Echo Chamber Risk Models
The dilemma is a classic – in order for a risk model to be credible, it must be an Echo Chamber – it must reflect the starting prejudices of management. But to be useful – and worth the time and effort of building it – it must provide some insights that management did not have before building the model.
The first thing that may be needed is to realize that the big risk model cannot be the only tool for risk management. The Big Risk Model, also known as the Economic Capital Model, is NOT the Swiss Army Knife of risk management. This Echo Chamber issue is only one reason why.
It is actually a good thing that the risk model reflects the beliefs of management and therefore gets credibility. The model can then perform the one function that it is actually suited for. That is to facilitate the process of looking at all of the risks of the firm on the same basis and to provide information about how those risks add up to make up the total risk of the firm.
That is very, very valuable to a risk management program that strives to be Enterprise-wide in scope. The various risks of the firm can then be compared one to another. The aggregation of risk can be explored.
All based on the views of management about the underlying characteristics of the risks. That functionality allows a quantum leap in the ability to understand and consistently manage the risks of the firm.
Before creating this capability, the risks of each firm were managed totally separately. Some risks were highly restricted and others were allowed to grow in a mostly uncontrolled fashion. With a credible risk model, management needs to face their inconsistencies embedded in the historical risk management of the firm.
Some firms look into this mirror and see their problems and immediately make plans to rationalize their risk profile. Others lash out at the model in a shoot the messenger fashion. A few will claim that they are running an ERM program, but the new information about risk will result in absolutely no change in risk profile.
It is difficult to imagine that a firm that had no clear idea of aggregate risk and the relative size of the components thereof would find absolutely nothing that needs adjustment. Often it is a lack of political will within the firm to act upon the new risk knowledge.
For example, when major insurers started to create the economic capital models in the early part of this century, many found that their equity risk exposure was very large compared to their other risks and to their business strategy of being an insurer rather than an equity mutual fund. Some firms used this new information to help guide a divestiture of equity risk. Others delayed and delayed even while saying that they had too much equity risk. Those firms were politically unable to use the new risk information to reduce the equity position of the group. More than one major business segment had heavy equity positions and they could not choose which to tell to reduce. They also rejected the idea of reducing exposure through hedging, perhaps because there was a belief at the top of the firm that the extra return of equities was worth the extra risk.
This situation is not at all unique to equity risk. Other firms had the same experience with Catastrophe risks, interest rate risks and Casualty risk concentrations.
A risk model that was not an Echo Chamber model would be any use at all in these situation above. The differences between management beliefs and the model assumptions of a non Echo Chamber model would result in it being left out of the discussion entirely.
Other methods, such as stress tests can be used to bring in alternate views of the risks.
So an Echo Chamber is useful, but only if you are willing to listen to what you are saying.
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