Activating this Blog again

A lot of developments to update that I do not know where to begin!

After clearing the dusts and cobwebs away, this blog is to be active again!

Risk Management is a Corporate Culture Issue

At the Wharton Finance Conference in 2007, Lloyd Blankfein, chairman and CEO of Goldman Sachs, and Kenneth Moelis of Moelis & Co (previously with UBS Investment Bank) gave their perspectives on risks, rewards and opportunities in Wall Street.

They both provided different perspectives and here are the excerpts :

"At its most fundamental level, they agreed, risk management is a corporate culture issue. To manage risks effectively over time, employees must put the firm's welfare and the preservation of important client relationships ahead of everything else. In October, said Moelis, "firms got hit from The Blind Side" -- a reference to a recent bestseller by Michael Lewis about professional football -- "and a number of Wall Street leaders suffered career-ending injuries." Said Blankfein, whose firm seems to have emerged from the recent credit implosion relatively unscathed: "Risk is risk, and you can't be perfect at managing it."

"Give an experienced trader a new rulebook on risk, and he will figure out how to game the new rules in minutes.... What you need from employees is a sense of relationships.... You need to have people who want to save the firm... one trader sitting next to another, saying, 'This doesn't look right' instead of saying, 'I want to join that scam.'"

Blankfein offered a comprehensive overview of Goldman's risk management approach. Besides the firm's daily mark-to-market disciplines, the three indispensable ingredients, he said, are "escalation, accountability and culture." Escalation means communicating risk concerns to higher levels of management, "getting more fingerprints" on potential problem risks and challenging the notion that a business group leader ought to make independent decisions on risks that affect the entire firm. Accountability, of course, means acknowledging that people are responsible for what their business groups do, and, equally important, holding senior management committees responsible for evaluating all aspects of risk, including the quality of the people with whom the firm chooses to do business.

Goldman's greatest risk protection, however, comes from ascribing as much status, prestige and compensation to those partners engaged in control functions as to those running businesses -- and in constantly rotating partners back and forth between risk control and business operations.

Going back to fundamental disciplines such as "escalation, accountability and culture" is to my mind where we should be focusing in instilling the discipline and practice of risk management in this organization.

The entire article can be read here.

Thinking about risks

Knowledge@Wharton recently published "Re-thinking Risk Management : Why the Mindset Matters More Than the Model" on April 15, 2009.

The entire article can be read by clicking the here

In reading this article, I relate this to our role as risk managers in this organization.

1. In refining our risk management approaches, mindsets in the manner we think about risk need to change. The article emphasizes that "too much blame being placed on the risk management model and other tools of the trade" and argues "that risk models or tools are not necessarily broken, but instead are only as good as the decisions that get made based on them". We need to understand that risk models and tools can only assist us in making decisions, albeit judgemental, and we need to provide these insights to complement these models to senior management. We need to understand the assumptions underpinning these models, and more importantly understand the risks that are not represented in these models.
2. It is not sufficient to get a fuller picture of risk, there is a need to develop a more integrated view of risk. In this risk managers need to understand events in the market that impacts us do not happen by risk type. The lines between credit risk, market risk, and operational risk gets blurred when there is a significant event or during the period of crisis. While the skills for each type of risk can be distinguished, it is more important to develop the capabilities in understanding how these risks impact each other and have an integrated view of risk.
3. "Decisions need to be made faster, but based on information we don't have."
4. While we have been "internally focused", "businesses around the globe have become increasingly interdependent" which increases companies' exposure to risks, perhaps risks that we don't know about. Risk management of the future needs to "look beyond the known issues to look at links and interdependecies." Key to this is to define not ALL links but rather the major links that we as an organization have not thought about OR we believe is key in achieving our growth strategies.
5. Elevating risk management to a strategic level means making risk management discussions more strategic than operational. I believe in risk management needs to be cast in operational decisions. However, another level of risk management, strategic, needs to be defined and approached. Risk managers should also be part of the team of strategists, and think about not just downside risk, but risk of not acting on the upside. Risk managers should facilitate decision making in uncertain conditions facing the industry that a company is in.
6. Risk considerations then need to be embedded at multiple stages in business, be it strategic planning, budgeting and evaluating risks vs. rewards in various aspects of decision-making. We can have the best tools and capabilities in risk management, but, if we are not serious in integrating risks with strategic decision-making process, risk management will continue to be thought as operational excellence, support and a compliance function.

These represents my thoughts as I was reading this article. Of course, implementation considerations and strategies to achieve the points raised above requires more thought than just summarized points above.

Risk means more things can happen than will happen

The Heart of Risk by Peter Bernstein, author of Against the Gods : The Remarkable Story of Risk

This article is courtesy of What Matters, a McKinsey & Company website. I find this excellent in framing and shaping our thinking about risk and uncertainty.

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What is risk management all about anyway? We use the words as though everybody understands what we are talking about. But life is not that simple.

Risk means more things can happen than will happen—which is a fancy way of saying we do not know what is going to happen.

If we do not know what is going to happen, some surprises will be damaging, but others will make us wealthier than we had anticipated.

For anyone wrestling with the task of managing risk, it’s important to understand both the potential losses and the potential gains. As we’ll see, if more risk managers had thoroughly assessed the former, the current financial crisis might never have come to pass.

In today’s world, mathematical analysis has become the fashionable method for managing risks. This has been most obvious on Wall Street, where the so-called Quants, many of them with PhDs in math or theoretical physics, used their arcane modeling skills to conjure profitable trading models and new products. Non-Quants were often afraid of these new techniques, but liked the profits they produced and shied away from debating whether or not they were reliable.

In fact, math can only take us part way toward managing risk. What it cannot manage is what is at the heart of risk: the unknown. With a mathematical approach alone, the risk manager risks never correctly defining the problem and never asking the right questions.

Let me say the same thing from another perspective: risk management really means attempting to optimize outcomes under conditions in which the full range of outcomes might be unknown. Numbers will be a frail reed in such an environment.

How, then, can we come to grips with risk management when mathematics fails us? I begin the answer to this question with an anecdote from my experience managing other peoples’ money back in the late 1960s. The story is interesting in its own right, but it also provides a profound insight into the essence of risk management.

A married couple came to see us at our offices one day, scruffily dressed and shy in manner. The man, John, opened the discussion by showing us their portfolio, which was worth a couple of hundred thousand dollars and consisted of only three stocks: AT&T, U.S. Steel, and Thiokol. The whole portfolio was on margin, but each position showed enormous profits. We were nonplussed and asked John why he needed us. Then he told us their story. He had been a reporter for the Brooklyn Eagle, but the paper had folded and he was now unemployed. At the time that he was fired, the couple had $15,000 in the bank, just about the amount they spent in the course of a year to meet their basic needs (don’t forget this episode took place over 40 years ago). John’s wife was a school teacher, so they had some money coming in—but nowhere near enough to cover their basic living expenses.

Unlike many people who hoard small accumulations of assets for fear of losing the little they have, John decided to go into the stock market and shoot the moon. “If I lose,” he figured, “I’ll just be broke a year earlier than I would be otherwise. If it works, though, we can be comfortable for the rest of our lives.”

That logic is what made John a master risk manager. The key question in decision making is, “What happens if I am wrong?” or, as in John’s case, “What happens if I lose?” In this instance, he could see that he and his wife were in such bad shape that they had little to lose but much to gain by taking this highly concentrated and leveraged risk in the stock market. (It did work. The problem John wanted my firm to help with was a different, though not uncommon one. John’s wife, who had been a firm companion while the great experiment was under way, now had high anxieties about the risk of losing their windfall. But John, transfixed by success, was psychologically incapable of unwinding his fantastic success. That was the role they wanted us to play.)

John was unaware of the hallowed history of his line of analysis, which dated back nearly four centuries to one of English literature’s most glorious achievements, Shakespeare’s Hamlet and Hamlet’s most famous soliloquy, “To be, or not to be.”

There is a powerful connection between the investment decision by an unemployed newspaper reporter and the contemplation of suicide by the Prince of Denmark (which is what he meant by the phrase, “To be, or not to be”).

Hamlet always deliberated at length before acting on his impulses. In this crucial scene in the play, he is considering what might happen to him if he does commit suicide: “To die: to sleep; no more; and by a sleep to say we end the heartaches and the thousand natural shocks that flesh is heir to.” An end to heartache. That is the outcome Hamlet hopes he will achieve. But then he asks a critical question: can we be certain of “no more”? Hardly. We can be certain of nothing that happens after death.

That being the case, suicide is not a riskless act. Suppose there is more to come after death? “To die, to sleep; to sleep: perchance to dream: ay, there’s the rub; for in that sleep of death what dreams may come . . . There’s the respect that makes calamity of so long life.” Hamlet prefers to suffer the immense pain of life rather than face the unknowable consequences of suicide: “to grunt and sweat under a weary life” because “the undiscovered country from whose bourne no traveler returns, puzzles the will, and makes us rather bear those ills we have than fly to others that we know not of.”

Hamlet left a perfect model for my client John to follow: what happens if I am wrong in taking this step? In John’s case, the consequences of being wrong were minor compared with the transformation he could achieve if his decision turned out to be the right thing to do. Hamlet’s choice of whether to be or not to be was precisely the opposite, because not acting was the better selection. But both John and Hamlet asked the right question.

Another example of the power of this line of analysis is Blaise Pascal, the great 17th century French mathematician who first articulated the use of probability in making estimates about the future. Despite the tremendous importance of Pascal’s work in the field of probability, his more fundamental contribution to risk management is similar to Hamlet’s, although I doubt that Pascal ever read any Shakespeare—or had even heard of Shakespeare. Like Hamlet, however, Pascal applied common sense, rather than higher mathematics, in managing the risk he faced.

Pascal was a deeply religious man, although he was also a skilled gambler—which is what led him to the study of probability in the first place. One day, in the silence of his room, Pascal asked himself a tantalizing question: “If I had to make a bet on whether God is or God is not, how should I respond?” He immediately recognized that “reason cannot answer.” Nevertheless, this was clearly a question of overwhelming importance, even though he would have to wait until the end of eternity to find out how his bet on God’s existence had worked out.

Pascal finally turned to an indirect approach to this puzzle, in which reason would help him decide which way he should bet on whether God is or God is not. He could choose what kind of a life he wanted to live: a life of virtue, restraint, and unselfishness, or a life of lust and self-indulgence. Suppose he chose a life of virtue and abstinence and then found out at the end of time that God is not? He would have passed up some goodies unnecessarily, but it would not have been such a bad life. If, on the other hand, he chose a life of lust, deceit, and self-gratification, and then found that God is, he would be in big trouble.

Therefore, Pascal decided he must bet that God is and choose the virtuous life, even though he had no way of knowing whether the bet would pay off. One thing he did know: the consequences of being wrong by betting that God is not and leading a life of sin could have intolerable consequences.

The heart of the matter is defining the choices. Shoot the moon or leave the $15,000 in the bank? To be, or not to be? God is or God is not? John, Hamlet, and Pascal all provide the same framework for risk management: whichever road you choose—whether you play it safe or take a risk—what are the consequences of being wrong?

In our own time, let us suppose that some of the people who took out subprime mortgages, or some of the lenders, had stopped for a moment to ask themselves, “What if we are wrong about the outlook for housing prices? I am confident they will keep rising, but nothing is certain in this life. I better think through the consequences if I am wrong.”

The consequence of being wrong about the trend of housing prices would be disaster, as the declining value of the mortgaged homes would soon wipe out the borrowers’ paper-thin equities. This tragedy is precisely what did happen when housing prices began falling in autumn 2006. If buyers or lenders had only taken the trouble to ask the question about being wrong, the history of the world economy could have been entirely different from the chaos that has overtaken us.
Thinking through what might happen if things go wrong is also a useful approach in routine business decision making.

In 1994, Avinash Dixit and Robert Pindyck wrote a book called Investment Under Uncertainty, which emphasizes the inherent irreversibility of most business-investment decisions. Dixit and Pindyck suggest a method for dealing with the risks posed by irreversibility: wait before acting. Waiting is valuable because the passage of time can produce additional information. This new information may have value that would not have been available if an irreversible decision had been made earlier. Thus, Dixit and Pindyck’s case has its roots in the deliberations of Hamlet and Pascal, because taking the risk of not waiting can have negative consequences. Waiting to make an irreversible decision may lead to a more rational choice than not waiting.

My client John, Hamlet, and Pascal, each in his own way, laid out the fundamental principle of risk management by defining the right problem and asking the right question. A purely mathematical approach would make sense only if the risk manager were indifferent to the possible outcomes, in which case, there would be no point to the exercise.

There is always uncertainty. Nothing is 100 percent sure. While a 95 percent probability is statistically significant, that still leaves us in the dark about the remaining 5 percent; we may decide to accept that uncertainly and bet on the 95 percent sure thing, but there is still a possibility of being wrong. The crucial question to ask is, “What would be the consequence if that 5 percent chance comes to pass?”

Thinking small where ERM is concerned

I am appalled at the selected narrow-mindedness in risk management thinking in this organization. I am of the view that the greatest challenge is therefore to change the mindsets of selected persons that definitely hampers the progress of Enterprise Risk Management in this organization.

What a pity this is.

EIU report : Managing Risk in Perilous Times : Practical Steps to Accelerate Recovery

This report from EIU, published in March 2009, sponsored by ACE, KPMG, SAP and Towers Perrin provides a guide in what it takes in an organization to enable and empower risk managers to perform their roles.

The summary of ten practical lessons that could help in addressing the perceived weaknesses of risk management are :

1. Risk management must be given greater authority
2. Senior executives must lead risk management from the top
3. Institutions need to review the level orisk expertise in their organization, particularly at the highest levels
4. Institution should pay more attention to the data that populates risk models, and must combine this output with human judgment
5. Stress testing and scenario planning can arm executives with an appropriate response to events
6. Incentive systems mustbe constructed so that they reward long-term stability, not short-term profit
7. Risk factors should be consolidated across all the institution's operations
8. Institutions should ensure that they do not rely too heavily on data from external providers.
9. A careful balance must be struck between the centralization and decentralization of risk
10. Risk management systems should be adaptive rather than static

There you go. I seriously think that in the context of this organization that the priority ishould be no 1,2 3, 7 and 9.

I recommend reading this report in detail. Click at the link here.

Survey Reveals Financial Services Firms Focused on Enhancing Risk Management Practices in Advance of New Legislation

Navigant Consulting yesterday announced the results of a new survey conducted by the Economist Intelligence Unit (EIU). Nearly 200 financial services professionals were surveyed to evaluate the evolving role of risk management in financial services organizations. The survey indicates that financial institutions around the world are focused on the impact of risk on enterprise business value and profitability, rather than merely complying with arbitrary levels of risk exposure and performance.

The survey results suggest there is significant room to improve risk intelligence – making it more current, comprehensive and consistent – an observation that is especially important as more than 70 percent of respondents cite risk disclosure as a likely element of expected regulatory reform.

“It is evident that the financial crisis has led to a 'crisis of confidence',” said John Schneider, Managing Director and head of Navigant’s Capital Markets Regulatory Advisory team. “We’re seeing a call to action by regulators across the globe to create additional transparency and risk monitoring capabilities to reduce the likelihood of another similar financial crisis.”

According to the survey, most respondents stand by their risk-monitoring capabilities, but concede they are most confident about their ability to monitor mainstream risks (e.g., credit, accounting, liquidity risk), and least confident in the areas revealed as problematic by the recent credit crisis.

For example, 87 percent say they are “Excellently” or “Well Positioned” to identify and monitor credit risk, but fewer (67 percent) are equally confident of their capabilities on enterprise risk, and 47 percent describe themselves as “Weak” on new and emerging risks.

“Effective risk management hinges not only on an organization’s ability to capture data on risk, but the ability to interpret, escalate, and make decisions based on the information. The survey data shows that financial professionals recognize this need but struggle with implementing meaningful solutions to enhance risk management. We work alongside clients to design, enhance, and implement robust risk and compliance programs to shore up investor confidence,” said Sharon Siegel Voelzke, Navigant’s Vice President of Business Consulting Services.

The survey respondents comprise nearly 200 executives from a broad range of financial services firms around the globe. Of the executives surveyed, 37 percent are based in North America, and 33 percent in Europe; 30 percent are from firms with global assets of more than $250 billion, and 41 percent are senior corporate executives (including chief executive, financial and risk officers, as well as board members).

News link to this story, click here

Link to survey results, click here