How to Manage Risk Better – or the JP Morgan ‘Surprise’

No one likes surprises - at least in finance – so MSCI has set out guidance on how to best avoid them.

(May 25, 2012)  —  The key to good risk management is using the right measures, and the right number of them, according to MSCI’s research division.

Using too few measures you might miss something; using too many and you will become lost in the detail, the firm asserts in a paper this month entitled: “The JP Morgan Surprise and the Need for Risk Governance”.

The author, Christopher Finger, Executive Director of Applied Research at MSCI, said ‘surprises’, such as the $2 billion dollar loss reported by JP Morgan earlier this month, were despised by all parties: banks, regulators and investors.

Finger said: “Avoiding surprises is a central aim of risk management. This is not an aim to be achieved by suppressing all risk-taking; rather it is to be achieved by making sure that risks are acknowledged, that risks are aligned with the views of those taking them, and overall that the overall risks are consistent with the firm’s risk appetite.”

Although the paper focusses on the JP Morgan trading loss and how it might have been avoided, the rules on risk management ring true across the whole financial spectrum from banks to the end investor hoping to meet their liabilities.

The paper continues: “If all risk measures require assumptions, then all risk measures have weaknesses. The only answer… is to employ multiple measures each based on a different set of assumptions.”

However, Finger adds that too many measures can often be even more unhelpful as at least one measure will be listened to and digested whereas too much information can lead to the issue being avoided entirely.

“The art of risk management, then, is to focus on enough risk measures, but no more,” Finger claims.

Finally, Finger says that models are no substitute for human input on risk management.

“Models can be useful, but they sometimes need to evolve and always need to be monitored. People manage risk, after all, and those who do can take lessons from these events,” he concluded.

Finger presented the paper at an MSCI client summit held in London this week.

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