One of the criticisms leveled at the risk assessment models blamed for many of the recent failures in the finance world is that they allowed too much room for error–that the models themselves were inaccurate. My argument is that it was not the models but operator error–sloppiness or excessive optimism–in dealing with probabilities.
Theoretical probability, a branch of mathematics that attempts to reconcile likelihood with random phenomena, is the basis of statistical analysis and other forms of quantitative analysis of large bodies of data. Most models have to accomplish the same reconciliation. Most Monte Carlo software, for instance, calls for user input of probability functions. Obviously, the models that result are only as accurate as the probability functions incorporated in them.
There have been questions raised about how appropriately the Wall Street risk analysis models used by hedge funds and banks accounted for real-world time horizons. According to at least one commentator, most of these models tried to account for very limited time horizons, weeks instead of years. Obviously, the shorter the time period a financial organization is exposed to risk, the less probability of a cataclysmic event. And the probability of the same devastating event occurring over a period of a decade or two is much greater. Unusual events are just that: they don’t occur very often.
There is no reason why the risk analysis programs that turn out Wall Street’s models could not be tweaked to account for longer time periods–unless the person doing the modeling wants–consciously or unconsciously–to develop an irrationally sunny scenario.
In a recent policy paper, the Association of Chartered Certified Accountants (ACCA) named the “failure of institutions to appreciate and manage the inter-connection between the risks inherent in their business activities” as a key factor that led to the credit crisis. The paper goes on to list the lack of influence of risk management departments and weakness in risk reporting as additional primary factors. According to the ACCA, “[Senior managers] did not understand the risks and were using risk assessment with tools which were inappropriate.”
As the global recession deepens, the ACCA paper underscores the growing emphasis on risk analysis in financial institutions and all businesses. @RISK and DecisionTools Suite software is specifically designed for risk analysis using Monte Carlo simulation and other techniques which can show virtually all possible outcomes, however unlikely. In today’s current economic climate, objective quantitative analysis of all risks cannot be overlooked.
» Read the policy paper "Climbing out of the Credit Crunch"
» Learn more about the DecisionTools Suite
» Learn more about risk analysis
Next week, one of the industry’s largest and best events will take place in Orlando, Florida. That is IQPC’s Lean Six Sigma Summit. Every year it is one of the few events that I look forward to attending. The IQPC does a great job gathering industry experts from around the world to share their thoughts, experiences, and wisdom.
This year will be a challenging year for all, so it is particularly necessary to spend travel and education funds wisely, should you be lucky enough to still have a travel budget. If you do, I would highly recommend considering this event.
There will be a cross-functional group of experts such as William Kimbrell of Blue Ocean Strategy, who will share his growth strategies in today’s over-crowded industries. Tina Huesing of Motorola and JD Sicilia, Director, Department of Defense, Lean Six Sigma Program Office will address the what I call “ Doing more with less. “ Ms. Huesing’s focus will be streamlining processes, timely execution, and waste elimination. Mr. Sicilla’s focus will be on Strategic Alignment, Consistency of Approach, Integration and Human Capital. Also, George Turner of Rock-Tenn will be speaking on professional development.
These topics have always been at the root of Lean Six Sigma but now more than ever they are very important in today’s business climate. I am looking forward to learning from these experts next week at the Summit.
Palisade will be demonstrating the latest and best in Monte Carlo Simulation for Six Sigma. If you are attending, please stop by and say hello! If you don’t attend, please contact me and I will be happy to provide you with a free trial and web demo.