Friday, 27 June 2014

The Objective of Risk Management

This is a continuation of an earlier post about identifying the value of risk management (here).  I would like to focus on the objective of risk management.  I hasten to say that I am writing from the perspective of financial services and that there may also be different views. These thoughts are inspired by an article by Stulz from 1996 (here).  

The starting point is that the aim of risk management as seeing in the traditional academic literature is minimising the variance in profits.  Not surprisingly, this would imply much more hedging and risk management that it’s generally observed from surveys and other sources, which is puzzling.

On the other hand, a company will have certain ‘comparative advantage’ in terms of skills, resources, or location that it can profitably exploit.  Today, we would see this as part of the ‘business model’.  If risk management seeks to reduce the variance in profits, it will also eliminate the upside that might exist as a result of the company’s business model.  If that upside is to be preserved, then the objective of risk management becomes the elimination of costly lower tail outcomes while preserving as much as possible of the upside. 

The key to risk management is therefore the firm's business model (earlier posts here and 
here).  It shapes the strategy and creates the risks that need to be managed and probably points at those risks that will emerge.  In practice, this means understanding the source of profits and being able to put this in the context of how the business operates and its strategy. 

Consider the business strategy of a currency trading desk.  The main question is whether profits arise from position taking (with the firm’s capital) or from market-making.  Incidentally, the evidence quoted in the paper suggests that profits arise from market-making rather than position taking.  For an insurer, this would involve understanding the extent to which profits arise from underwriting, investment performance or fees and the alignment with the business strategy. 

Where this understanding forms the basis of how risk management operates, it makes financial distress less likely.  In turn, this means that risk management can be regarded as a substitute for equity capital; the same amount of equity capital can go further in terms of supporting a wider set of profitable activities. 

Unfortunately, a similar outcome can be observed when the risks are under-estimated.  How can a company that adopts this approach to risk management distinguish itself?  I don't think that there is a simple answer.  It is important that risk management takes a truly holistic perspective and seeks to demonstrate the alignment between business model, strategy, risk assessment and senior management incentives.   

If you work in financial services, I would be keen to hear your thoughts.  If you don’t, I would be keen to know if this articulation of the objective of risk management resonates with your experience.  

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Thursday, 19 June 2014

The Cost and Benefits of EU Membership

A lot that has been said about the recent elections to the European Parliament.  (Full disclosure: I am an EU national living in the UK.)  For me, part of the debate in the UK represents a useful reminder of the challenge of cost-benefit analysis.  Not surprisingly, there isn’t an accepted view about the balance between costs and benefits of EU membership.  Here is an illustration of the range of estimates (as of 2013) from a research paper of the UK Parliament:

I reviewed some of what has been written and have also read with interest Hugo Dixon's recent book - 'The in / out question'.  I thought that rather than develop another cost-benefit analysis, I would set out the main considerations to take into account if you choose to read one of them to form your own views.

It seems uncontroversial – I think – that the economic benefit from EU membership is the access to supply products and services to a market of 510 million consumers and an economy the size of the US.  Hugh Dixon quotes an estimated benefit of the order of 4% to 5% of UK GDP.  If you accept this, then the key questions are whether: 
  •  the costs to the UK of achieving that benefit offset it; and  
  •  the benefit can be achieved through an alternative arrangement. 
To consider this, a cost-benefit analysis must set out the ‘counterfactual’, i.e. what would happen in the absence of EU membership, and identify what is incremental as a result.  However, there are a number of options.  The ‘do nothing’ option means trading with the EU based on the UK membership of the World Trade Organisation (WT0).  This does not mean free-trade; it will entail custom duties for certain products such as cars.  There are also other options as represented by the cases of Norway, Switzerland and Turkey.  The bottom line is that you cannot seriously consider the costs and benefits of EU membership without taking an explicit view on an alternative from the very beginning.

If so, here are a number of questions and answers to identify what is incremental (including the benchmark of EU membership).  A "smiley" indicates that the change (or lack of it) is a positive development from a cost-benefit perspective.

A couple of points to note about the table.

Firstly, UK manufacturers exporting to the EU will need to comply with EU product regulations.  They are likely to end up manufacturing to UK and EU product regulation standards so (at best) cost savings would be limited. 

Secondly, the distinction between goods and services in the table is the reality of “free trade”, which does not usually apply to services, such as financial, business and legal services.  They represent 78% of the UK GDP. 

The table suggests that being outside the EU could be cheaper on a ‘cash’ basis.  However, none of the options would appear to replicate the benefits of a single market.  Norway replicates many of the benefits at a reduced cost.  However, note that they are bound to follow EU legislation without having a saying on it – an interesting view about sovereignty! 

Overall, I struggle to see how the UK would be able to replicate the economic benefit of the single market in products and services outside the EU. 

However, the real value of cost-benefit analysis is the impetus to focus on increasing benefits and reducing costs.  This means considering how to reform the EU and get the best from a single market of 510 millions of consumers and a GDP that is as large as the US.  Dixon suggestions include cutting red-tape, negotiating trade deals with US, Japan and China.  For me, one of the more interesting suggestions is the potential gains from banking disintermediation and providing long-term finance to industry through capital markets.  As he puts it, the crisis was a banking crisis not a financial crisis.  Something for another post …  

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Thursday, 12 June 2014

‘Start With Why’ and the Value of Risk Management in Financial Services

A conversation with a friend about a book called ‘Start with Why’ helped me to put some order to my thoughts about the value of risk management. 

At one level the question of ‘why risk management’ can be answered by saying that it adds value to the business in the medium to long term. 

This is not a rhetorical question given the sums of money and senior management time that are being devoted (or is it diverted?) to risk management.

But, how can we identify the value of risk management? 

This is not a simple question.  I believe that there are two broad aspects to consider to answer this question.  Firstly, it is about identifying the right objective.  Secondly, it is about evidencing that pursuing the objective of risk management generates value. 

I intend to cover these issues in future posts from the perspective of financial services.  It will also be interesting to hear your thoughts and evidence about the value of risk management.

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