Contributor: Marcus Cree
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 therisk 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.]
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February 17th, 2012 at 10:53 am
MF Global can not be compared to AIG or even Madoff for that matter. At MF Global, $1.6 billion was stolen from segregated client accounts. This is a fact and has nothing to do about insufficient communication of risk.
February 17th, 2012 at 3:22 pm
#MF_global: Defining risk #management_failure http://t.co/Po3YdHjA #tenfs
February 17th, 2012 at 4:53 pm
Compelling, via @MarcusCreeRisk: #MFGlobal was was management failure, not a risk-management one. http://t.co/i16Tr6p7
February 17th, 2012 at 9:05 pm
Compelling, via @MarcusCreeRisk: #MFGlobal was was management failure, not a risk-management one. http://t.co/i16Tr6p7
February 17th, 2012 at 9:09 pm
Latest blog on #risk mngmt 'failure' at #mfglobal – http://t.co/gWc2m0cC – my view: management, not risk mngmt failure. Comments please!
February 17th, 2012 at 9:20 pm
Latest blog on #risk mngmt 'failure' at #mfglobal – http://t.co/gWc2m0cC – my view: management, not risk mngmt failure. Comments please!
February 18th, 2012 at 2:26 am
MF global: Defining risk management failure | SunGard …: The failure at MF Global has sparked much debate with… http://t.co/ccsMKQd3
February 18th, 2012 at 4:32 am
MF global: Defining risk management failure | SunGard …: The failure at MF Global has sparked much debate with… http://t.co/5yV7GyWf
February 21st, 2012 at 10:39 am
Latest blog on #risk mngmt 'failure' at #mfglobal – http://t.co/gWc2m0cC – my view: management, not risk mngmt failure. Comments please!
February 21st, 2012 at 1:55 pm
MF global: Defining risk management failure http://t.co/xfEuVnTf #riskmanagement
February 21st, 2012 at 1:56 pm
MF global: Defining risk management failure – http://t.co/yoCKKMjW
February 27th, 2012 at 3:05 pm
Do you really know what #risk management means? – http://t.co/Kw5B5FXT
February 28th, 2012 at 4:15 pm
When answering the quesiton, “how much risk is too much” it is important for management to consider what the company’s counter-parties would have thought. In the case of MF Global this management failure cause its counter-parties to either bolt from the company or demand additional collateral creating a “crisis of confidence which cut off its liquidity and created yet anotehr example of poor stewardship of investor’s funds.
Compounding its inadequate analysis of future market events was its internal inadequacies associated with its own operations (i.e. it suffered from excessive operation risks). Example: failure to forecast accurately future cash requirements; inability to execute funds transfer using its own funds. According to the WSJ MF global relied on manual spreadsheets to track its cash. Funds from the commodities side of the house got “tangled up” (deliberately? inadvertently?) with other transactions at MF Global’s London subsidiary. This inter-company “snafu” illustrating that operating risk / settlement of inter-company positions appearing between legal entities is just as serious as market or credit risk.
The tragedy of MF Global is a multidimensional tale that has yet to be finished, but it strongly illustrates why profitability metrics are not enough when managing a global company. Liquidity and risk metrics are needed, preferably ones that accurately reflect what the market, not just management, thinks.
Possible solutions – better use of technology such as treasury workstations which can serve as compliance engines, more frequent reporting internally or externally; quarterly reporting in a 24/7 world maybe too little too late.
Another solution: If would have been interesting to learn if an 8-K filing upon the resignation or firing of a Chief Risk Officer (not a requirement today) would have alerted MF Global’s counter-parties to its risky strategy early enough to have reduced losses for all concerned.
March 7th, 2012 at 2:23 pm
Bruce,
All of the above points are well made and correct. In many ways the operational risk consideration is so overarching that it effectively defines the role of a CEO. Understanding the risk metrics is key, and just as important as the profitability ones.
Given that most of us learned about the concept of efficient fontiers a long long time ago, it seems incredible to me that the two sets of metrics are not linked in every case.
Your point regarding the market (rather than management) projections is also well taken. This is not always so easy to get right, and unfortumately there is a bit of a survivor bias in terms of whose projections and estimates are trusted in these matters. I have always thought that the idea of stress testing on the upside and the downside is the way forward, across all risk measures, just to illustrate the costs of the inputs being incorrect, but I do appreciate that this is not always practical.