take a look at various financial cases and what events led to the problems. Thus the timing of the FENews article on " The Invisible Problem of Risk Blindness is especially good:

A few look-ins:

"There is an old saying that everything changes, but everything remains the same. This is especially true with financial disasters. The precise circumstances – the people, amounts lost, etc. – always vary, but underneath these superficial differences there are remarkable similarities....Their risk models turn out to have been blind to the risks the firm was actually taking and no one realized until too late."

"So what are the causes of this “risk blindness?” One cause is false assumptions.... Another example is when VaR models rely on historical correlations and fail to allow for correlations polarizing in crises....." A second cause is estimation error.

And later:

"So what can be done to reduce these problems? Part of the answer is for risk managers to pay more attention to qualitative factors, to focus less on the models and more on the judgmental questions surrounding them."

And finally:

"agency problems go right the way up the corporate hierarchy. So how do we ensure that senior managers and directors take their responsibilities seriously? Again, the answer is simple, but won’t be popular – at least with senior management....to abolish limited liability."

Wow! Good article! Highly recommending reading the entire thing!