Evolution of risk management in finance from World War II to derivatives

¶ … History of Risk

The historical development of risk management grew out of the need for investors to insure their investments and to hedge against overexposure/risk. For example, today farmers may purchase weather derivatives to protect themselves against inclement weather that could adversely affect their harvests (Matei, Voica, 2011). Essentially, risk management is supported by a number of pillars, such as the exercise of due diligence, oversight, the establishment of clear goals and guidelines, and means of accountability. Mathematic formulas and international regulations also became important to financial markets as more and more risk management strategies were implemented in the 1980s (Dionne, 2013). This paper will discuss the evolution of risk management and show how the pillars of risk have stayed the same though the strategies have differed.

Bernstein (2003) states that risk management evolved out of the need to assess chance and probabilities -- and was used by individuals who understood the importance of mathematics in architecture, science, and technology. But underlying all risk management is a common sense approach that depends upon a habit of virtue: for example, it was one of the pillars of risk management, Nobel Laureate Harry Markowitz, who "demonstrated mathematically why putting all your eggs in one basket is an unacceptably risky strategy and why diversification is the nearest an investor or business manager an ever come to a free lunch" (Bernstein, 2003, p. 6). Other pillars, such as Keynes, or Mises, or Foucault or even Adam Smith, have approached the underlying principles of risk management from different perspectives and with different outlooks -- but essentially the objective is the same: and in the world of finance that means to devise a safety net for investors.

As Dionne (2013) notes, the actual formal study known as risk management today "began after World War II" when a new international system of commerce, finance, regulation, and transaction was being erected (p. 147). Market insurance was expensive for many and alternative ways of hedging were wanted as a result. Thus arose derivatives, which became both a vehicle for hedging and for trading. Weather derivatives for instance are one such example of how the derivatives market, meant to be a way for risk managers to hedge, became a tool for traders and manipulators: the "manipulation of derivatives" (Lemus, 2014, p. 41) shown by Enron, for example, is just one instance of this coming to pass and still researchers view "models" as reliable when the contrary has been shown in the face of a deregulated derivatives market. The sophistication involved in engineering trades and hiding losses beats the purpose of the derivatives market and makes it just another vehicle for Ponzi-type scheming.

But Ponzi-type scheming is one of the reasons that risk management needs special consideration: sometimes what passes as risk management is actually nothing more than manipulation, control, and outright scheming by one party to the detriment of another. Nowhere is this more evident in the individuals who pass as pillars of risk today: the grandfathers of the Federal Reserve.

The ultimate pillars of risk management may be found in the men who gathered at Jekyll Island to "fix" the economy: they were Senator Nelson Aldrich, Henry Davison of J.P. Morgan, Paul Warburg of Kuhn, Loeb, among others. They crafted the charter that would ultimately come to be known as the Federal Reserve Act of 1913. It would effectively give the banks the right to print money and lend it to the government with interest. This was the greatest act of "risk management" ever in the in United States. That it did not work was soon evident in the stock market collapse of 1929. Ever since, market players and makers have attempted to understand "risk management" and use it to hedge investments and provide adequate insurance for themselves, while others have used the notion of "risk management" exploitatively (Charles Ponzi is the pillar of risk management exploitation in this sense -- with many followers, one most notably and recently being Bernie Madoff). The creation of derivatives trading is one such way in which "risk management" in the financial world has created opportunities for both hedging and exploiting market positions (Dionne, 2013). While derivatives have offered on the one hand a degree of "insurance" for investors, they have opened the door for even more risk, as the 2008 crisis showed (Lewis, 2010).