Risk management, financial or otherwise, follows a logical process. At its simplest it involves three steps: an awareness of the risks being taken by the firm, organisation or individual; measurement of the risks to determine their impact and materiality; and risk adjustment through the adoption of policies or a course of action to manage or reduce the risks.
Risk Awareness
It is not obvious how we may become aware of or identify risks. Some risks will be well known since they have long been identified; other risks will emerge as a result of changing conditions. Management may have a prior awareness, or there may be a specific experience of certain risks. Other methods of becoming aware of risks include standard analytic methods such as fault tracing; the use of experts (for instance Delphi forecasting); scenario building (via an investigation of Murphy’s law – that is, what can go wrong will go wrong); brainstorming; and other similar approaches used to identify the factors in a particular industry, economic environment or within the firm. Careful examination of accidents that happen to others is also useful in creating awareness
Being aware of risks is an ongoing discovery exercise that needs to be repeated at frequent intervals to capture changed conditions. As human beings, we also have the problem that we may not either perceive the risk or be able to assess its significance due to our interpreting data through our own ‘world view’. In addition, different financial markets have varying degrees of efficiency, market transparency and development. Dominic Casserley (1993) suggests three levels of risk awareness.
1. Risks that are unknown and unmeasurable (that is, they have not manifested themselves or have not been perceived). An example would be global interlinkages that affected banks and other financial institutions in the wake of the collapse of the US housing market. The contagion effect from the global holding of various kinds of collateral debt obligations (CDOs) was unexpected, especially since CDOs were supposed to diversify risk rather than enhance it. While a few commentators had questioned the suitability of CDOs as financial instruments, no one had understood the systemic risk that the wide dissemination of these instruments had created. Banks in virtually every single major country were adversely affected by the collapse in the CDO market and in a number of countries required government support. Fear that some banks were holding large quantities of CDOs and other such ‘toxic assets’ caused a virtual collapse of the world financial system in 2008, and only intervention by governments, regulators and central banks prevented the system from totally failing.
2. Risks that are known but still unmeasurable (where, although the risk is known, there are insufficient data on which to base an evaluation of the likely consequences or to quantify the exposure). The Greek crisis started in late 2009, when Greece announced that, far from having a manageable budget deficit as previously forecast of 3.7 per cent of GDP, this was an unsustainable 12.7 per cent. A few months later, in May 2010, the country was given a bailout by the European Union and the International Monetary Fund. While the risk of a country defaulting is known, it is hard to measure, since there are relatively few countries and few incidences of default. In addition, there are individual factors that make each country’s case unique. Ireland and then Portugal were also given European Union assistance later on. There are common factors that affect all three countries, but, equally, the causes of their need for bailouts to prevent default are also country specific.
3. Risks that are both known and measurable. (In such cases, there are many observations on which to build a statistical model in order to predict future behaviour.) This is the situation with which risk management typically has to deal, when organisations seek to measure their exposure to the principal financial risk factors. As discussed earlier, we have historical data on currency exchange rates, commodity prices and interest rates that show how these have fluctuated considerably over time.
