Anticipating the Unthinkable: The Adequacy of Risk Management in Finance and Environmental Studies

Abstract:     
The purpose of the Article is to consider the role of risk management in the current financial crisis. My argument is that risk management in systemically important financial institutions failed, which contributed to the recent collapse of the financial system. For a number of reasons that I explore, risk management did not fulfill its purpose, which was to prevent financial institutions from suffering the kinds of losses that they experienced in the crisis. This Article identifies these risk-management failings and offers remedies to them. At times, environmental risk management, which deals with extreme environmental risks such as global warming, inspires my discussion of financial risk management.

The Article proceeds as follows. Part I briefly identifies the financial crisis. Part II then discusses the practice of risk management in financial institutions and identifies its failings as revealed by the financial crisis. These failings include problems in risk management modeling, questions about the reliability of the models themselves, failures to supplement models with other risk management approaches, governance problems in financial firms regarding risk management, and imperfect regulatory oversight of risk management in these firms. Part III considers the lessons that can be drawn from the financial crisis and identifies improvements to risk management that would avoid a repetition of the crisis. This Part also highlights obstacles to risk management reforms, which include compensation practices in financial institutions and, more generally, human limitations in dealing with complexity. In addition, it provides a course of action for risk management in light of these obstacles.

Number of Pages in PDF File: 26

Keywords: risk management, risks

JEL Classification: G28, K23

Accepted Paper Series