Financial industry firms must manage risk more effectively to prevent cases of rogue trading similar to the one UBS AG recently experienced, according to Thomas Coleman, author of a risk management publication by the Research Foundation of CFA Institute.
In a webinar on Thursday, Coleman said risk management is not just a mathematical and quantitative function. It’s part of managing people, he said.
“Risk management is nothing more nor less than good management, and good management is paramount,” said Coleman, author of A Practical Guide to Risk Management.
He pointed out that many of the largest cases of “rogue” trading do not involve fraud, but involve a trader trying to cover up a relatively minor loss or mistake to protect his or her reputation. In some cases, an organization’s management also takes steps to try to hide these types of errors, which worsens the situation and further damages the reputation of the firm.
For instance, a bond-trading scandal at Japan’s Daiwa Bank in 1995 involved a trader trying to hide an initial loss of US$200,000. Efforts to recoup the money led to further losses that eventually grew to more than US$1 billion, and once executives discovered the scandal, they didn’t report it to the authorities right away.
While the loss was manageable, the cover-up and mismanagement at the company caused irreparable damage, according to Coleman.
To prevent these types of situations, Coleman said firms must ensure that staff are being effectively managed. This includes having the proper compensation and incentive structures in place to encourage appropriate behaviour, along with enforcement procedures to discourage wrongful behaviour. Organizations should also promote a culture of openness that encourages staff members to come forward when they discover errors, rather than trying to hide them.
Effective risk management should also include strong operational infrastructure and information technology systems that catch errors as quickly as possible, Coleman said.
Financial firms should not have a single department responsible for risk management, according to Coleman. Rather, he said all managers throughout an organization should be involved in managing risk.
“Managing risk cannot be separated from the rest of the business,” he said.
He acknowledged that it can be challenging for the average manager to understand the technical and quantitative aspects of risk measurement, especially as these measurement tools become increasingly complex. But since these tools are an important part of managing risk, Coleman encourages firms to train their managers on quantitative risk measurement tools such as volatility and value at risk.
IE