Classic Risk Management Pitfalls

In the upcoming Harvard Business Review for March 2009, Rene M. Stulz highlights six ways companies mismanage risk.  Dr. Stulz suggests that these classic missteps can occur in good economic times as well as the rough economic times we are currently experiencing.  However, the current crisis has certainly magnified the impact of the following mistakes.

Relying on historical data. A risk manager who assessed real estate risk on the basis of statistics from the past three decades would have been sorely unprepared for the volatility of house prices in 2007.

Focusing on narrow measures. A daily Value-at-Risk (VaR) measure is commonly used for securities trading. But a daily measure assumes that assets can be sold quickly or hedged, so it doesn’t apply to portfolios with which the firm may be temporarily stuck.

Overlooking knowable risks. Risk managers often distinguish among market, credit, and operational risks, which they measure differently and in isolation rather than cross-organizationally. They may also fail to assess new risks embedded in the instruments they use for risk mitigation.

Overlooking concealed risks. Risk takers may deliberately hide their risks, as happened at the French bank Société Générale in 2007. Or they may underreport them when their trading positions are complex and short-lived.

Failing to communicate. Sometimes even the most scrupulous risk manager cannot clearly explain a state-of-the-art system to the CEO and the board. In such a case, their confidence in the system’s capabilities may be unwarranted.

Not managing in real time. It is difficult to hedge trading positions when their risk characteristics can change completely within a single day—as can happen, say, with barrier calls.

A truly effective enterprise risk management program should address all six of these potential shortcomings. Visit www.WheelhouseAdvisors.com to learn more about how we can help your company avoid these problems.