Any firm that sets up a risk management department wants to ensure that the department works efficiently and effectively. Just like all other people and departments, the risk management department is also subject to periodic reviews. In these reviews, the effectiveness of the risk management department, as well as the methods that they use, is gauged.
It is important to correctly define the objectives so that the performance of the department can be correctly appraised. It is a misconception that the function of the risk department is to prevent any financial loss from occurring. Such a target would be an impossible one! There is no predictive science or crystal ball in the world which can completely eliminate the possibility of financial losses.
Instead, the risk management department should be appraised on the basis of their ability to predict the risks and prepare for them. No organization can eliminate risks. However, there are mechanisms to minimize its impact and that is the function of the risk management department.
There are several possible reasons which could lead to the failure of the market risk management team. In this article, we will have a look at the five most common reasons behind the failure of market risk management.
- Ignoring a Known Risk: Ignoring a known risk might seem like an outright failure of a risk management department. However, it is surprising to see the number of times this happens. Even the most sophisticated players like the ones at Long Term Fund Management sometimes forget to include certain risks in their model.
For instance, they were aware of the market risk and hence hedged them with Russian banks as counterparties. However, during the 1998 Russian Roubles crisis, many Russian banks defaulted. This was not taken into account by the LTCM fund management team. It was astounding that a fund that was entirely built on quantitative prowess and risk management suffered such huge losses because they failed to take certain risks into account!
Another common risk forgotten by risk managers is that of correlation between various asset classes. Risk managers should be mindful of this risk or else there is a possibility that all their assets might lose value at the same time.
- Not Discovering All Risks: A lot of the time, risk managers are simply not able to detect all the risks which may impact the firm. This can also be considered to be a failure of the risk management department. This is because failure to account for the risk distorts the picture of the firms performance. Hence, the firm may be compelled to take unnecessary risks by investing in risky assets.
A lot of the time, the risks which are not discovered are related to the baseline assumptions. For instance, almost everyone in the financial world believes that the probability of default of assets with an AAA+ credit rating is very less. The possibility of sovereign default is considered to be even more far-fetched. Hence, when one of these supposedly risk-free security defaults, it causes a lot of mayhem in the markets.
- Improper Modelling of Risk: The risk management department is in charge of developing the risk models as well as keeping them up to date. With the passage of time, more and more variables that impact a particular risk are discovered. Many times, companies fail to incorporate this new information in their models. As a result, their models become less efficient than their peers. In many cases, the models become completely obsolete.
It is the job of risk management to ensure that these models remain up to date. The inability to do so and to find new risk metrics which enable better monitoring and management of the situation should be regarded as a failure of the risk management department.
- Inability to Communicate the Risks: The job of the risk management team is to find out information about the outstanding risks and then relay that information to the senior management in time. The senior management then decides what action needs to be taken on this information. However, in many cases, this information is not effectively transmitted. This must be considered to be a failure of the risk management department.
The job of the department does not end with identifying risks. It must be communicated to the proper stakeholders. In some cases, the information is distorted by intermediaries. In some other cases, the information may not reach the relevant people in a timely manner. Efficient risk management needs to have the right strategy in place to ensure effective communication.
- Inability to Manage Market Risks: The risk profile of a security may not necessarily remain static. The characteristics of a lot of market securities undergo change during their lifetime. It is the job of a risk manager to stay abreast of all these changes and incorporate them into the decision-making of the firm. A lot of the time, these changes are brought about by the risk managers themselves.
For instance, if they buy derivatives to hedge foreign currency exposure, they may instead end up being exposed to interest rate risk. It is often said that the practice of risk management often shifts risk from one variable to another. It is commonly referred to as the Heisenberg Principle amongst the market players.
There are several more ways in which the market risk department of an organization can fail. However, if these five basic types of risks are covered and mitigated, then it is quite likely that the risk management department will perform effectively.
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