Changing perceptives on risk management

In implementing integrated financial risk management, senior management's view of risk management shapes the risk management thinking and culture throughout the organization. Key to this is a consistent message about the importance of risk management and changing perceptions regarding risk management.

The benefits of risk management is not clear throughout the organization resulting into inconsistent interpretation of the value proposition of risk management. The recent financial crisis has somewhat provided the impetus for pockets of people, entities or business units within this organization to consider risks in their businesses or where financial risks complacency existed, financial risks became a priority in their management radar. This is evidenced by the multitude of financial risk advisory and guidance that has been sought from us in the past 6 months, with market risk and counter-party risks as their top risk management concern.

This development that came about arising from the financial crisis is indeed a positive development in that businesses are realizing the importance of understanding how risks impact their businesses and makes efforts to manage these risks. In my view, these developments still fall short of what constitutes an effective risk management practice.

In this posting, I will attempt to list key risk management concept and ideas that I believe will shape the organization's thinking on the value proposition risk management brings and the practice of risk management.

Understanding the value proposition of risk management

Based on our experience in implementing integrated financial risk management, there are still companies that think of risk management as compliance and that risk management will stop businesses from expanding because their view is that risk management is risk aversion. There are also companies flush with cash that believes managing risks does not apply to them. Why manage risks when we have survived all these years without having the governance, framework and discipline of risk management in place?

These are dangerous mindsets because as I mentioned earlier, the practice of risk management is shaped by how senior management perceives it to be. Key to this is consistent message on risk management value proposition. Risk management (more so ERM), when designed comprehensively especially in a large organization is not just about having in place a process to protect businesses from setbacks, it enables better business performance by prioritizing risks that businesses want to reduce and risks that businesses want to profit from. With the uncertainty facing businesses in 2009, particularly brought about by economic uncertainty, subsidiaries and businesses should jump at the opportunity to leverage on the strengths of a risk management program in having a total view of its risks and knowing how these risks will impact their business growth strategies.

Credit Crunch : A Practical Guide

For those who are interested, I found this guide reinforcing or sharing our viewpoints in managing risks arising from the crisis.

Read on.

This hands-on booklet, The Credit Crunch: A Practical Guide, provides an explanation of some of the recent major financial events and an assessment of how they may affect the typical business. The guide also lays out 10 action items to consider as businesses manage through the crisis

http://www.boardmember.com/media/files/risk-mgmt-pdfs/TheCreditCrunch_GrantThornton.pdf

Integrated Financial Risk Management (IFRM) notes

IFRM Guidelines content

• Reference to the principles in the appropriate sections in CFP - principles of oversight and transparency
• Building on existing practices in the organization i.e. the risk organization in each entity, and identify governance improvements based on the compliance checklist i.e. risk tolerance levels as an agreed consensus by an entity's Board, the adequacy of risk management design and effectiveness of internal controls over financial risk
• Widely recognized principles in risk management - what are they? Leveraging risk management in light of the financial crisis and its impact
• What is the current baseline risk management practice in general, and financial risk management practice in particular?
• Lessons learnt in the CFP roll-out and differing risk management practices
• Integration of financial risks - where financial risks are embedded into key decision-making i.e.supply chain risk management, contractor risk assessment, project risk assessment
• Common tools and methodologies in risk assessment, risk compliance, risk measurement

To be continued

A Modeling Manifesto Now?

A spectre is haunting Markets – the spectre of illiquidity, frozen credit, and the failure of financial models.
Beginning with the 2007 collapse in subprime mortgages, financial markets have shifted to new regimes characterized by violent movements, epidemics of contagion from market to market, and almost unimaginable anomalies (who would have ever thought that swap spreads to Treasuries could go negative?). Familiar valuation models have become increasingly unreliable. Where is the risk manager that has not ascribed his losses to a once-in-a-century tsunami?
To this end, we have assembled in New York City and written the following manifesto.

Manifesto

In finance we study how to manage funds – from simple securities like dollars and yen, stocks and bonds to complex ones like futures and options, subprime CDOs and credit default swaps. We build financial models to estimate the fair value of securities, to estimate their risks and to show how those risks can be controlled. How can a model tell you the value of a security? And how did these models fail so badly in the case of the subprime CDO market?
Physics, because of its astonishing success at predicting the future behavior of material objects from their present state, has inspired most financial modeling. Physicists study the world by repeating the same experiments over and over again to discover forces and their almost magical mathematical laws. Galileo dropped balls off the leaning tower, giant teams in Geneva collide protons on protons, over and over again. If a law is proposed and its predictions contradict experiments, it's back to the drawing board. The method works. The laws of atomic physics are accurate to more than ten decimal places.

It's a different story with finance and economics, which are concerned with the mental world of monetary value. Financial theory has tried hard to emulate the style and elegance of physics in order to discover its own laws. But markets are made of people, who are influenced by events, by their ephemeral feelings about events and by their expectations of other people's feelings. The truth is that there are no fundamental laws in finance. And even if there were, there is no way to run repeatable experiments to verify them.

You can hardly find a better example of confusedly elegant modeling than models of CDOs. The CDO research papers apply abstract probability theory to the price co-movements of thousands of mortgages. The relationships between so many mortgages can be vastly complex. The modelers, having built up their fantastical theory, need to make it useable; they resort to sweeping under the model's rug all unknown dynamics; with the dirt ignored, all that's left is a single number, called the default correlation. From the sublime to the elegantly ridiculous: all uncertainty is reduced to a single parameter that, when entered into the model by a trader, produces a CDO value. This over-reliance on probability and statistics is a severe limitation. Statistics is shallow description, quite unlike the deeper cause and effect of physics, and can't easily capture the complex dynamics of default.

Models are at bottom tools for approximate thinking; they serve to transform your intuition about the future into a price for a security today. It's easier to think intuitively about future housing prices, default rates and default correlations than it is about CDO prices. CDO models turn your guess about future housing prices, mortgage default rates and a simplistic default correlation into the model's output: a current CDO price.

Our experience in the financial arena has taught us to be very humble in applying mathematics to markets, and to be extremely wary of ambitious theories, which are in the end trying to model human behavior. We like simplicity, but we like to remember that it is our models that are simple, not the world.
Unfortunately, the teachers of finance haven't learned these lessons. You have only to glance at business school textbooks on finance to discover stilts of mathematical axioms supporting a house of numbered theorems, lemmas and results. Who would think that the textbook is at bottom dealing with people and money? It should be obvious to anyone with common sense that every financial axiom is wrong, and that finance can never in its wildest dreams be Euclid. Different endeavors, as Aristotle wrote, require different degrees of precision. Finance is not one of the natural sciences, and its invisible worm is its dark secret love of mathematical elegance and too much exactitude.

We do need models and mathematics – you cannot think about finance and economics without them – but one must never forget that models are not the world. Whenever we make a model of something involving human beings, we are trying to force the ugly stepsister's foot into Cinderella's pretty glass slipper. It doesn't fit without cutting off some essential parts. And in cutting off parts for the sake of beauty and precision, models inevitably mask the true risk rather than exposing it. The most important question about any financial model is how wrong it is likely to be, and how useful it is despite its assumptions. You must start with models and then overlay them with common sense and experience.

Many academics imagine that one beautiful day we will find the 'right' model. But there is no right model, because the world changes in response to the ones we use. Progress in financial modeling is fleeting and temporary. Markets change and newer models become necessary. Simple clear models with explicit assumptions about small numbers of variables are therefore the best way to leverage your intuition without deluding yourself.

All models sweep dirt under the rug. A good model makes the absence of the dirt visible. In this regard, we believe that the Black-Scholes model of options valuation, now often unjustly maligned, is a model for models; it is clear and robust. Clear, because it is based on true engineering; it tells you how to manufacture an option out of stocks and bonds and what that will cost you, under ideal dirt-free circumstances that it defines. Its method of valuation is analogous to figuring out the price of a can of fruit salad from the cost of fruit, sugar, labor and transportation. The world of markets doesn't exactly match the ideal circumstances Black-Scholes requires, but the model is robust because it allows an intelligent trader to qualitatively adjust for those mismatches. You know what you are assuming when you use the model, and you know exactly what has been swept out of view.

Building financial models is challenging and worthwhile: you need to combine the qualitative and the quantitative, imagination and observation, art and science, all in the service of finding approximate patterns in the behavior of markets and securities. The greatest danger is the age-old sin of idolatry. Financial markets are alive but a model, however beautiful, is an artifice. No matter how hard you try, you will not be able to breathe life into it. To confuse the model with the world is to embrace a future disaster driven by the belief that humans obey mathematical rules.

MODELERS OF ALL MARKETS, UNITE! You have nothing to lose but your illusions.
The Modelers' Hippocratic Oath
~ I will remember that I didn't make the world, and it doesn't satisfy my equations.
~ Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.
~ I will never sacrifice reality for elegance without explaining why I have done so.
~ Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.
~ I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.

The Approach in Setting Risk Appetite

Coming soon

Lessons Learnt in 2008 and Looking Ahead in 2009

Happy 2009 to everyone and Good-Bye 2008!

I doubt if any risk manager would or could have anticipated the extent of events that had unfolded in 2008. I certainly didn't, and most of us in oil and gas, cushioned by crude oil prices reaching new highs, felt we were insulated by what really began in as early as 2007. I think we are all still reeling from the impact of events as we navigate ourselves, in our personal and professional capacities, to steer the ship to ride this storm.

What was unimaginable happened and having experienced this organization's weathering through the 1998 Asian Crisis and the 2008 Credit Crisis, these crises ultimately in my view, will have long term implications in shaping the practice of risk management.

There will be a series of risk management areas that I will be writing this year focussing on scrutinizing our own risk management practices and what we should be doing in shaping the practice of risk management in this organization.

I would like to begin with the topic of risk governance. Risk governance is the key element in risk management that sets the foundation for the remaining key elements. It is the glue that holds together the remaining elements in risk management. Without risk governance our efforts in risk management becomes futile.

What is risk governance? When we mention risk governance, we conjure images of risk management structure, principles of independence, creating a risk culture, developing risk capabilities etc. While these are crucial elements in risk governance, I am of the view that at the core of risk governance is that risk management must be given equal seat in any business decision-making process and treated at par with the growth and profitability strategies.

In the past risk management is treated as a process that each business activity or strategy undertakes to perform, identifying potential risk events and potential mitigation strategies and typically takes place in the form of workshops and templates. Unfortunately, the good intentions of these processes gives us a false picture or assurance that the risks are always mitigated. Now the reason I say that is

• Who monitors the effectiveness of such mitigation strategies?
• Who monitors the appropriateness of such mitigation strategies in the event of a stressed situation?
• Who re-evaluates whether the risk events and therefore its risk mitigation approaches and strategies are still relevant to the current situation? How quick do we respond to a certain risk event?
• Who executes the risk mitigation strategy? Given the multi-disciplinary experts required to manage such risks, who coordinates these collaborative approaches?
• Are our risk management talent empowered in a way that they have the ability to say "No" and business decision-makers pay heed to risk management because they bring value to the discussion table?

Who holds the answer to these questions depends on the risk governance approach and design of the organization.

• Is the risk culture pervasive enough that each business will be able to monitor the impact of risk events and trigger a chain of command to respond appropriately?
• Is there a risk management function at the business level that will work closely with the business decision-makers and act as an enabler to manage such risks?
• Or is there a role for those in Enterprise Wide Risk to play an intervention role when a risk event is triggered and before an action is taken, the impact to the Group is quickly assessed, rather than making a marginal business decision?

To be continued