!DOCTYPE html PUBLIC "-//W3C//DTD XHTML 1.0 Strict//EN" "http://www.w3.org/TR/xhtml1/DTD/xhtml1-strict.dtd"> Streamline Training & Documentation: Mismanaging Risk

Thursday, February 19, 2009

Mismanaging Risk

Previous posts (e.g., here and here) have dealt with principles of effective risk management. As a complement to these posts, I'd like to cite "Six Ways Companies Mismanage Risk," by René M. Stulz in the March 2009 issue of the Harvard Business Reivew. Stulz is a professor of banking and monetary economics at Ohio State University's Fisher College of Business.1

In clear, concise style, Stulz explains these risk management failings:
  1. Relying on historical data even though such data do not include performance information for recently invented types of financial assets. Historical data can also be misleading if they do not accurately capture correlations among price movements of various asset classes.

  2. Focusing on narrow measures, e.g., daily value at risk (VaR), a metric whose validity depends on its being safe to assume that assets can be sold quickly or hedged.

  3. Overlooking knowable risks, which include:

    • Risks outside the normal risk class a business unit incurs.

    • Risks incurred by hedging i.e., by particular efforts to mitigage risk.

    • Market-concentration risks, e.g., the risk that a single large institution's distress asset sales will reduce the creditworthiness of other enterprises by reducing the value of assets they hold.

    • Value-assumption risks, i.e., risks related to "changes in normal trading behavior due to doubts about the value and liquidity of assets."

    Stulz stresses the importance of managing risk in an integrated fashion, and of assessing new risks associated with instruments used for risk mitigation.

  4. Overlooking concealed risks, e.g., risks that employees get away with not reporting clearly and completely to management.

  5. Failing to communicate intelligibly to the board and CEO the enterprise's risk status. This may result in misplaced confidence concerning the level of risk the enterprise has assumed.

  6. Not managing in real time, which is dangerous when asset values are subject to rapid changes in value, a circumstance which complicates life by making it hard to get hedges in place in timely fashion.
Stulz concludes by recommending that companies "augment the models you have with scenario analyses of how a financial crisis might unfold depending on how your firm and other large companies react to the crisis." The idea is to have survival strategies in place before crises occur.

1 Stulz has just been named Risk Manager of the Year by the Global Association of Risk Professionals, as reported here.