Weighing Risk: Not Sexy, But It Matters

Since the financial crisis, there has been a growing emphasis on stress testing. After being forced to undergo regulatory stress tests, executives at the nation’s biggest banks began to see the light. At first, the data the Fed requested seemed extreme, but then bankers saw how useful it was to know what would happen to their institution’s balance sheet and profits if say, the U.S. unemployment rate soared to 13 percent. Since then, systems are being overhauled to deliver the kind of data the Fed is requesting and more.

“It’s absolutely the most important thing that any company can do — and I would say that whether it was financial or industrial — to be able to run through a “what-if” scenario,” Leach noted.

But stress testing is an art. The doomsday scenarios risk managers test for have to have some credible basis. An asteroid hitting the earth — “You can’t manage to that,” said Leach. On the other hand, what about testing the effect of a 50 percent move in the premium to government interest rates paid by corporate borrowers? Sounds improbable, but Leach pointed out it has happened four times in the last decade.

“If your stress scenario is that rates move 50 percent, then you really have not done much,” said Leach.

While banks have become more attune to stress testing for events like the disintegration of the euro, or an Israeli attack on Iran, these models are not the only tools they use to assess risk.

The concept of Value at Risk or VaR is one of the most hotly debated in risk management circles. It’s a measure of how much a bank could lose on any given day with the investing positions it has taken. Bankers accuse the press of making a simplistic assumption that they rely solely on VaR to determine their risk profiles. Leach says VaR is useful for looking at every day risk – something stress testing is not meant to do.

Wall Street continues to struggle with measuring and managing risk, but since the financial crisis, it has set the bar a lot higher.

“What you want to get across to people in the firm who take risk, is that you want them to take intelligent risk,” Leach said.

-By CNBC's Margaret Popper and Kate Kelly
@poppermand @katekellycnbc