In light of the events of the past couple of years, a company (especially in the financial sector) would have to be deeply irresponsible not to take a close critical look at its risk management practices and organizational culture. But what, specifically, should a company look for? What are the major sources of risk management errors? And how can businesses make changes that have a good chance of working next time a crisis erupts, no doubt from a different and again unexpected source? Stulz believes that financial risk management usually takes one of six paths to failure. In this article, he explains each path in detail and makes some promising recommendations.
The first source of error comes from relying on historical data. Modeling risk based on historical data can go wrong in a couple of big ways. You would substantially underestimate the probability of a plunge in prices if house price volatility was higher in the future than in the past. You might also mistakenly assume that the distribution of future house price changes was described by the bell curve. These kinds of error show how hard it is to accurately extrapolate from past data to the future. You may use a time frame that is too short, or you may wrongly assume that previous correlations are constant, when they actually increase during periods of crisis. As Stulz points out, “rapid financial innovation over recent decades has made history an imperfect guide”.
The second major problem area results from focusing on narrow measures. Stulz points out problems with using a daily Value-at-Risk (VaR) measure. For instance, it doesn’t apply to portfolios with which the firm may be temporarily stuck; it says little about the company’s actual financial health; and it fails to capture catastrophic losses that have a small probability of occurring. The third problem is overlooking knowable risks: those outside the class of risks normally associated with particular units; those related to the hedging strategies used to manage risks already identified and assessed; those that arise when a market is dominated by one or two large institutions; and those that pertain to changes in normal trading behavior due to doubts about the value and liquidity of assets. The other three problem areas are overlooking concealed risks, failing to communicate, and not managing in real time.
The fixes for these problems are usually not easy, often requiring changes in compensation and organizational culture. If organizations are to achieve what the authors calls sustainable risk management, they will need to take into account catastrophic risks despite having extremely small probabilities; they will need to build scenarios for them; and they must design strategies for surviving them.
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