CRO is not the Moral Compass

The American Banker has a new column on risk management.  The first article is here.  Clifford Rossi makes some good points about the JP Morgan story.  But Riskviews takes issue with one point that he makes…

The paradigm of the trader and the risk manager are fundamentally at odds. The trader will believe that if they are given the funds to make one more trade, they will make up all of the past losses and post a large gain. The stories of successful traders and hedge fund managers all read the same, losses, growing losses, no one else believes in the trader. Finally, they are vindicated by a large gain that makes them the hero. When you listen to the stories from Bear Sterns and Lehman, folks who were involved all say that it was just a liquidity issue. If they just had a little more funds, they would have made the trades that would have brought the firm back.

The risk manager on the other hand believes that there must be a limit to the amount that is put at risk by the firm. Do not bet what you cannot afford to lose. The risk manager believes that even the best theory can have a run of bad luck that the firm cannot afford.

Ultimately, the risk manager is not the moral compass of the firm. The risk manager is nothing more or less than the person who is charged to make sure that the CEO and the Board understand and are fully aware and approve of all of the risk taking activities of the firm. To make that process work, the risk manager will ask the board and CEO to pre-approve some activities and to require to be notified about others.

In JP Morgan’s case, the board and CEO should have been aware of what was going on, of the size of the positions. Perhaps they did not give clear directions to the risk manager or perhaps the risk manager for some reason failed to report the risk positions.

However, it should have been a business decision made by the Board and CEO, not a decision of the trader or of the risk manager.  The loss that resulted would be a decision that did not work out as intended, not even necessarily a bad decision.  All decisions do not work out well.  And while $3 Billion is a large amount of money, it is only a fraction of earnings for a good year for JP Morgan.

If the decision to make the trade(s) that added up to the $3 Billion loss were made by the trader and not reported to the CEO and Board, then and only then is this a risk management failure.

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