Why risk management failed

No society can thrive without taking risk. We should not respond to the sub prime crisis by swearing solemnly. “Never again shall we take risk.” Rather, the efforts must be channelized towards finding loopholes in the current risk management framework, and strengthening systems and processes. Such efforts will encourage companies to take risk once again and pave the way for the return of the animal spirits.
But before we gaze into the future, it is a good idea to look at the recent past. In the months before the crisis, many banks claimed to have put in place sophisticated risk management systems. Yet these systems failed to deliver and many a bank landed in a mess after the sub prime crisis started to unfold. Why did this happen?

Risks went out of control for various reasons. To start with, mechanical approaches were followed by many banks with human judgment and intuition being completely ignored. For example, credit ratings were used to justify heavy investments in the super senior tranches of CDOs. In some cases, the top management did not become sufficiently involved while dealing with risk. In the name of delegation, they abdicated their responsibility. We saw this in some detail in the case of UBS in Chapter 10. Sometimes, the top management did raise the right questions. But they did not follow through with appropriate actions. In other cases, traders fooled risk managers into believing that all the rules were being followed. To a large extent they were able to do this by hiding behind technical jargon and sophisticated quantitative models. Only banks like Goldman Sachs, JP Morgan and Toronto Dominion (of Canada) where the top management asked the right questions at the right time and took principled decisions, escaped relatively unscathed.
In short, the ability of the top management to get involved and ask the right questions at the right time will have a crucial influence on the quality of risk management in an organization.