TYPES OF RISK.

Over the weekend, the Times Magazine had a useful article on the role risk measurement tools played in the financial crisis. The question of the piece is simple: Did Value at Risk -- the central risk measurement algorithm -- prove helpful or harmful? But the answer is complicated. VaR was irrelevant when the crisis hit. It's not that it missed the problems so much as it didn't try and notice them. It was never built to measure highly improbable, totally catastrophic events. Insofar as it had a role in the meltdown, its existence potentially lulled traders into a false sense of complacency. But that wasn't the measurement's fault. It's human nature. When nothing bad has happened for 20 years, you begin to forget that bad things can happen. More to the point, the competitive pressures align to encourage you to ignore the fact that bad things can happen.

At the height of the bubble, there was so much money to be made that any firm that pulled back because it was nervous about risk would forsake huge short-term gains and lose out to less cautious rivals. The fact that VaR didn’t measure the possibility of an extreme event was a blessing to the executives. It made black swans all the easier to ignore. All the incentives — profits, compensation, glory, even job security — went in the direction of taking on more and more risk, even if you half suspected it would end badly. After all, it would end badly for everyone else too. As the former Citigroup chief executive Charles Prince famously put it, “As long as the music is playing, you’ve got to get up and dance.” Or, as John Maynard Keynes once wrote, a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.”

As Henry Blodgett has written, you have to make a distinction between types of risk. "Investment risk is the risk that your bets will cost your clients money. Career or business risk, meanwhile, is the risk that your bets will cost you or your firm money or clients." The problem with the VaR was not simply that it didn't measure black swans. It's that it only measured one dimension of risk. It measured daily risk to your investors. It did not measure daily risk to your career. That meant it missed the risk that unforeseen black swan events posed to investments, yes, but it also meant that it missed the more predictably risk of being fired if you refused to follow the bubble like all you competitors. It might have been imperfect in measuring risk to portfolios, but that was a minor flaw compared to its total inability to measure risk to careers. And so it missed a powerful influence on trader behavior.