Conventional wisdom has it that compensation in the financial industry is apparently responsible for much of the credit crisis. For instance, Paul Krugman states that “reforming bankers’ compensation is the single best thing we can do to prevent another financial crisis a few years down the road.” Unfortunately, the facts are stubborn and they do not fit this conventional wisdom.
In press accounts and popular commentaries on the current financial crisis, a constant refrain is that the risk management function in many of the world’s largest financial institutions has failed to carry out its responsibilities. To cite just one example, an article in the Financial Times declares “it is obvious that there has been a massive failure of risk management across most of Wall Street.”
I have written an article in which I challenge or, at least qualify, this assertion by examining what it means for risk management to fail. This article is available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1278073 . My main aim is to show that the fact that an institution makes an extremely large loss does not necessarily imply that risk management failed, or that the institution made a mistake. Getting the diagnosis right is important because the changes in risk management that take place in response to the crisis could be the wrong ones. Most troubling, top executives and investors could continue to expect more from risk management than it can actually deliver. With this goal in mind, I show when bad outcomes can be blamed on risk management and when they cannot. In so doing, I offer what amounts to a taxonomy of risk management failures.
I uploaded a new paper with Nicole Boyson and Christof Stahel titled “Hedge fund contagion and liquidity”. In this paper, we investigate when different hedge fund styles perform poorly at the same time and whether poor performance across hedge fund styles is accompanied by poor performance in the broad markets. Our empirical work uses returns […]