Risk is Not a Game: How do Banks Mismanage Risk?

How did global financial institutions mess up so badly in 2008? In three words, poor risk management.  Of course, financial institutions can suffer major losses even when their risk management is first-rate after all, these firms are in the business of assuming big risks to reap large rewards. And, risk management is hard to consistently get right in the best of times. Nonetheless, the potential for catastrophic losses – trading, legal and otherwise – within the firm and the financial sector require Banks to improve their risk management performance.   

To do this, it is crucial that these companies understand the flaws inherent in the current risk management model.  According to an excellent article in the Harvard Business Review, financial institutions mismanage their risk in 6 ways.  The article’s key conclusions are summarized below:

  1. Over-reliance on historical data – The rapid financial innovation of recent decades has made historical data less useful in predicting risk, particularly catastrophic meltdowns like in 2008. In essence, poor data can make sophisticated risk models ineffective when market conditions change quickly and with high volatility.
  2. Focusing on narrow measures of risk – Traditional daily measures of risk (e.g., Value at Risk calculations) can’t capture a company’s full exposure when market fundamentals are shifting quickly. Furthermore, VaR models are weak at identifying two other kinds of daily risk:  the risk of catastrophic losses that carry a small probability of occurring and; the daily portfolio risk when the firm is stuck with that portfolio for a much longer period than was anticipated.
  3. Misunderstanding knowable risks – Risk managers often fail to recognize and account for the magnitude and correlation of various risks (market, credit and operations) that is found within their purview.  For example, hedging (e.g., counter-party exposure), market-concentration and value-assumption risks are often underestimated or unaccounted for.
  4. Overlooking concealed risks – Risk managers often have their hands full dealing with reported risk.  However, concealed or hidden risk, whether through employee intent, management oversight or process breakdown, can generate massive losses like what was experienced by the French bank Société Générale in 2007.  These kinds of risks tend to expand in financial institutions where the culture, compensation plan and operating model do not align with risk management strategies. 
  5. Poor communication up to senior management – Complex and expensive risk-management systems can induce a false sense of security when their output is poorly communicated to top management and the Board.  Bad communication could involve a delay in getting key risk information to senior decision makers or it may be manifested in the massaging or misrepresentation of key risk information.    
  6. Inability to cope with rapid change – Given that markets are dynamic, the risk characteristics of securities may change too quickly to enable risk managers to properly assess and hedge the risk, especially within the context of minute-to-minute volatility.  Additionally, the introduction of mark-to-market accounting can also complicate the ability to manage and hedge risk.  Finally, many firms also underestimate the the likelihood and impact of political upheaval on their risk exposure.  For example, each of the emerging BRIC countries (Brazil, Russia, India and China) has had recent bouts of political and economic instability not to mention significant and ongoing disputes with neighbors.

As the above points indicated, conventional approaches to risk management are challenged to handle today’s sophisticated financials products and volatile markets not to mention working within traditional banking processes and structures. New risk management models and strategies will be needed to cope with these issues.

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4 comments so far

  1. Kyle McGuffin on

    So Mitch, how do we get OSFI to listen? Great article.

    Make it a great week!

  2. […] Given the potential,  firms can ill afford to ignore doing business in emerging markets.   However, managers need to tread carefully and strategically manage their risk. […]

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  4. […] or worse, management judgement, to predict potential interruptions to their operations.  However, standard ERM approaches are problematic when it comes to forecasting Black Swans.  For practical and budgetary reasons, these systems focus […]

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