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Practical Advice

By Richard Skora

The Practice of Risk Management: Implementing Processes for Managing Firm-Wide Market Risk

Goldman Sachs and SBC Warburg Dillon Read. London: Euromoney Books.

The term “risk management” is relatively new to the finance industry, but the concept has been around as long as banking itself. The responsibilities of risk managers now run from measurement and validation to control and reporting. But banks and regulators have also learned that risk management is neither easy nor obvious. Indeed, many of the financial institutions that suffered large trading losses in recent years believed that they already had adequate risk management groups in place.

A new book, “The Practice of Risk Management,” written by staff at SBC Warburg Dillon Read and Goldman Sachs, tries to help readers through this difficult terrain. It is the first complete and authoritative guide to risk management for modern financial institutions, written by people who quickly recognized the importance of risk management and got it right.

The book was written by approximately 20 SBC and Goldman employees who are identified in the acknowledgments. Robert Gumerlock of SBC and Robert Litterman of Goldman conceived the book, while Denise Hayman-Loa of Goldman and Tim Shepheard-Walwyn of SBC blended the different writing styles together into a readable book.

The book, unlike most books on the subject, balances theory and practice perfectly. It explains why sound risk management involves working with different people in different locations with different mandates. Because these mandates are often vague, the first step toward sound risk management is a clear definition of responsibilities.

The book’s first section reviews some of the history of risk management and the financial industry, and explains the importance of having a risk management culture throughout the firm. A dissection of various risks is particularly enlightening. The authors label market and credit risk as business risks, for instance, because they are risks that banks deliberately take in the hope of making profit. In many institutions, these risks are now managed separately, but the book presents compelling theoretical and practical reasons for managing the two risks together.

The second section of the book discusses risk aggregation and quantitative tools such as stress testing, value-at-risk and scenario analysis. Although much has been written on VAR, the authors present a balanced discussion on the pros and cons of using VAR. They note, for example, that although most implementations of VAR assume incorrectly that returns are normally distributed, this assumption is not essential and can be corrected by choosing other distributions.

The chapter on capital is particularly interesting. It demonstrates how risk management can contribute directly to business planning. Although banks often talk about reducing risk, they also want to maximize their return on risk. The authors point out that risk managers often have the best information and expertise for measuring return on risk because they know which risks are quantifiable and which are not. With this in mind, they can help their banks arrive at various calculations using capital as a proxy for risk.

The book also draws some conclusions about the cause of the decade’s derivatives debacles. Because each fiasco was unique, the authors write, one might be tempted to try to prevent future disasters simply by patching up existing policies or regulations. But this would be a mistake. The authors make it clear that while the losses were market- and credit-related, they did not really result from market or credit risk. The main cause was the violation of the fundamental tenet of risk management—oversight. In virtually all cases, someone was claiming to be “making money” without risk, and nobody was watching. “What Barings showed in the clearest terms was that the real issue was not derivatives in general or over-the-counter derivatives in particular,” the book explains. “The real issue was about the quality of management and control required in modern international financial markets.”

One comes away from this book with the knowledge that risk management is complicated if done right. “The Practice of Risk Management” is an excellent book that should prove valuable reading for risk managers, officers, directors and regulators.

Richard Skora is president of Skora & Co., a credit risk management consulting business. His e-mail address is richard.skora@skora.com.

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