Tuesday 31 March 2015

Losses Are Not Failures of Risk Management

Well, not necessarily.  But we need to remind ourselves and our stakeholders that that’s really the point.  Losses will happen with certain regularity.  This is the message of a system of a risk appetite system where the limits are calibrated to a 1-in-10 chance over a one-year horizon.   Whether the implications are really appreciated is a different point. 

A paper by Rene Stulz (here) is a good reminder that losses may not represent a failure of risk management.  This is particularly the case where “managers [know] exactly the risks they faced―and they decided to take them.  Therefore there is no sense in which risk management failed”.  He goes on further to say that “deciding whether to take a known risk is not a decision for risk managers.  The decision depends on the risk appetite of an institution.” 

This is consistent with the practitioner’s view as expressed by James Tufts, Group CRO of Guardian Financial Services, expressed in a guest post in this blog: “[T]he objective of the ‘Risk Function’ should not be ‘risk management’.  That’s a business objective.  The objective of the ‘Risk Function’ is to provide the ERM [Enterprise Risk Management] framework and the source of challenge and oversight on all aspects of the business model, relative to this framework.”

There may be risk management failures nevertheless and Stulz’s paper goes on to provide a useful classification:
  1. Mismeasurement of known risks  
  2. Failure to take risks into account 
  3. Failure in communicating the risks to top management 
  4. Failure in monitoring risks 
  5. Failure in managing risks 
  6. Failure to use appropriate risk metrics
I find these categories rather intuitive and I wonder how they can be used in practice.  There is an increasing regulatory expectation of formal assessment of the effectiveness of risk management and these categories could usefully feed into that process in two complementary ways. 

Firstly, banks and insurers track a range of risk events/incidents.  It would be useful to consider if reported incidents fall into any of the above categories.  Alternatively they may be consistent with risk appetite.

Secondly, insurers and banks using an internal model are expected to use it to support a profit and loss attribution.  This means explaining actual profits and losses by reference to the output of the internal model and the risk categories considered.  It would be interesting to consider if the losses arise from changes in values consistent with risk appetite or any of the reasons set out above. 

The above might seem a simple idea but learning from failures, or risk management failures in this case, is usually anything but a simple idea.

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