Financial Risk Modeling

/ September 12th, 2011/ Posted in Social, Economic and Financial Risk / No Comments »

financial-risk-modelingDo financial models support corporate values?
“My goal for the workshop is to understand: How do data modelers view the question of risks that cannot be readily quantified?  It would be helpful to discuss how financial and statistical modeling should be related to strategic planning. It would be helpful, too, to examine critically the role that assumptions and corporate values plays in doing modeling.”

Those were the goals I set for myself not only for the RIMS workshop back in March 2009: ” Risk Analysis Tools” in Miami, but also for the May 2010 session held in Toronto: “Finance for Risk Managers”.

Validating the model’s assumptions
It’s at least comprehensible that actuaries, and others with reliable historical data for certain types of risk, should manage risk with quantitative methods. Quantity surveyors, for example, will inform a construction risk assessment on the range of costs associated with discrete operations and associated physical elements (e.g., foundation, structural steel frame).

Still, these calculations, the economic forecasts that underpin them, and the range of cost of risk given by Monte Carlo simulations, are as reliable as the assumptions that they rest on (even leaving aside the question of political and other pressures that make construction estimates, for example, notoriously unreliable).

So, in quantitative risk methods, one issue is that of validating assumptions.

Determining the model’s scope and management context
Another issue is determining which processes any particular model comprehends. Does the data model somehow support corporate values and long term objectives, or can it be overwhelmed by core activities outside its scope? (See my post: Economic Crisis: Why ERM Did Not Fail).

Market consultant Allyson Heumann also touched on the role of greed and sanctioned profit taking in her remarks back in September 2008:

All the amazing Models created by Mathematicians and Software Engineers did not fail because they were inaccurate, they failed because the Risk Managers did not have the common sense or drive to address the growing and problematic OTC portfolios they were hired to manage.

In view of the lack of oversight and over-reliance upon financial models, risk experts are going back to first principles. Commentator Bennett Voyles said, back in April 2008:

CEOs discovered too late that they had traded their old-fashioned blind spots for a new kind of blindness: one induced by the comfort of new technology and elaborate quantitative models […]

With such disasters [Société Générale’s US$7 billion rogue trading loss] as a backdrop, many risk management experts say it’s time for companies to revisit the fundamentals. It may be a useful exercise—while some complex risks certainly demand technology and sophisticated models, most threats confronting a business can be dealt with using humbler means. (2)

Enterprise Risk Management is not then confined to narrowly conceived data models, nor should it be construed merely as financial hedging. ERM is also a matter of operational processes and the values they support.

At the 2009 Infonex conference in Ottawa “Public Sector Risk Management”, I addressed the economic crisis in my keynote. I made the point that, in the climate ensuing after the initial financial crisis, it may be easier for risk managers to get the authority to oversee data analysis and financial models, to review their scope and assumptions, and consider them in a wider context of corporate goals and values.

In my most recent address at the Infonex event Public Sector Risk and Controls, Victoria, June 2011, I repeated the message. In my talk called “Overcoming Fragmented Risk Management Culture”, I said ERM has to comprehend and integrate risks in all domains, and investigate the assumptions in financial models.


(1) Huemann, Allyson “Calling All Risk Managers”,, 24 Sep 2008

(2) “Overlooking the Obvious – Have technology and math blinded companies to the dangers at their feet?” Bennett Voyles, CFO Asia, Apr 2008 [CFO Asia was discontinued but Voyles’ text was re-posted in this blog.]

[Revised. Originally published 22 Feb 2009.]

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