Failure of Market Risk Management
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.
|❮❮ Previous||Next ❯❯|
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Risk Management - Introduction
- Benefits of Risk Management
- Principles of Risk Management
- Risk Management Process
- Risk Identification and Assessment
- Aspects of Risk Management
- Steps in Risk Management Process
- Approaches to Risk Management
- Risk Management Policy
- Commonly Used Measures of Risk
- Risk Management Plan
- Evaluation of Risk Management Plan
- Risk Treatment
- Role of HRD in Risk Management
- Enterprise Risk Management
- Implementing ERM
- Risk Management and Stock Market
- Outsourcing Risk Management Program
- Risk Management as a Profession
- Anticipating and Mitigating Organizational Risks in the Digital Age
- Challenges Facing the Australian Economy
- The Economic Costs of MeToo
- Automated Claims Processing
- Challenges in Global Insurance And International Claims
- Conflicts of Interest in the Insurance Business
- The Cost Structure in the Insurance Industry
- How Drones Will Impact the Insurance Industry?
- How Is Health Insurance Funded?
- How Self Driving Cars Impact Insurance?
- How Stock Market Volatility Affects Insurance Companies?
- Insurance Agents vs. Insurance Brokers
- The ABCs of Insurance Fraud in India
- Technological Advances in the Insurance Industry
- The Basics of Unemployment Insurance
- The Pros and Cons of Unemployment Assistance and Why it Matters in the Present Times
- The Role of Insurance In #MeToo Movement
- Why the Flood Insurance Market should be Privatized?
- Basics of Pet Insurance
- Cannabis Insurance
- Challenges Facing Cryptocurrency Insurance
- Evolution of Insurance Regulation
- Food Delivery Apps and Insurance
- How Does Captive Insurance Work?
- On-Demand Insurance
- Reinsurance vs. Double Insurance
- Solvency Regulations in the Insurance Industry
- Terrorism and Insurance
- The Basics of Microinsurance
- The Basics of Reinsurance
- Types of Captive Insurance Companies
- What is P2P Insurance?
- How Risks Affect Companies Providing Financial Services
- Risk Management Information System
- Disadvantages of Risk Management Information Systems
- The Known-Unknown Classification of Risk
- Operational Risk: Definition and Drivers
- How Regulations Have Affected Operational Risk?
- Identification of Operational Risks
- How to Identify Operational Risks
- Using Internal Loss Data to Mitigate Operational Risks
- External Loss Data in Operational Risk Management
- Risk Control Self Assessment (RCSA)
- Scenario Analysis in Risk Management
- Key Risk Indicators
- Basel Approaches in Operational Risk Management
- The Basel Risk Categories
- Cause Categories in Operational Risk Management
- Loss Distribution Approach
- The COSO Framework for Internal Control
- Mistakes to be Avoided While Building a Risk Management System
- Credit Rating Terminology
- Types of Exposures to Determine Credit Limit
- Types of Credit Events
- Active Credit Portfolio Risk Management
- Metrics to Measure Credit Risk
- Credit Derivatives: An Introduction
- Credit Linked Note
- How do Credit Default Swaps Work?
- Why are Credit Default Swaps Dangerous?
- Total Returns Swap
- What are Collateralized Debt Obligations and How do they Work?
- Collateralized Debt Obligations: Advantages and Disadvantages
- Mark To Market Accounting
- What are Recovery Rates? - Different Types of Recovery Rates
- Netting, Close Out, and Acceleration
- Expected Default Frequency (EDF)
- Expected Default Frequency: Advantages and Disadvantages
- Altmans Z Score Model
- Unexpected Loss and Economic Capital Buffer
- Stress Testing in Credit Risk Management
- Provisioning in Credit Risk Management
- How Corporate Governance Impacts Credit Risk
- Exit Strategies In Credit Risk Management
- What is Market Risk? - How its Measured and Sources of Market Risk
- Why is Market Risk Management Important?
- Introduction to Value At Risk (VaR)
- The Three Types of Value at Risk (VaR)
- Marginal, Incremental and Component Value at Risk (VAR)
- How Value at Risk (VaR) is Implemented?
- Backtesting Value at Risk (VaR)
- Advantages of Using Value at Risk (VaR) Model
- Disadvantages of Using the Value at Risk (VaR) Model
- How Margins Are Calculated Using Value at Risk (VaR)
- Market Risk Limits
- Tail Risk
- The Upside of Market Volatility
- Relationship between Volatility and Risk
- Importance of Data Quality in Risk Management
- Impact of Using Poor Quality Data and Metrics to Measure Data Quality
- Enterprise Risk Management (ERM) vs Traditional Risk Management
- Benefits of Enterprise Risk Management
- Corporate Risk Governance
- International Risk Governance Committee (IRGC) Framework
- Failure of Market Risk Management
- Mistakes to Avoid in Risk Management