Spreadsheets are not the problem
The media have latched on to a story.
The culprit in the 2012 JP Morgan trading loss has been exposed. Spreadsheets are to blame!
The only problem with this answer is that it is simply incorrect. It is blaming the bad result on the last step in the process. Like the announcers for a football game who blame the last play of the game for the outcome. It really wasn’t missing that one last ditch scoring effort that made the difference. It was how the two teams played the whole game.
And for situations like the JP Morgan trading loss, the spreadsheet was one of the last steps in the process.
But the fundamental problem was that they were allowing someone in the bank to take very large risks that no one could understand directly. Risks that no one had a rule of thumb that told them that they were nearing a situation where any bad day, they could lose billions.
That is pretty fundamental to a risk taking business. To understand your risks. And if you have no idea whatsoever of how much risk that you are taking without running that position through a model, then you are in big trouble.
That does not mean that models shouldn’t be used to evaluate risk. The problem is the need to use a model in the heat of battle, when there is no time to check for the kinds of mistakes that tripped up JP Morgan. The models should be used in advance of going to market and rules of thumb, or heuristics for those who like the academic labels, need to be developed.
The model should be a tool for building understanding of the business, not as a substitute for understanding the business.
Humans have developed very powerful skills to work with heuristics over tens of thousands of years. Models should feed into that capability, not be used to totally override it.
Chances are that the traders at JP Morgan did have heuristics for the risk and knew that they were arbitraging their own risk management process. They may not have known why they gut told them that there was more risk than the model, but they are likely to have known that there was nore risk there.
The risk managers are the ones who most need to have those heuristics. And management needs to set down clear rules about the situations where the risk models are later found to be in error that protect the bank, rather than the traders bonuses.
No, spreadsheets are not the problem.
The problem is the idea that you can be in a business that neither top management nor risk management has any “feel” for.Enterprise Risk Management, Modeling comment below, or link to this permanent URL from your own site.