Red-Blooded Risk: The Secret History of Wall Street

Unspeakable Truth Number Three: Risk Managers Create Risk

It was game theory that proved adding artificial risk to a situation can improve outcomes. A related idea is Monte Carlo analysis, which taught that adding artificial randomness to deterministic problems can make them easier to solve. But big institutions are more comfortable with risk managers who seek only to manage the risk that arises naturally from the business, and to minimize all other risks.

This is the most unspeakable of the three truths. That the risk manager is planning for a nonzero probability of firm failure is not something people like to say, but it is something implemented in meetings and committees. It's not an idea the risk manager imposes on the firm, but something that people throughout the organization accept. In fact, the risk manager is usually not the person best qualified to direct the effort. He is a champion for the idea, and sometimes the only one willing to say it aloud, but other people usually do the heavy lifting.

That superposition creates trans-VaR opportunities is less well known. It's something the risk manager usually exploits privately, by giving the green light to projects that take advantage of it. People know the risk manager approves some projects and vetoes others, but they seldom ask why. If someone does ask, she is usually satisfied with “It was too risky” if the answer was no, and “It had a risk-return trade-off within our appetite” if the answer was yes. People don't like ...