Risk Management In A Nut Shell

ERM: a solution that is simple, elegant… and wrong

The popular attempt to convert management decision making processes into a theoretically less-fallible integrated enterprise risk management “system” has blurred investors’ and executives’ view of real risks. Instead of taking real actions, the risk management profession has become focused on manipulating numerical quantifications of estimated effects that real risks might produce under a specified range of expected economic, market, and financial performance conditions.

Although credit risk models and derivative instruments do not create or eliminate risk, they do carve up and disguise the inexorable intrinsic risks as formulaic processes that can be measured and controlled. The power to measure and control the frequency of loss events is a delusion often adopted by managers with a mandate to quantify the current value of capital that is subjected to the forces of an unknown future. Many of them have yet to learn the fundamental principles of risk management.

Companies that accept the delusion of predictability and control created by models, derivatives, and risk management systems remain exposed to the unmitigated risks embedded in the past agreements they have made. The new hazard that arises from this acceptance is that the conditions and behavior that created the original risk of loss have not changed and remain uncontrolled.

Escaping the ERM Delusion

Every business is faced with an extensive list of risks. The first step toward controlling them is to classify these risks into:

Risks to pass through to the investors in the business
Risks to avoid or hedge
Risks to seek out

Firms often hedge risk that they should be passing through to investors, seek out some risks that they should not be seeking out, and avoid risks that they should be taking. The second objective of a risk manager is to change past operating decisions made in error to ones that are aligned with the classifications above.

Even if the first two objectives are performed well, the risk management decision will often turn out to be wrong – sometimes wrong on the upside (the potential for profit was underestimated), and sometimes wrong on the downside. Successful companies preserve their options to take advantage of both scenarios:

The option to expand an investment, if faced with the potential for more upside than expected.
The option to abandon an investment, if faced with more downside than expected.

Quantifying the cost of preserving the above options is the third objective of risk management. Accomplishing the three basic objectives is a major challenge in any large company.

This is because most risks have an unquantifiable element of exposure and cannot be profitably accepted over the long term without an offsetting position that eliminates the unquantifiable exposure. Companies that appear to be successful in profiting from large risk exposures are more likely to be lucky than knowledgeable about the future. A greater number of experienced and intelligent executives have subjected their firms to unquantifiable and unpredictable risky events and lost the value of their entire company. Read any business newspaper published in the past year for a list of their names.

The fundamental risk-management principle that many companies (and risk managers) have yet to learn is that unquantifiable and unprofitable risks can and should be eliminated. Sometimes the only way to do that is to exit the risky industry or abandon the risky project. However, managers and owners often create a perception that this option is no longer available following a long-term capital investment, or explicitly reject it as part of a conscious decision to remain exposed to an uncontrolled risk in anticipation of extraordinary and unsustainable profits. This is the essence of mismanagement.

The Ultimate Risk Management Option

When managers are mandated by the board of directors to accept and control a particular risk, and it cannot be done profitably, the only remaining option is to gain control of and change the conditions that created it. Failure to do this is often the result of accepting the delusion and obfuscation created by a model-based risk management system that implies accuracy with precision.

Credit risk models, derivatives and risk management systems are, at their core, reactive tools developed to help endure uncertain consequences of past agreements and imposed economic conditions. The vision and willingness to change the agreements and conditions that created the risk of loss is the ultimate determinant of whether a firm thrives or struggles to survive in the industry from which it attempts to extract its profit. The ability to identify and eliminate embedded risks by changing the uncertain conditions of their genesis is the mark of a competent risk manager.

For more information about this topic or for assistance with risk management, contact us at info@newvaluellc.com or 215-850-1403.