Risk management in finance : six sigma and other next generation techniques.

Abstract

According to the Book of Genesis, God decided to destroy the world in a great flood because of mankind’s sinful and wicked ways. But God knew Noah was a righteous man and decided to spare him and his family. He instructed Noah to build an ark, a very large vessel of no economic or recreational value, to hold Noah’s family and representatives from the animal kingdom. While there was no business case or quantitative or qualitative risk model to justify this endeavor, Noah decided to mitigate his risk and build the ark. We can imagine that conventional wisdom of the time condemned Noah for such a foolish waste of time and money and that community and media reaction would have been very negative as well. Noah’s risk mitigation proved to be quite timely as conventional wisdom and traditional risk management failed in a catastrophic manner. Noah survived the great flood and began rebuilding civilization after the waters of the great flood receded. Some time later, Toyota, a Japanese car manufacturer, decided to build a hybrid car to mitigate the risk of rising fuel prices and need to curtail greenhouse gases. As with Noah, there was no valid business case or accepted risk model to justify such a foolish waste of time and money. Conventional wisdom of the time was that large gas-guzzling vehicles were the safe choice. They were all the rage and generated very high returns. Fuel-efficient cars were much less profitable and lacked the status and prestige of larger and more muscular vehicles. As with Noah, we can imagine industry leaders making fun of such a wimpy car that would appeal only to a small number of tree-hugging environmentalists on the American West Coast. Again, conventional wisdom and traditional risk management failed in a catastrophic manner. The energy crisis and push for green energy made the little hybrid car a huge success and helped propel Toyota into a leadership position as the most profitable and best-capitalized manufacturer in the industry. Conversely, their American competitors are now on the verge of bankruptcy and capitalized below their World War II levels. A few years ago, Wells Fargo decided that the risk inherent in the subprime mortgage market was unacceptable, and minimized their exposure. Again, the conventional wisdom and accepted quantitative and qualitative risk models argued against their conservatism. Profit margins for subprime mortgages, mortgage-backed securities, and credit default swaps were much higher than the more traditional vehicles and instruments offered by banks. Government regulators, rating agencies, and business media all promoted the subprime market, either directly or indirectly. This created shareholder pressures to jump into this very lucrative market. As with Noah and Toyota, media and public reaction was negative to Wells Fargo’s conservative approach to risk mitigation. As with Noah and Toyota, we can imagine industry leaders making fun of a bank with a stagecoach as a corporate symbol—too sentimental and old fashioned to grasp the huge profit potentials in subprime.