Risk Management 2.0 stillborn

An article from Wharton "Re-thinking risk management: why the mindset matters more than the model" is a rambling essay about financial risk management, mostly. There is a strong undercurrent that the global financial crisis/recession of recent years was created by flaws in risk management practices at the banks and other financial institutions, in other words the infamous sub-prime mortgage fiasco and systemic issues with the financial industry relating to the highly-leveraged and extremely risky financial instruments that were all the rage.

"Knowing the historic risk profile, we made investment decisions. But historic data does not shape the future anymore, given how rapidly the world is changing. We usually look at the known issues and make a nice diagram with probability on one axis and impact on the other. That’s Risk Management 1.0. Risk Management 2.0 is [going] beyond the known issues to look at the links and interdependencies. You can no longer look at the risks independently of each other."

"Historic data does not shape the future anymore"? That's a remarkable assertion! It may possibly sum up the depressing mood within the financial risk management community, but it is certainly not representative of the rest of the universe. It is patently and provably false in fact.

I was thinking about this last night as I watched "Margin Call". The film tells the story of an investment company that finally realized it was too heavily committed to highly-leveraged mortgage-type investments, and took the momentous decision to sell out of the market at break-neck speed. There's a fair bit of artistic licence, but the film does put across the years of outrageous profitability/greed and the final two weeks of increasingly extreme instability in the markets, leading to the fire-sale and (as we know now) market collapse followed by the global financial crisis.

The boom-bust periods may vary but it hardly takes a rocket scientist to figure out the general pattern. At that level, historic data virtually guarantee that we are currently in the early stages of the next greed-fueled boom, and that as sure as night follows day, it will end in yet another bust.

Call me a cynic but I rather suspect that if 'Risk Management 2.0' simply attempts to link risks into a bigger picture, it won't avoid the inevitable.