Why did risk management tools fail to predict the latest crisis in which we all went through? Many studies and risks experts have found one common conclusion: managers relied too heavily on short-sighted models and too lightly on their own expertise and insight. Indeed, if anything is to be learned from crisis, it is that nothing substitutes for human judgment in evaluating business risks and setting the right course of action.
Executives and managers must understand the risks associated with their business. Monitoring key economic indicators will provide insights into potential structural risks that may impact the company financial statements. Then, deciding which risks to mitigate may optimize the company competitive advantage.
In this paper, we will firstly evaluate risks that companies are facing, secondly we will present the biases of current risk methodologies, and finally we will discuss how using insight and foresight may be a powerful tool to mitigate risk and to gain competitive advantage.
Evaluating Risk
Company executives must recognize the financial and non-financial factors that have the potential to significantly affect the company’s earnings or even its long-run viability.
Some of the specific risks that must be monitored include:
Market risk is related to changes in interest rates, exchange rates, equity prices, commodity prices and so on.
Credit risk is the risk of loss caused by a counterparty’s or debtor’s failure to make a promised payment.
Liquidity risk is the possibility of sustaining significant losses due to the inability to take or or liquidate a position quickly at fair price.
Operational risk is a loss due to failure of the company’s operational systems or from external events outside the company’s control.
Settlement risk is present whenever funds are exchanged
Model risk is linked to initial assumptions on risk factors
Regulatory risk
Political risk (including, tax, accounting, legal risks)
In evaluating your company ERM system, you should ask if:
Capital is consistently allocated on a risk-adjusted basis
ERM system properly identifies and defines all relevant internal and external risk factors
ERM system utilizes an appropriate model for quantifying the potential impacts of the risk factors
Risks are properly managed
Risk Models biases
The major bias with risk models is, firstly, the use of historical data: predicting the future mainly from past events, and considering that past shall repeat with certainty (i.e. mean reversion or cyclical behavior).
Secondly, managers are overconfident in models without considering the possibility of biases in risk factors or underlying assumptions and underestimate the importance of their judgment and insights.
This combination of biases emphasized the amplitude of the crisis that were disastrous for financial industry and therefore for the world economy.
Furthermore, stress-testing that measures the impact of unusual events is another area where the complacency of managers weakened companies’ ability to ascertain risks promptly and accurately. Scenarios analysis were usually limited to observed events, and are mostly unable to accurately measure major factor movements (i.e. the impact a major movement in one factor has on other factors) or unable to include the effects of simultaneous adverse movements in risk factors.Furthermore
Over-reliance on the risk models designed to assist managers in risk mitigation was clearly an exacerbating factor in the crisis. While models play an important role, managers must fully acknowledge that these models provide only a limited view of reality and should not in any circumstance substitute for sound managerial judgment.
If existing tools are not the answer, what do managers need to better steer their business in the future?
Using insight and foresight to mitigate risk
Company executives must change their approach to risk decision making. They should pursue a proactive and strategic approach, using insight and foresight to identify and mitigate emerging risks.This continual process comprises four steps:
Understand your risks: identify and measure specific risk exposure
Decide which risks to own and set specific risk tolerance levels
Anticipate new risks
Know when to mitigate your risks by monitoring the process and by taking any necessary corrective actions
Step 1: Understand your risks: identify and measure specific risk exposure
You should develop a comprehensive risk mapping tool that highlights:
Your structural risk
The impacts in your financial statement for each category of risk
Step 2: Decide which risks to own and set specific risk tolerance levels
You should develop sensitivity analysis that
Develop different scenarios for each risk (including extreme cases)
Assess inter-dependencies among diverse market risk factors
Gauge the potential impact of these inter-depencies on your financial statements
Set specific risk tolerance levels
Decide which risks to own
Increase robustness against undue risks
Such risk modeling requires both scenario planning and stress-testing that translates risks into “extreme but possible” business scenarios.
Some forms of non-financial risk, such as operational risk due to power outage can be anticipated and steps can be taken to avoid or compensate for them. Other types of operational risk such as extreme weather can have dramatic consequences, but the possibility of the events is difficult to assess as is the extent of any related loss. Most non-financial risks are difficult to measure; therefore buying insurances are the best ways to protect against losses.
Step 3: Anticipate new risks
An early-warning trigger shall help your company to spot potential market anomalies and the level of threat they pose. To do so:
Recognize that some risks are not foreseeable
Continuously measure current level of each risk
Develop and monitor early-warning indicators
Revise the probabilities of the scenarios with new information available
Define a benchmark scenario to trigger a warning signal
Transform contingency plan into action plan if adverse scenarios are likely to occur.
Step 4: Know when to mitigate your risks by monitoring the process and by taking any corrective actions
Your company should use a contingency plan tracker aimed to:
Execute your contingency plan (which is your risk mitigation plan) according to the situation that occurs
Monitor the results and compare with the expected impacts previously forecasted
Take corrective actions (i.e. modify your initial assumptions)
Conclusion
The risk management process is ongoing, data and analysis must be continuously updated. Once a risk to the company has been identified, it may be necessary to determine appropriate models to quantify the risk and or evaluate possible ways to adjust the risk.
To reduce the effect of model biases, companies must use a 4-step risk management plan that takes into account insight and foresight into the process for identifying and mitigating risk. By doing so, companies must be able to anticipate new potential risks and develop contingency plans to respond to changing market conditions and therefore enhance their competitive positioning.
Article written by Tristan Van Iersel
Sources:
1. CFA curriculum 2015
2. S. Angius, C. Frati, A. Gerken, P. Härle, M. Piccitto, U. Stegemann (2010), Risk modeling in new paradigm: developing new insight and foresight on structural risk. McKinsey Working Papers on Risk. McKinsey & Company
