Managing Risk: From a Guy Who Has Been in the Trenches

This is pretty good from today's Washington Post:

The Art of Managing Risk
By Steven Pearlstein

The article is based on an interview with Vince Kaminski, a highly educated mathematician-economist who worked for Salomon Brothers and Enron as a risk analyst, and saw both get into world famous problems due to failure of risk management.
Excerpts:

As Kaminski sees it, the first problem is that the models these systems are based on, while potentially useful, have serious limitations that are too often ignored.

The data that go into them, he says, are so aggregated and "averaged" that they disregard outliers and abnormalities that turn out to be important. There are also risks -- like risk to reputation -- that are ignored because there is no data set by which to quantify them.

Moreover, by relying heavily on past patterns of behavior, they are often useless in dealing with the new products and new markets that are most often the source of the trouble.

Most importantly, Kaminski says, the models have been unable to capture the cascading effect as problems spread, confidence is undermined and people start to act irrationally.....

But even if the models were better able to predict such calamities, risk management would probably fail, Kaminski says, because risk managers are routinely ignored or overruled.

Comment: Don't be fooled into thinking that risk analysts are so often ignored because they are so often wrong. That is only one reason, but it is an important one. I figure the risk of an avian flu pandemic is about one in ten years, and the risk of a Spanish flu level pandemic is about one in 100 years. If I predict a flu epidemic is likely five years in a row, and none occurs, people are likely to ignore the next prediction, people being what they are. But the cost of a not having planned for a pandemic that does in fact occur is so much greater than that of planning for a pandemic that does not occur that we should make the latter error quite often. Politicians tend not to have century long memories!

On the other hand, I think Kaminski is right. Too often organizations have incentives for short term success, and get into life threatening crises as a result of their employees ignoring relatively improbable risks to obtain those short term gains. Prudence should also be rewarded!

It also seems to me that governments and large organizations could do much better by improving risk management, and hiring risk analysts. Financial institutions have lead the way, employing mathematical economists. But there are also experts in evaluating political risks, and bringing in social scientists to advise on social and cultural risks may be quite important in a globalizing world. JAD

Source: "Initiation and Conduct of All 'Major' Risk
Assessments within a Risk Analysis Framework", USFDA