Risk Management Challenges

In studies of financial and non-financial firms across the globe, it has been shown that risk management practices are not without problems. To summarise the work of Stulz (2008) there are five types of risk management failures:

1. Failure to use appropriate risk metrics

   VaR is a popular risk metric, but it can only tell us the largest loss the firm expects to incur at a given confidence level. VaR tells us nothing about the distribution of the losses that exceed VaR. This would suggest the application of VaR doesn’t guarantee the success of risk management. In addition, the effectiveness of implementing VaR also depends on the liquidity of the financial market. If the market is illiquid, then daily VaR measures lose their meaning. This is because if a firm sits on a portfolio that cannot be traded, a daily VaR measure is not a measure of the risk of the portfolio because the firm is stuck with the portfolio for a much longer period of time.
2. Mismeasurement of known risks

   Risk managers sometimes make mistakes in assessing the probability or the size of losses. Similarly they could use the wrong distribution. For a financial institution with many positions, although they may properly estimate the distribution associated with each position, the correlation between the different positions may be mismeasured. Mismeasurement of known risk is a common problem in risk management practice.
3. Failure to take known risks into account

   According to Stulz, it is very difficult to consider all the risks in a risk measurement system, or it is costly to do so. This is because nobody can forecast future events perfectly.
4. Failure in communicating risks to top management

   Risk managers communicate information about the risk position of the firm to top management and the board. The management and board use this information to determine the firm’s risk strategy. If a risk manager is unable to communicate this information effectively, top management may make decisions that are badly informed, or they may develop an overoptimistic perception of the risk position of the firm.
5. Failure in monitoring and managing risks

   Finally, it is challenging for risk managers to capture all the changes in the risk characteristics of securities and to adjust their hedges accordingly. As a result, risk managers may fail to adequately monitor or hedge risks simply because the risk characteristics of securities may change too quickly to allow them to assess them and put on effective hedges.

Risk Management: A Complex Business

These problems in risk management practice confirm that risk management is a complex system. Done well, it can be a very effective tool, but risk managers and management should be aware of the potential for failure. In addition to using quantitative measures like VaR, companies should also conduct stress testing and scenario analysis to provide a more rounded and comprehensive risk assessment. Stress testing involves subjecting the company’s financial positions to extreme movements in critical variables. Scenario analysis involves modelling a combination of events (eg, changes in exchange rates, interest rates, and commodity and asset prices) to capture the interactions within and between markets.

Reference: Stulz, R M (2008) ‘Risk Management Failures: What Are They and When Do They Happen?’, Journal of Applied Corporate Finance, 20(4), 58-67.