10:36 am - Wednesday June 28, 2017

Principles of risk management

Introduction

Any activity is associated with risk – a loss or gain.

More so, in trade and commerce, due to complex nature of transactions and the individual characteristics of the players, commodity, practices, customs, currencies.

Like in any other human activity, risk cannot be avoided in trade and commerce. However they can be managed to reduce the impact of loss or maximize gains.

Risk management has been defined in a variety of ways. Although they vary in detail, most definitions offered thus far focus on two points: risk management is concerned principally with risk and that it is a process or function that involves managing those risks.

Thus risk management can be defined as an approach to dealing with risks and managing them. It deals with designing and implementing procedures that minimize the occurrence of loss

Risks and financial institutions

Financial institutions face interest rate risk when the maturities of their assets and liabilities are mismatched.

They incur market risk for their trading portfolios of assets and liabilities if adverse movements in the prices of these assets or liabilities occur.

They face credit risk or default risk if their clients default on their loans and other obligations.

They encounter liquidity risk as a result of excessive withdrawals of liabilities by customers.

Modern day financial institutions engage in significant amount of off balance sheet activities, thereby exposing them to off balance sheet risks – changing values of their contingent assets and liabilities.

If financial institutions conduct foreign business, they are subject to foreign exchange risk. Business dealings in foreign countries or with foreign companies also subject financial institutions to sovereign risk.

The advent of sophisticated technology and automation increasingly exposes financial institutions to both technological and operational risks.

Financial institutions face insolvency risk when their overall equity capital is insufficient to withstand the losses they incur as a result of such risk exposures.

The effective management of these risks – including the interaction among them – determines the ability of modern financial institutions to survive and prosper over the long run.

Risk management is a scientific approach to the problem of risk, which has as its objective the reduction and elimination of risk facing the financial institutions.

Risk management is now recognized as a distinct and important function for all financial institutions.

Many financial institutions have highly trained individuals who specialize in dealing with risk.

In some cases, this is a full time job for one person, or even for an entire department within the financial institution.

Those who are responsible for the entire programme of risk management are risk managers

Although the term risk management is a recent phenomenon, the actual practice of risk management is as old as civilization itself.

In the broad sense of term, risk management is the process of protecting one’s assets.

In the narrower sense, it is a managerial function of business, which uses a scientific approach to dealing with risks

As such it is based on a specific philosophy and follows a well defined sequence of steps.

The emergence of risk management was a revolution that signaled a dramatic shift in philosophy due to the development and growth of decision theory, with its emphasis on cost benefit analysis, expected value and the other tools of scientific decision-making

Decision theory is a branch of management science, a broad discipline that includes all rational approaches to decision making that are based on the application of scientific methodology.

Decision theory is applied to complex problems in which the outcomes of the various choices are uncertain including situations in which the probabilities of outcomes are unknown

As it exists today, risk management represents the merging of three specialties: decision theory, risk financing and risk control.

Decision theory has its roots in operations research and management science.

The risk-financing specialty came from the disciplines of finance and insurance.

And risk control specialty represents the merger of traditional safety management and loss prevention.

Risk management defined

Risk management is concerned principally with risk and it is a process or function that involves managing those risks

Thus risk management is a scientific approach to dealing with risks by anticipating possible accidental losses and designing and implementing procedures that minimizes the occurrence of loss or the financial impact of the losses that do occur

It may be noted that risk management is defined as a scientific approach to the problem of risk

Although risk management seeks to proceed in a scientific manner it must be admitted that risk management is not a science in the same sense as the physical sciences are, any more than management itself is a science

Risk management derives its findings from the general knowledge of experience, through deduction and from precepts drawn from other disciplines, particularly decision theory.

Although risk management is not a pure science, it uses a scientific approach to the problem of risk.

This scientific approach distinguishes risk management from earlier approaches to risk decisions.

Often the institutional, legal and societal pressures dictate risk management in the business world.

Business managers have found themselves responsible for the management of a financial institution’s risks without any notion of how to go about the process.

Risk management by approaching the decisions related to risks scientifically is a solution to the challenges in dealing with risks.

In fact the distinguishing feature of risk management is the way in which it approaches the decision making process.

Risk management seeks to make the best decision about how to deal with a particular risk

Measurement of risk

Identification and understanding implication of risk is the first step in embracing or avoiding risk.

Measurement of risk is a very important step in risk management.

Some risks can be easily quantified like exchange risk, interest rate risk and market risk. They can be measured using mathematical or statistical tools like value at risk etc.

Some risks like country risk, operational risk, and reputation risk cannot be mathematically deduced. They can only be qualitatively compared and measured.

Therefore it is very important to identify and appreciate the risk and quantify.

Risk management tools

Our above definition of risk management states that it deals with risk by designing and implementing procedures that minimize the occurrence of loss or the financial impact of the losses that do occur

This indicates the two broad techniques that are used in risk management for dealing with risks

In the terminology of modern risk management the techniques for dealing with risk are grouped into two broad approaches: risk control and risk financing

Risk control focuses on minimizing the risk of loss to which the firm is exposed and includes the techniques of avoidance and reduction

Risk financing concentrates on arranging the availability of funds to meet losses arising from the risks that remain after the application of risk control techniques, and includes the tools of retention and transfer

Risk control

Broadly defined, risk control consists of those techniques that are designed to minimize at the least possible costs, those risks to which the organization is exposed.

Risk control methods include risk avoidance and the various approaches at reducing risk through loss prevention and control efforts

Risk avoidance

As the name itself indicates, risk avoidance focuses on a negative rather than a positive approach.

Personal advance of the individual and progress of the organisation require risk taking.

If avoidance is used, the organisation may lose vast opportunities for growth and hence may not be able to achieve its primary objectives.

Avoidance takes place when decisions are made that prevent a risk from even coming into existence. Risks are avoided when the organisation refuses to accept the risk, even for an instant.

A classic example of risk avoidance could be a decision made by a business firm not to permit its executives to travel by air because of the inherent risks. It may also decide against computerizing its operations because its employees may be exposed to possible eye defects by staring at computer screens.

Though we cannot completely decide against risk avoidance as a control measure, we can still practice risk avoidance in circumstances when the exposure has disastrous consequences and when the risks cannot be reduced or transferred. Generally such risks will have very high frequency and severity.

Therefore risk avoidance can be used when there is no other alternative. In some contexts, it is also referred to as risk prevention

Risk reduction

Any effort or technique that has a focus to reduce the impact of loss or the potential severity of loss can be brought under risk reduction

One can easily differentiate the efforts aimed preventing losses (risk avoidance) and the efforts aimed at minimizing the severity of losses (risk reduction)

Installation of sprinkler systems for controlling fire mishaps can be cited as one risk reduction technique.

Risk financing

Broadly speaking, risk financing consists of those techniques that focus on arrangements designed to guarantee the availability of funds to meet those losses that do occur and it takes the form of risk retention or transfer.

Risk assumption (retention)

Risk assumption or retention can take place either intentionally or unintentionally. Unintentional retention occurs when a risk is not recognized.

Risk retention is a technique in which exposures that cannot be avoided, reduced or shifted are assumed or retained. When nothing can be done about a particular exposure, the risk is retained.

Risk retention can be voluntary or involuntary. In voluntary retention risk is retained without making any effort to avoid, reduce or transfer it. It depends upon the risk appetite of the assumer or retainer. Involuntary retention occurs when it is not possible to avoid, reduce or shift the exposure.

Risk transfer

In risk transfer, the risk is transferred at a cost. In insurance business the primary approach is risk transfer.

Risk transfer can also be achieved through the process of hedging. In this the individual protects his exposure in a particular asset against the risk of price changes.

Foreign exchange futures and commodity futures markets have been created to facilitate the players and the farmers to protect themselves against changes in the foreign exchange rates of currencies and also the price of commodities.

Risk management process

Risk management is a dynamic process needing constant focus and attention.

There can be no single prescriptions for all times. Decisions have to be made at short notice. Positions may have to be acquired and shelved. Views may have to be changed very often.

Though all these may point out the complex nature of the risk management process, actually it is an interesting game indeed. It is virtually a hide and seek game between the players and the risk or uncertainty itself in the market place.

Who will win? Who will lose? It all depends on the alertness of the market participants. However there can be no permanent winners or losers in any market.

Let us now delve into the very process of risk management.

First step involves identification of all areas of risk.

Second step involves evaluation of all these risks

Third step involves setting various exposures for the types of business, mismatches and counterparties

Fourth step involves issuing clear policy guidelines and directives for all those dealing with risk in the organisation

Fifth step involves periodic monitoring and review

Top management responsibility

In risk management exercise, the top management has to lay down clear cut policy guidelines in quantifiable and precise terms – for different layers, line personnel, business parameters, limits, etc

It is very important for the top management to plan at the macro level, what the organisation is looking in for any business proposition or venture and convert these expectations into micro level factors and requirements for field level functionaries. Only then they will be able to convert expectations in to reality.

A very important assumption is made but normally omitted or over looked is provision of infrastructural support and conducive climate.

Therefore the top management has a greater role to play in any risk management process

Do you know?

Every bank claims that their ATM (automated teller machine) network is totally dependable. In fact some even brag in their promotional campaign that their ATMs provide Any Time Money.

During September 2001, for almost five hours a leading international bank’s 2000 plus strong nationwide ATMs, its debit card system, and online banking functions were knocked out in the US, sending customers scrambling for other ways to get their money. After briefly coming back to life, the system crashed once again. It took more hours now to make these ATMs up and running.

During this period, customers who tried to make purchases with the bank’s debit cards or who tried to bank on line were turned away. The outrage was unusual in its scale and length. It left the bank’s employees scratching their heads over what went wrong. Of course finally the official answer was provided as software problems – it was not elaborated.

However industry experts bet that computer systems on which banking networks are based are ageing – and trouble shooters who can fix problems quickly are becoming rarer. In fact, most banks run on mish-mash of systems slapped together after years of computer upgrades and bank mergers. They are made all the more confusing by the profusion of computer languages than run the internet. Most of them are in compatible with their mainframe predecessors……….

Source: The Wall Street Journal, 6th September 2001  by Paul Beckett and Jathon Sanford

A short cut to remember….

How to recall the various risk management tools?

Just remember CAR AND FAT

C – Control

A – Avoid

R – Reduce

F – Finance

A – Assume (retain)

T – Transfer

Quotable quotes

Financial risk management is not about avoiding risk.  Rather, it is about understanding and communicating risk, so that risk can be taken more confidently and in a better way.

David Koenig
The Professional Risk Manager Handbook

I think ‘risk manager’ is a misnomer.  I don’t manage the risks – it’s up to the businesses to manage the risks.  What we’re here to do is to provide assurance that risks are being monitored and managed.

Kate Boothroyd
Head of Risk Management
Treasury and Risk Management, November 2004

… a company may die a quick death if it does not manage its critical risks, it will certainly die a slow death if it does not take enough risks

James Lam
Enterprise:  Risk Management
New York:  Wiley (2003)

By definition, if you’re looking for ships across a certain strip of ocean, the enemy will attack you somewhere else.  That’s the problem with risk management – what by definition can hurt you is what you expect the least, which is not the thing that people expect will hurt them.

Nassin Taleb
Derivatives Strategy, March, 2001

Risk managers are often portrayed as the folks who make a living by saying “no.”:  “No, you can’t do that trade.” or “No, you can’t launch that product.” But the best risk managers contend that they actually make their living by finding the right way to say “yes.”

Yasuko Okamoto
JP Morgan
AsiaRisk, November 2000

Risk management is akin to a dialysis machine.  If it doesn’t work, you might have a noble obituary, but you’re dead.

Ben Golub
Managing director and Head of derivatives risk management, BlackRock Financial Management
Derivatives Strategy, October, 2000

There is a lot of risk we take all day long that is not particularly quantifiable. You can still get screwed even with good risk management.

Mike Riley
AMEX Specialist
Derivatives Strategy, July 2000

Investors don’t like to hear the word risk, unless you follow it with management.

William Margrabe
Derivatives Strategy, October, 1999

Risk management is like a piece of infrastructure, it is not an objective in its own right. When you are trying to make a business succeed, then you don’t buy insurance against all eventualities.

Stephen Hodge
Group Treasurer, Shell
Risk, March, 1999

“The risk manager’s job is not an easy role,” this source added. “He or she has to call fire repeatedly and still be credible. Look at Long Term Capital Management. Are the managers all fools? No. It’s easy to fault the risk management infrastructure, but it could be a function of risk appetite as well.”

“What Really Happened at UBS?”
Derivatives Strategy
October, 1998

(I)t is important to remember that million-dollar risk management and portfolio valuation systems – unlike used cars in many states – are not covered by lemon laws.

Karen Spinner
Derivative Strategies, April 3, 1998

 

They’re trying to convince us that risk management will become a science – plug in this number and that number – but I still think it is very much an art.

Deborah Williams
Meridien Research
Enterprise-wide Risk Management, November, 1997

Not managing risk is itself a risky option.

Tsatsu Tsikata, chief executive
Ghana National Petroleum Corp
Risk, September, 1997

The Barings collapse has been one of the chief spurs to European and US banks to embark on firm-wide risk management projects.

Clive Davidson
“The Future is Firm-Wide”
AsiaRisk, July, 1996

Our most important risk management decision in trading is the hiring of our people. I can’t emphasize that enough.

Tom Juterbock, managing director
Morgan Stanley
Futures Industry August-September, 1996

Georges Clemençeau, French prime minister at the end of the First World War, once said: ‘War is too serious a thing to be left to generals.’ I consider risk management too serious to be left solely to risk managers.

Eric Albrand, CFO
Seita
Risk, July, 1996

Risk management is somewhat like apple pie: we’re all in favour of it so long as someone else does all the cooking and it comes free. But risk management is not a free lunch: and the more elaborate the pie, the more expensive it is.

Clifford Smoot
Bank of England
Financial Risk Management Supplement
Risk, July, 1996

Our proposed risk management program, discussed below, not only protects the pump profit margins with a minimum amount of risk from the spot market, but also offers us an opportunity for extraordinary upside profit with no additional risk.

Quoted from Metallgesellschaft’s Business Plan
Antonio S. Mello and John E. Parsons
“Maturity Structure of a Hedge Matters: Lessons from the Metallgesellschaft Debacle”
Working Paper, February, 1995, Columbia University

Measuring risk is essentially a passive activity. Managing risk is a proactive process, where, in dynamic markets, people are actively seeking to change their positions so that their institution has the risk profile they want it to have.

Patrick Brazel
Sun Guard Capital Markets
Risk, January, 1996

Risk management is a comprehensive process that combines philosophy, principles and methodology to produce a culture of risk management permeating the firm.

Bankers Trust
RAROC and Risk Management
1995, back cover advertisement

Risk management is state-of-the-art technology combined with some of the oldest tools in business – experience, judgement, common sense.

Bankers Trust
RAROC and Risk Management
1995, back cover advertisement

Risks can be managed with foresight. Damage can be controlled with hindsight. Your choice.

Coopers and Lybrand, L.P.
Advertisement in The Wall Street Journal, December 7, 1995

You may also want to read these

No comments yet.

Leave a Reply