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When Clever People do Silly Things with Money

Many years in investment banking taught McGill University Professor Gregory Vit that risky decisions ‘happened’ far more frequently than they were thoughtfully ‘made’.

We asked Professor Vit about this and his new book 'The Risk in Risk Management' in which he addresses risk management in financial organizations. Click through to read the interview here.

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What prompted you to write this book?

Over many years as an investment banker, I observed that many important decisions regarding big risks "happened" rather than were "made". So decision-making regarding risk is sometimes a misnomer, decisions oftentimes "form", rather than are "made". By this I mean that banks pretend to be able to control many things but oftentimes get hit by Tolstoyan waves of history and social processes. What is even more interesting is that even the things that banks can control, should control, such as trading rooms and large credit exposures, oftentimes go badly off the rails because banks decouple thought from action.

What would you identify as the biggest mistake an investment bank can make in terms of risk?

The biggest mistake is to stop thinking and questioning. Yet there is tremendous pressure within an organization to conform, to go along with things, and to pretend that things are understood when they are not. One recent example is the repackaged subprime debt junk that was rated AAA by Moody's. Few understood the models and, importantly, their assumptions. In my book I mention that the US government's Financial Crisis Inquiry Report noted that since the crash of the entire market of mortgage backed securities it had rated its highest triple A rating in 2006, Moody's downgraded 76% to junk.
When anyone says “this is a ‘no-brainer’, just do it”, it usually requires your brain and careful consideration.

What is the most common way Fraudsters play the system and how can their activity be nipped in the bud?

Fraudsters are very good at making simple and transparent transactions become very complicated and opaque. Consider the recent alleged Sino Forest fraud. It appears that the opacity of finance (offshore flows) and China (anonymous intermediaries) allowed its auditors and board to stop thinking. Also, language, stories and rhetoric are effectively used to hoodwink risk takers. In fact, many terms in finance mean precisely the opposite of what they purport to mean such as the following meanings and (opposite meanings): hedge fund (actually means gambling fund), investment banker (actually means speculator), high yield bond (actually means high risk bond), risk management (actually means return management), and so on. The antidote is to be aware of this and to keep asking annoying questions until all is clear, and if it is not, then to pass on deals. To say, “no”.

Your book features illustrative cases of massive risk mismanagement; could you share with us one of these in brief?

One of the most dramatic cases that I discuss is the National Australia Bank 2004 currency options trader fraud. The data available is particularly rich as the bank was very open to release confidential reports to the public. It’s a textbook example of what not to do, yet my brief discussion of crises at SocGen, UBS, Parmalat, and the Gaspesia project show similar non-economic social processes at work that over-ride reason.

Please could you provide a quick explanation of the four risk management perspectives that you identify in your book; economic, institutional, evolutionary, and contrarian.

The economic risk management perspective is the conventional wisdom used to control risk. It is vital to understanding risk and the assumptions found in conventional finance, such as clear and efficient markets, and that the best, and sometimes luckiest, will succeed. This is the dominant mindset we teach our students and it is assumed that a lot of agency and free will is at play and that the markets always work.

The institutional risk management perspective assumes that institutions work and that understanding invisible social structures and norms is equally important in managing risk. By this I mean that almost every large old industry that gets ossified, may not actually be very competitive, and have invisible rules and walls that I call an ‘institutional fortress’. To continue with this image, if you are in the fortress and not focused on hunting for food every day, you shift from market efficiency to ceremony and build legitimacy for yourself via conformist behavior that is sometimes nonsensical. This may be good or bad, but change usually only occurs when there is a major shock to the system. Banks in many countries are still fortresses and I call this the ‘Canadian banking paradigm’ in my book.

The evolutionary risk management perspective is the special case where risk managers have neither an appreciation for how Nobel prize-winning relationships in finance work, nor do they understand the invisible institutional structuration of things. This means that they are left adrift and subject to the sum total of many small chance events that may add up to big trouble (trader frauds both legal and illegal), as well as unthinking incumbent routines that result in sub optimality in the best case, and blow up the bank or organization at worst. Most large disasters are the result of many small missteps and a failure to question irregularities that are outside the reassuring unthinking organizational routines.

The contrarian risk management view (that I also call the ‘holistic risk management model’ or ‘HRMM’) requires a deep understanding of both the economic and non-economic perspectives. Excellent fraudsters use this understanding to their advantage legally and illegally, as do excellent risk managers who are on the other side of the same coin.

What was it that led you to identify these as your framework for risk management? Do you have any anecdotes of trial and error that might illustrate this?

I came up with the framework after living through many financial crises (the Latin American debt crisis of 1981, the US Savings and Loan crash, the dot-com bubble, the sub-prime debt crisis, etc.) and by making the problem of conformity in financial institutions the topic of my academic research.

To cite a very recent negative risk management anecdote, Montreal is in the midst of a construction contractor scandal, as elucidated by the Charbonneau Commission. Until recently, if you wanted to build a bridge in Montreal, you needed to understand the technical rationality or engineering science of doing so (analogous to the economic perspective), as well as the invisible corrupt side of attaining contracts with government officials (the non-economic perspective). Failure to understand one or the other perspective would limit your chances, and failure to understand both could lead to a bridge not getting built or to it tumbling down…

What is the reason most oftentimes given for social forces overriding economic rationality?

Rogue individuals, financial manias, poor leadership, poor risk management, lack of capital, meteorites, aliens, locusts, bad loans (why not bad bankers?) and other opaque catch-all meaningless attributions.

What do you think the reason is?

The reason for non-reason? My book suggests that the lead lemming is usually much more than just one individual. Also, the conventional risk management systems oftentimes function surprisingly well sending off giant flares and ringing alarm bells. What is most interesting is why and how the warning signals are understood and ignored, over-ridden and manipulated by fraudsters, or misunderstood. Given the staggering sums involved, my book moves us forward in understanding why banks are full of very clever people that sometimes do ridiculous things with our money. It describes manipulation and conformity and prescribes contrarian thought and action.

Related Products

  1. The Risk in Risk Management

    Financial Organizations & the Problem of Conformity

    By Gregory B Vit

    Banks take very large risks by consistently herding in the same perilous directions while believing they are safe and unique. This book presents a risk management framework to understand conformity and deviance within investment banks and other large organizations. It suggests that some groups...

    Published June 3rd 2013 by Routledge