Risk Management

With the constant reporting of various failures in banks, government budgets and large trading losses, the focus is squarely on risk management as opposed to risk taking.

What then is risk management and is it profit-making tool or really a profit reduction tool instead?

There are two ways of which we can view risk management: 1) it is in effect, a profit-making tool where we can take insofar that much risk in lieu of rewards, without tipping over- give and take a certain amount of buffer: like sitting on a knife’s edge without cutting ourselves and to give sufficient space for any deviation- therefore giving maximum effect and minimum loss.

Or alternatively we can give it a more straightforward way: 2) basically reducing risk by increasing control. Or reducing risk by simply reducing exposure. A linear approach, one could say.

Recent reports and bank failures have suggested that the first approach: very much seen as the portfolio approach have failed- given the humongous losses as a result of marked to market policies, a standard deviation or probability approach. This approach assumes that we can minimize losses given a certain probability and thereby maximizing profits rather than taking an approach of an outright ban which might result in losing precious opportunities. Therefore quantifying risk in this approach is of absolute importance. Only when we can quantify risk, can we justify how much risk to take and how much reward is justifiable to take in the first place.

 Therefore there have been quite alot of advancement in this area as one can see the sophistication in this approach as opposed to the linear one. The problem in this approach lies not in the philosophy but rather the confidence one has on historical data to predict future losses or profits.

In actual fact, this approach is more similar to the second approach than one might think: it is the assumption of linearity of history in predicting the future. Historical data is useful only if we can predict with confidence the relationship between the past and the present- and therefore in most cases the linearity relationship.

The use of historical data would have no basis in calculating risk if we would to take the opposite assumption which is that data is of a random nature, then this approach would then be of no use whatsoever. The utility in this approach would therefore lies in the assumptive assumption in this approach that when we take this much risk, we can expect this much reward- give and take a certain an amount of “negligible” deviation.

This approach therefore underestimates human capacity not to conform to models but rather have a knee-jerk reaction to any form of emotional shocks. And at the same time, the ability for humans to alter human reactions by way of data presentation hence eliciting a positive response of which can be made use of or exploited.

And thereby the financial crisis, the credit crisis, the housing crisis is probably not the result of negligent handling since banks and other halo-ed institutions would not wish to be perceived as such but rather a very human propensity to assume that what used to work will always work in the future: thereby meaning that since these models work so well on their own-almost quite automatically and gives a very quantifiable report as well which I can see clearly and a macro view as well- it should be fine. When suddenly, an event which deviates from this rather underlying linearity prejudice in our head, we are at a loss on how to explain it. And thereby swing quite incorrectly I believe, to the primitive approach: of which is the second one- which is to cut the head off from the body to stop the loss; or to impose controls, reduce exposures, a black and white approach or enter and exit strategy.

This second approach is useful insofar that command and control is almost total and therefore encompassing. It means that one can enter and exit almost cleanly as one can cut through butter. And at the same time, this second approach requires almost clockwork vigilance and therefore requires a simple organizational structure.

The complexity of institutions- both private and public- meant that it would indeed be impossible to reduce risk at precisely the right moment and with the entire organization working in tandem as well. And the second drawback of this approach is it might show almost a lack of commitment towards a certain orientation. Hence it attracts questions more then it attracts decisive-ness. Its communications almost have to be as perfect as its delivery. Such approach is almost always used only in times of crisis and in smaller organizations with straightforward communication chains: otherwise, its ramifications can be rather widespread.

And such organization must not be conflictual by nature- which means that it would only contain only one person at the top with the final decision almost always resting on his shoulders. And only can the execution, delivery, communication be total, consistent and all-encompassing. With the complexity of modern organizations, it would be quite impossible to envision a person with such tentacle-like influence.

But the question then begs: would it be possible therefore to allow such a person to sit on top while ensuring an effective and well-managed organization. And would it be risky or risk-managed organization.

It is my belief that most organizations are already with such an organization structure. It means, the President or CEO sits on top of everyone - and being checked by a Parliament or board; and who responsible to its people or shareholders. The leader is thereby supported by cabinet ministers, and fellow C-suite personnel which reports to him periodically. In various areas of concern, they formed committees focused on tackling pertinent issues- he might or might not intervene but are given reports on the progress. He ultimately more or less sets the agenda but does not interfere much in the daily operations of matters unless required.

And an alternative appears to be a matrix one where- responsibilities and functions are often cross-checked with multiple departments and powers of which I think are most useful for a project-based organization with diversified portfolio as compared with an organization with a relatively constant mission and objective.

And even then, for such organizations, it perhaps arguable that in times of crisis: the matrix organization would almost flatten out to effect a more effective and efficient organization just in case, there would be a deviated objective.

Hence the most effective organization for implementing the first approach would of course be the existing structure of organization. The complexity of business means that the single person sitting on top with tentacle-like influence would not come into grasp quite a number of issues by which only distinct business units are aware of. But having said that: it is of critical importance that the leader is not just nothing more than a figurehead and a facilitator but rather a person who knows what is going on rather than one leaves everything to their department or committee heads.

Similarly, each and every single executive faces the same problem of an agency problem. Of which he who acts might not act in the best interest of those that he purports to represent or protect- and the board and other checking institutions would come into play to ensure its fidelity to the objective at hand.

  Hence the present structure of which most companies and modern organizations are predicated on- and as far as all the malaise is concerned- would it be fair therefore to lay blame on the structure or rather the individual organization or company concerned. Is then the way we organize structures the cause of poor risk management or basically just poor risk management on the part of organizations.

My feeling is that in most cases, people really don’t know what is going on. And can we blame them for not knowing when they have very well paid executives below them managing individual areas or should we lay all the blame on them since they are the ones presiding over all meetings and reports.

Very often, this is what happens when one’s influences outstrips one’s functions and vice versa. The people below them might be smarter than them and therefore are able to skirt around the controls and issues but at the same time, how do we blame them for skirting around them when there are profit and organizational objectives are at hand. The leaders therefore as the leader would have to take the moral responsibility of not steering the ship correctly- and for not knowing what is going on effectively- but is probably incapable of knowing too, since things are moving so fast and complex that it would be quite impossible to be in the know of everything.

This at the end of the day seems apparent that it has almost nothing to do with methods of risk management but rather the economic realities that we lived in. And we are ultimately complicit in all the malaise that plagued the various sectors of our societies: and we all are to blame in one way or another in causing a crisis, a bubble- when we did not say no to the current state of affairs. We did it not you.