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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