If you don’t trade, you can’t make money. If you lose all your chips, you can’t bet. So it’s better to manage risk accordingly.
“JP Morgan was warned risk management not up to task”, “SEC looking at risk management breakdown at Knight”, “Corporate boards increase focus on risk management issues” quoted as headlines on news site. Why there is too much emphasis on risk management? Does risk management really play a crucial role for the firm?
What is Risk Management anyway?
Risk management is the process of assessing, communicating, monitoring and managing risks. In layman’s terms, risk management is the process of first knowing what we are trying to achieve, what factors might affect it and which of those factors could help or hinder the achievement. This helps us to identify risks and then we need to prioritize the factors on basis of which can affect most adversely to achieve the goal. Further, we quantify the risk through probability, statistics or various complex risk models. After knowing the risks, question yourself -what should be done about it? Whether we should mitigate, eliminate, accept or transfer the risk.
The last two decades have witnessed the collapse of institutions because of not managing risks properly and that cost not only to the local economy but also to the global economy.
How risk management fail?
Do you think that a huge loss to the firm is a sign of risk management failure? Not necessarily. The losses occur only if firm takes risk which is necessary for value creation. The objective of the firm should be to recognize the losses and take preventive measures to deal with them.
Risk Management fail if one or more of the following events occur:
- Not measuring known risks precisely
- Not knowing some risks
- Not monitoring risks adequately
- Not using the appropriate risk metrics
- Not communicating risks to top management.
There are number of financial disasters which happened due to risk management failures.
Founded in 1994, Long term capital management (LTCM), a hedge fund, generated galactic returns in first few years of operation. Investors invested in the fund in spite of not knowing their secretive trading strategies and trusted the people (included Noble Prize winners –Myron Scholes and Robert Merton) who managed the fund. Though most of the LTCM trading strategies were relative value, credit spreads and equity volatility and that were quite difficult to understand for investors. LTCM grew enormously with positions in equity, derivative and fixed income market across the globe. In early 1998, LTCM had $ 124.5 billion debt and $ 4.72 billion equity, yielding a leverage of 27 to 1 and it’s holding position were around $ 1.25 trillion notional.
In August 1998, Russia startlingly defaulted on its debt and the spillover effect emerged across the globe resulting in the crash of LTCM. Extreme leverage and inadequate risk model put LTCM in cash flow crisis. Their risk model assumed that historical relationships are good predictor of future relationships but that goes wrong during economic shocks. Though LTCM partly adjusted the model by using higher correlations as compared to historical correlations, it failed to capture the spike in correlations caused by the cascading effect of economic shocks. The LTCM case demonstrated the importance of not measuring known risks precisely and not knowing some risks, and further suggested some improvements from risk management perspective such as greater position disclosure, better utilization of stress testing, provide initial margin while taking positions, incorporate potential liquidation costs into prices in the event of adverse market conditions.
Procter & Gamble and Gibson Greetings sought the assistance of Banker Trust to reduce funding costs. In order to reduce funding costs, BT used derivative trades which were too complex to understand for both parties and offered the small reduction in funding costs with high probability in exchange for a large loss with low probability. Later, both parties realized that they had been misled when they suffered huge losses. BT used to tape phone conversations of its traders and marketers in an effort to resolve verbal contract disputes and unfortunately in some of these conversations BT staff blustered how badly they fooled the clients through complex derivative structure. In 1995, both Procter & Gamble and Gibson Greetings sued BT. This case demonstrated the importance of communication that could be the major risk for firm.
A Treasury bond trader, Toshihide Iguchi, at Daiwa bank misled the management through hiding losses and forging customer trading slips. Losses surmounted to $ 1 Billion during the period 1984-1995 and the misleading reporting was undetectable due to his dual role as the head of both trading and back office support function. When senior executives came to know of the fraud it was too late to take any action to recoup the losses. Finally, his trading losses led to shutdown of Daiwa bank US operations. This case demonstrated the importance of monitoring risks.
There are many more risk management case studies such as Barings, Allied Irish Bank, Metallgesellschaft and Kidder Peabody, which illustrate different cases of risk management failures. These case studies and moreover recent financial crisis highlighted the need for better risk management system in the firm.
To build an effective risk management system in the firm is essential for the success of the firm. The firm needs to list all the exposed potential risks, quantify the risks using risk management tools such as Value at Risk (VaR), Sensitivity Analysis, Scenario Analysis, Decision Trees, Simulation and then determine whether the risks to avoid, retain or transfer. The decision on whether to hedge the risk depends on cost benefit ratio. If the cost benefit ratio of risk reduction is too high, it’s better to leave the risk unhedged but firm needs to monitor the unhedged risk. For risks which need to be hedged, firm can choose relevant hedging vehicles such as insurance, derivatives and tailored products. On the other hand, the unknown risks may not be a severe problem for management as long as the management realizes that not all risks can be known and make appropriate capital allocation to account for unknown risks.
Risk management should always monitor the change in risk characteristics because the relationship among variables never be static over long period. For Instance, a security may increase in value as interest rates decline over some time and then may decrease in value for an extended period. Firm should have an adequate incentive structure to promote effective risk management in order to avoid risk management failures. Moreover, if compensation of employees is aligned to risk then employees would more likely to reduce the risk. Risk management efforts are wasted if not properly communicated to decision makers who basically make decisions to maximize the firm value. The whole point of risk governance is to increase the value of the firm and the value increases by taking risk which provides opportunities to outperform competitors. In all this, firms should step forward to build not only an effective risk management but also a good risk management which takes into account the risks of risk management too.