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Risk management means taking the risks your competitors take.

It is frequently said nowadays that the risk management function in Wall Street firms failed because of lack of accurate and credible information and/or executive incompetence. However, the piece of information that generally overwhelms all other information about the riskiness of an investment is whether competitors are taking the risk. Consider this reflection of completely ordinary business behavior from Rubin's Teflon Finally Wears Off:

Mr. Rubin was deeply involved in a decision in late 2004 and early 2005 to take on more risk to boost flagging profit growth, according to people familiar with the discussions. They say he would comment that Citigroup's competitors were taking more risks, leading to higher profits.

The problem isn't limited to investments, of course. Businesses everywhere are having frequent and agonizing meetings of their credit committees to decide whether to accept, for example, the next order for parts from GM or Acme Widget when they have been refused COD, credit insurance, and factoring. Or whether to ship to a large retailer with disturbing credit scores and rumored to be on the edge of BK. If they don't take the order, the consequences for their business may be dire, permanent loss of the customer, for example. Usually, they will wring their hands and take the risk.

Credible technical information about risk is not enough. There must be prudential regulation to keep financial firms "too big to fail" from following the herd onto dangerous ground. I am much more upset about Rubin's failings as a government official than I am about his performance at Citi. The scandal of the subprime mortgage meltdown is not that a few bad apples committed crimes or deceit but that practically everything that happened was perfectly legal.

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  • Response
    Interesting post. I like your blog and will add it to my RSS Reader. Thanks for the great content.

Reader Comments (2)

Sometimes it's really that simple, isn't it? I feel a little stupid for not thinking of this myself/earlier, though.

July 29, 2009 | Unregistered CommenterKerstin-Alfons

Hey, ok, I get it, I guess - but does this really work?

July 31, 2009 | Unregistered CommenterMartin-Maers

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