In sports, unforced errors are "mistakes made by players that occur independently of the opponent's action. They arise when the athlete has the opportunity to make a successful play but fails due to their own shortcomings, which can be attributed to errors in technique, focus, or judgement".
This concept of unforced errors can also be applied to banking, trading, and risk management. Here, a mistake occurs due to a poor decision without any direct pressure from external factors or forces, such as competition or changes in the regulatory regime. It is simply a lapse in judgment, operational inefficiency, or failure to follow the processes established by the institution.
For example, this might involve compliance errors where regulatory requirements or internal policies are not met. This is down to an oversight or lack of due diligence, even when the bank has the resources and knowledge to avoid such an issue.
It can also include operational mistakes such as entering incorrect data, failing to meet deadlines, and mismanaging customer accounts.
Examples in trading include execution errors where traders execute a trade incorrectly – buying or selling the wrong amounts or currencies, mixing up buy orders with sell orders, or placing an order at the wrong price due to a lack of attention or discipline.
Emotional decision-making is another factor, where a trader deviates from their original strategy, driven by emotions such as fear of missing out, overconfidence, or loss aversion.
In risk management, we might see a failure to follow risk controls, ignoring warnings from risk models, or a lack of diversification, resulting in concentrated portfolio risk.
These are a few of the unforced errors I've seen:
The realisation of asset swaps being held in an accrual environment to boost short-term profit and loss. The cause is management pressure to increase the business’s bottom line.
Hedging long-term risk with shorter-dated contracts, anticipating that the hedge can be rolled over in the future at favourable prices. This assumes future conditions will be like the past, which may or may not happen, thereby increasing the risk of losses and reducing the hedge’s effectiveness.
Investing in fixed-interest securities denominated in a foreign currency and hedging the risk using currency swaps. This strategy ignores potential regulatory changes involving capital and counterparty risk.
Building up a portfolio of assets that appears to give a good return without fully appreciating how the risks could evolve. Examples include equity release portfolios and emerging market bond portfolios hedged with swaps. The nature of these underlying assets is complex and long-dated, and they may be subject to market illiquidity should they need to be sold.
Buying and selling in the short term to benefit from market opinions, while failing to factor in the transaction costs.
Building a new pricing model and entering numerous trades based on this new model without proper oversight as to whether it is accurate and robust.
Ignoring basis risk. (Remember Base versus admin rates)? This failure to deeply consider the relationships between spreads used in pricing and the factors driving them resulted in a concentrated portfolio of loss-making deals. Basis risk of some type is embedded in most financial institutions.
Holding onto investments that fall below credit criteria, in the hope that they will mature in the future and repay the principal sum.
Adding higher-yield assets to liquidity portfolios because they are eligible from a regulatory standpoint while ignoring the potential impact of market disruption. This is especially concerning when these assets need liquidating during a crisis.
Increasing risk limits because the underlying trades or assets are generating strong returns, only to discover that when things go wrong, the losses exceed anything experienced before.
Looking at this sample, I can see some common themes.
There is an over-reliance on assumptions about future market conditions. Whether it is hedging long-term risk with short-term contracts or building a complex portfolio of assets without fully appreciating or exploring how risks might evolve. Simply extrapolating current favourable conditions is not a sound way of making decisions.
A second trend is the prioritisation of short-term gains at the expense of long-term stability. Traders and institutions often focus too heavily on immediate profit because that is how they are incentivised, which leads to downplaying potential future risks and leaves portfolios vulnerable to shifts in market conditions. Furthermore, many of the errors involve insufficient or ineffective risk management, as short-term performance has overridden longer-term considerations. There is also a lack of deep analysis and oversight to integrate robust controls that adapt to market dynamics and enforce changes to positions.
Regulatory missteps also play an important role, where potential changes in the regulatory environment have not been fully accounted for, leading to higher capital charges in the future. This reflects a lack of forward-looking risk management.
Finally, these issues are often compounded by emotional decision-making, driven by pressure from management or market sentiment.
Whilst hindsight is a wonderful thing, two questions capture many of the unforced errors I have mentioned:
"How are we prepared for changes in the market or regulations, and what plans do we have if things don’t go as expected?"
"Are we taking any big risks for short-term gains, and how are we making sure these decisions are safe for the long term?"
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