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ORIGINAL FRENCH ARTICLE: « Le contrôle des risques est juge et partie »

by Thomas Lemahieu

"Risk Management Is Both Judge and Judged"

Translated Monday 28 January 2008, by Isabelle Métral

Olivier Godechot, researcher at the French national centre for scientific research (CNRS) and a specialist on the financial industry, points out the structural flaws in the risk management network set up by major banks.

“Everybody is astounded because the transactions that hit the headlines today took place in a sector that represents the very core of Société Générale’s activity. And this bank is credited with a fairly sophisticated system of risk management. It would not have been so baffling perhaps if it had happened in the US subsidiaries, for French banks are so keen on being established in the US that that have not always been very careful as concerns the people they recruited or the money they paid out.

“From a more structural point of view, one cannot but note that this kind of scandal takes place at regular intervals; every two or three years massive losses will occur as a result of regular or fraudulent transactions (the line between regular and fraudulent being often quite fuzzy in this sector).And every time banks say they are going to take measures to ensure that this never happens again. And they do, but it is a neck-and-neck race between those in charge of risk management and ingenious financial operators who strive to bypass their ever stricter mechanisms.

“In major banks the risk-management mechanism is slightly biased in favour of front office financial operators and traders. There are three reasons for this. Firstly, the higher the risks, the higher the estimate of the costs and the higher the amount deducted from the income. Risk management serves the front office’s interests in so far as it prevents mistakes and so helps perpetuate its middle-term and long-term activities; but it is not in the front office’s interest that risk management should be too finicky because this might lead to a cut in its profits and bonuses. Endless discussions permanently agitate trading floors as to whether risk management is not recommending over-cautious approaches, where the front office will always plead for rather short term approaches.

“Secondly, there is a strong income hierarchy in the banking sector: people in charge of risk management get rather low bonuses and pay. They are highly qualified young people who have studied financial mathematics and master the adequate methods to calculate the risks attaching to all the various products. But the problem is that those who are in charge of risk management often aspire to become traders themselves: so it is their task to assess people whom they would like to be one day their bosses. This dissuades them from being too fussy for fear they might displease them.

“Thirdly, although the risk managers’ bonuses may not always directly proceed from the traders’, there is often a link between the two. In the system I was familiar with in major banks around 2000, the overall amount of bonuses that went to risk managers was a percentage of the overall amount of bonuses that went to traders. So it is not in the former’s short term interest to be too strict either.

“What I have been explaining here does not account for Société Générale’s specific case but maybe it can shed light on the whole system. And this probably holds for sub-primes too: whenever there is a new product the front office will insist on the risks not being overrated and one thing leading to another, those in charge of risk management end up being both judge and judged.”

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