The Art of Managing Risk
Vince Kaminski has seen firsthand how sophisticated companies systematically underestimate and ignore the financial risks they take on until it's too late.[an error occurred while processing this directive]
He was at Salomon Brothers when a rogue trader used false bids at Treasury auctions to corner the market in some government bonds, a scandal from which the venerable investment bank never really recovered.
At Enron he was one of the few who tried to warn top management of the financial house of cards created by Andy Fastow's off-book partnerships and the inadequate capital the energy company had to support its extensive trading operations.
So I was curious about what Kaminski might have to say about the unfolding credit crisis engulfing Wall Street's banks and investment houses.
"Let's just say that all the demons of Enron have not been exorcised," Kaminski said from his home in Houston, where he is writing a book and teaching part time at Rice University. "In many ways, it is the same story all over again."
Kaminski hardly fits the mold of the corporate gadfly. He is a careful man with a Ph.D. in economics, an MBA and a nearly completed degree in mathematics. His expertise is in the relatively new field of risk management, in which sophisticated quantitative techniques are used to measure and model a business's risks and what would happen under various unpleasant scenarios. It is this "science" of risk management that supposedly gives management the ability to foresee and prevent the kind of things that brought down Enron and that now befall Citi, Merrill, HSBC and the rest. And it is this "science" that regulators rely on to protect the health of the banking system.
So why doesn't it work?
As Kaminski sees it, the first problem is that the models these systems are based on, while potentially useful, have serious limitations that are too often ignored.
The data that go into them, he says, are so aggregated and "averaged" that they disregard outliers and abnormalities that turn out to be important. There are also risks -- like risk to reputation -- that are ignored because there is no data set by which to quantify them.
Moreover, by relying heavily on past patterns of behavior, they are often useless in dealing with the new products and new markets that are most often the source of the trouble.
Most importantly, Kaminski says, the models have been unable to capture the cascading effect as problems spread, confidence is undermined and people start to act irrationally.
"You cannot model behavior of humans under conditions of extreme stress," Kaminski says.