6 Ways Companies Mismanage Risk
2nd Article Review
“6 Ways Companies Mismanage Risk”
Philippine Women’s University
Julie Ann R. Perez
2nd Semester 2013-2014
November 6, 2013
1. Discuss the ways by which companies mismanage risks? Effective risk management is difficult even in the best situations, and failure of risk management can cause large losses within an organization. There are six fundamental mistakes risk managers routinely make: relying on historical data, focusing on narrow measures, overlooking knowable risks, overlooking concealed risks, failing to communicate, and not managing in real time.
Reliance on Historical Data Risk-management modeling usually involves extrapolating from the past to forecast the probability that a given risk will materialize. But the past may not always reflect the future.
Limited View of Risks
The actual measures of risk can lead the company to ignore risks that it should be taking into account. If a bank uses VaR to protect itself from losses, it may have insufficient capital to support the risks it is taking. VaR does not capture catastrophic losses that have a small probability of occurring. Similarly, a daily measure does not capture the risk of a portfolio when the firm is stuck with the portfolio for a much longer period. When unwinding a position takes a long period of time, a much higher level of capital is needed.
Overlooking Knowable Risks
A third source of risk management failure is overlooking knowable risks. One type of knowable risk that is often overlooked is risk outside the normal risk class. Many organizations manage market, credit, and operational risks in isolation, ignoring correlations and associations among these risks that could be more easily identified with a firm wide assessment of risk. Market-concentration risks are also sometimes overlooked because much of the theory underlying statistical risk models assumes markets are largely frictionless. This assumption can lead to ignoring
“6 Ways Companies Mismanage Risk”
Philippine Women’s University
Julie Ann R. Perez
2nd Semester 2013-2014
November 6, 2013
1. Discuss the ways by which companies mismanage risks? Effective risk management is difficult even in the best situations, and failure of risk management can cause large losses within an organization. There are six fundamental mistakes risk managers routinely make: relying on historical data, focusing on narrow measures, overlooking knowable risks, overlooking concealed risks, failing to communicate, and not managing in real time.
Reliance on Historical Data Risk-management modeling usually involves extrapolating from the past to forecast the probability that a given risk will materialize. But the past may not always reflect the future.
Limited View of Risks
The actual measures of risk can lead the company to ignore risks that it should be taking into account. If a bank uses VaR to protect itself from losses, it may have insufficient capital to support the risks it is taking. VaR does not capture catastrophic losses that have a small probability of occurring. Similarly, a daily measure does not capture the risk of a portfolio when the firm is stuck with the portfolio for a much longer period. When unwinding a position takes a long period of time, a much higher level of capital is needed.
Overlooking Knowable Risks
A third source of risk management failure is overlooking knowable risks. One type of knowable risk that is often overlooked is risk outside the normal risk class. Many organizations manage market, credit, and operational risks in isolation, ignoring correlations and associations among these risks that could be more easily identified with a firm wide assessment of risk. Market-concentration risks are also sometimes overlooked because much of the theory underlying statistical risk models assumes markets are largely frictionless. This assumption can lead to ignoring