MF GLOBAL: DEFINING RISK MANAGEMENT FAILURE

The failure at MF Global has sparked much debate within the financial industry, not least around the apparent shortfall of risk management at the institution. This raises an interesting question about what a good risk management program should be expected to achieve.

When thinking about risk management, it is important to understand the objectives and parameters of what the term “risk management” can mean. Some important definitions are:

• Risk – Risk sits at the very center of any financial organization. Financial services as an industry could be defined as the pricing of risk and the investment in activities where the expected returns are judged to compensate for accepting that risk.
• Risk Appetite – The level of risk, actively sought, in search of higher returns, is one of the differentiating characteristics of financial firms.
• Risk Tolerance – Unlike risk appetite, the risk tolerance is a measure of how far beyond the sought risk level an institution is willing to be, as situations and strategies play out.
• Risk Management (Process) – Risk management itself, at its best, is an internal process that allows all knowable risks to be determined, from both a current and strategic viewpoint, to be priced correctly, and then to be compared to the risk appetite of the organization. Further, the position needs to be stress tested against a variety of possible scenarios to determine the extent to which the risk tolerance is breached.
• Risk Management (Function) – The role of the risk management function is to facilitate risk management process, and to further aid the communication between strategic decision makers and those responsible for the risk appetites and risk tolerances. It is critical that risk taken into the firm is understood throughout that firm and in line with the corporate levels of risk accepted by the board and shareholders.

The key with the MF Global story is that failure of a financial firm is not the same as failure of risk management within that firm. A firm exists to take risks and profit from them (hopefully) and/or suffer from them (possibly).

It is clear, though, that the risk appetite and tolerance for MF Global was insufficiently communicated, creating a situation where losses occurred to investors and clients who believed the risk appetite to be far lower than it was. This is a management failure, rather than a risk management one.  A true risk management failure would be the failure to account for the liquidity effect of the losses, rather than the losses themselves, and the resultant lack of a contingency plan for that event.

It is also pertinent to compare the MF Global failure with the AIG bailout, as both have been labeled as examples of risk management failure. AIG presents an interesting comparison, as the firm moved from a top-down, focused risk management approach to a less coordinated one, which meant that knowledge of the risks, particularly CDO-based risks, and lack of communication about the known risks being taken, led nearly to a global systemic disaster. In this case, it is far easier to conclude that the lack of communication between the risk takers and the risk appetite setters was a risk management failure.

So, what are the lessons to be learned?

• Risk management is not risk mitigation. Financial organizations exist to exploit under-priced risk, and some will suffer as a result, while other grow and prosper.
• The risk management function must enable communication and full understanding throughout the organization. This function should be providing a backdrop to discussion on strategic risks, and empowering risk takers to work within the appetites and tolerances set by the board and senior management.

[NOTE: This commentary is based on reported details and “facts,” and therefore is based on incomplete information. In the case of MF Global, I have looked at what has been reported, and in the case of AIG, I use, as reference, the book Fatal Risk: A Cautionary Tale of AIG's Corporate Suicide, which is an extremely detailed, but very readable, description of happened leading to the bailout.]