Quantitative Risk Management: A Practical Guide to Financial Risk, + Website

3.3 Understand the Business

A cardinal rule of managing risk is that managers must understand risk. Managers must understand the risks embedded in the business, and they must understand the financial products that make up the risk. This is a simple and obvious rule but one that is often violated: Do the bank board members and CEO understand interest rate or credit default swaps? And yet these instruments make up a huge portion of the risk of many financial firms. And how often, when a firm runs afoul of some new product, has it turned out that senior managers failed to understand the risks?

Managers, both midlevel and senior, must have a basic understanding of and familiarity with the products they are responsible for. In many cases, this means improving managers' financial literacy. Many financial products (derivatives in particular) are said to be so complex that they can be understood only by rocket scientists using complex models run on supercomputers. It may be true that the detailed pricing of many derivatives requires such models and computer power, but the broad behavior of these same products can often be surprisingly simple, analyzed using simple models and hand calculators. Many in research and trading benefit from the aura and status acquired as keepers of complex models, but a concerted effort must be made to reduce complex products to simple ideas. I do not wish to imply that dumbing down is advisable but rather that improved education for managers is required, together ...