Risk manager explains why transparency and not complex regulations needed

In a ProPublica article, Jesse Eisinger lets a former Wall Street senior risk manager explain why transparency and not complex regulation is needed.

I've been talking to him periodically over the years about how giant financial institutions should manage the aggressive traders slinging giant sums around the world in ever more complex transactions. 

After the Senate issued a report last month on JPMorgan Chase's multibillion-dollar "London Whale" trading loss, an incident where the mathematical modeling went seriously wrong, I reached out to him again. 

That debacle encapsulates much of what is wrong about how banks manage their risk and how the regulators oversee those efforts. 

At JPMorgan Chase, the risk models hid — and were used to hide — risks from the traders and top executives. 

Too many measures and too many numbers undid the risk managers.....

Please note the reliance on models which can be manipulated to hide the risk of a trade as oppose to actually looking at the trade details.

Early in his career, Mr. Breit figured out that models for markets aren't like those for physics. They don't come from nature. It was necessary to know the math, if only so that he couldn't be intimidated by the quantitative analysts. 

But the numbers more often disguise risk than reveal it. "I went down the statistical path," he said. He built one of the first value-at-risk models, or VaR, a mathematical formula that is supposed to distill how much risk a firm is running at any given point. 

The only thing from capital markets math he came to embrace was this immutable law of nature: Investors make money by taking risk. "If it's profitable and seems riskless, it's a business you don't understand," he told me....

One of the benefits of requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details is that it lets competitor banks flag for the regulators the risks that each bank is taking.

It is a lot easier for a regulator to figure out that there is a problem if a bank says a trade is risk-less and its competitors see it as being risky.

All the while, he was on the lookout for bad trades. Most traders who get into trouble, he thinks, aren't bad guys. The bad ones, who try to cover up improper trades, are relatively easy to detect. 

The real threat, he said, comes from the "crazy ones" who really believe they've found ways to spin flax into gold. They can blow up a firm with the best of intentions.

Please note that with transparency, market participants have an incentive to scan for these trades that could blow up a bank and bring everyone's attention to them.

They don't do it suddenly. "I hate the whole Black Swan concept," he said, referring to the notion, popularized by Nassim Nicholas Taleb, that the true risks lie in unforeseeable events that occur with much more frequency than the mathematical models suggest. "It takes years of concerted effort to lose a lot." 

Yes, a big market move might reveal a fatally flawed trade, but that volatility is not the root cause of an oversize loss.

The root cause is misunderstanding the risk or a trade where the risk is hidden for a period of time (think investing in subprime mortgage-backed securities).

The problem, as Mr. Breit sees it, is that this has nothing to do with how risk management is practiced today, or what the regulators encourage. 

Regulators have reduced risk managers to box checkers, making sure they take every measure of risk and report it dutifully on extensive forms. "It just consumes more and more staff, turning them into accountants and rotting brains." 

Take VaR. In Mr. Breit's view, Wall Street firms, encouraged by regulators, are on a fool's mission to enhance their models to more reliably detect risky trades. 

Mr. Breit finds VaR, a commonly used measure, useful only as a contrary indicator. If VaR isn't flashing a warning signal for a profitable trade, that may well mean there is a hidden bomb.

Recall that VaR can be manipulated by manipulating the risk models.  Just ask JP Morgan how this played out in the London Whale trade.

He despises the concept of "risk-weighted assets," where banks put up capital based on the perceived riskiness of the assets. 

Inevitably, he argues, banks will "pile into" the same types of supposedly safe investments, creating bubbles that make the risks far more severe than the initial perceptions. 

Paradoxically, risk-weighting can leave banks setting aside the least capital to cover the biggest dangers.

Say sovereign debt having a zero risk weight.

"I could not be more disappointed," he said. "The cynic in me thinks this is all in the interests of senior management and regulators to avoid blame. They may not think they can prevent the next crisis, but they then can blame the statistics."

It is an exercise in both covering the regulators' backside when the next crisis happens and also preserving opacity so that bankers can continue to bet with taxpayer money.

Instead, Mr. Breit believes that regulators should encourage firms when they reach different conclusions on what is risky and what is safe. That creates a diverse ecosystem, more resilient to any one pestilence.

Please re-read Mr. Breit's comment because he nicely summarizes a major benefit of requiring the banks to provide transparency.  Each bank can reach its own conclusions on what is risky and what is safe and adjust their exposure to the other banks based on its own conclusions.