Today's economic mess has led to plenty of finger pointing, but the failure of risk management models is surely a prime culprit. As it turns out, however, a fair number of risk managers were warning about the stability of financial derivatives, according to a new report from the Deloitte Center for Banking Solutions. Unfortunately, the report also says too many institutions either ignored them or mis-measured the risk.

The failure of risk management was rooted in overdependence in value-at-risk models, or VaRs. "Partially as a result of the Basel Market Risk Amendment [in 1996], major global banks widely adopted VaR in the mid-to-late 1990s, and it became the industry standard approach for measuring risk," according to Deloitte. This turned out to be a flawed approach. For one thing, VaR "is not a predictive tool-it cannot foretell catastrophe from so-called stress or tail events, as it is usually based on historical data, which creates an overly sanguine picture in prolonged boom periods."

Equally pernicious, there were not enough data for the VaR method to function as designed when it came to the financial derivatives. "There was a limitation on the data periods as these products were created," notes Edward T. Hida, co-author of the report and global leader of risk and capital management at Deloitte & Touche. "The only data available was from the boom itself." Because of the products' complexity "and the fact that they were being developed faster than the risk models could keep up, managers resorted to simplified spreadsheets to measure risk." Instead, companies "should have used stress testing and other measures across different kinds of scenarios," Hida believes.

Deloitte proposes a "back-to-basics" approach, with a strengthening of governance and monitoring. The chief risk officer "should serve as a central point. Risk management should be a robust process across functions," says Hida. Deloitte recommends empowering the CRO with veto power. "We believe the CRO must be the quarterback, that there can't be end-runs," Hida explains.

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