Photo Credit: Chris Piascik
Most formal statements on financial risk are useless to their users. Why?
They are written in a language that average people and many regulators don't speak.
They often don't define what they are trying to avoid in any significant way.
They don't give the time horizon(s) associated with their assessments.
They don't consider the second-order behavior of parties that are managing assets in areas related to their areas.
They don't consider whether history might be a poor guide for their estimates.
They don't consider the conflicting interests and incentives of the parties that direct the asset managers, and how their own institutional risks affect their willingness to manage the risks that other parties deem important.
They are sometimes based off of a regulatory view of what can/must be stated, rather than an economic view of what should be stated.
Occasionally, approximations are used where better calculations could be used. It's amazing how long some calculations designed for the pencil and paper age hang on when we have computers.
Also, material contract provisions that are hard to model/explain often get ignored, or get some brief mention in a footnote (or its equivalent).
Where complex math is used, there is no simple language to explain the economic sense of it.
They are unwilling to consider how volatile financial processes are, believing that the Great Depression, the German Hyperinflation, or something as severe, could never happen again.
(An aside to readers; this was supposed to be a “little piece” when I started, but the more I wrote, the more I realized it would have to be more comprehensive.)
Let me start with a brief story. I used to work as an officer of the Pension Division of Provident Mutual, which was the only place I ever worked where analysis of risks came first, and was core to everything else that we did. The mathematical modeling that I did in there was some of the best in the industry for that era, and my models helped keep us out of trouble that many other firms fell into. It shaped my view of how to manage a financial business to minimize risks first, and then make money.
