Enterprise Risk Management

CHAPTER 17Risk Management: Techniques in Search of a Strategy

JOE RIZZI

Senior Strategist, CapGen

INTRODUCTION

Spurred primarily by regulators, financial institutions invested significant resources in risk management over the last decade. An actuarial statistical approach to estimate future losses based on past experiences was used to create an illusion of improved control. Unfortunately, markets are not actuarial tables. The magnitude of the error became apparent once the 2007 credit crisis unfolded. For example, Merrill Lynch’s one-day value at risk (VAR) at the end of 2007 was $154 million,¹ which was supposedly the maximum it could lose over a one-day period at the 99 percent confidence level. The undisclosed risk in the 1 percent beyond the confidence level was substantial, triggering its forced sale to Bank of America.² Other institutions with similar experiences include Citigroup, Wachovia, and Washington Mutual. These losses triggered massive shareholder value destruction resulting in dilutive recapitalizations, replacement of whole management teams, the failure of numerous institutions, and the adoption of the $700 billion TARP³ rescue program. Clearly, something is wrong with the current state of risk management, which requires a rethinking of the activity.

Institutions, both large and small, assumed more risk to maintain income growth to offset challenging industry conditions and declining core profitability. As it turns out, the golden age of banking was not that ...