1. Lecture Notes: Risk Management
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2. Contents What is Risk Defining Risk Management
Risk Management Perspectives
Key Drivers of Risk
Risk Management Architecture
Why Practice Risk Management
Benefits of Risk Management
Tools and Techniques for risk identification
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3. Defining Risk WHAT IS RISK
Risk is the volatility (Unpredictability) of the
performance of business and/or Industry
Actual Outcomes differs from Expected
Returns/Rewards and will be worse than
expected Returns/Rewards
Risk is a condition in which there exists a quantifiable dispersion in the possible outcomes from any activity.
It can also be defined as uncertain future events which could influence the achievement of the organisation's strategic, operational and financial objectives.
Two aspects to risk to note:
*Uncertainty
*Exposure
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4. Theories of Risk Management
1.0 The normal hypothesis
The transactions which incur higher risk will yield higher returns.
Under the normal hypothesis of risk, firms are assumed to take a view that the more risk they take, the more the return.
This approach attaches a positive correlation between risk and return such that the profitability of an organisation is intricately linked to the risk appetite of the organisation.
Profit seeking organisations are therefore assumed to be risk takers given the relationship between risk and return.
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5. Hypothesis of increasing marginal disutility of risk
The relationship between risk and return is not always linear as suggested under the normal hypothesis of risk.
Although not necessarily contradictory to the normal hypothesis of risk theory, the marginal disutility of risk approach postulates that a firm can increase its risk taking activities only up to a certain point after which the return will start to decline regardless of how much more risk is assumed.
Therefore, the firm will have to take a decision on whether it is necessary to continue assuming more risk when the returns are diminishing. This approach is generally consistent with economic theory on utility.
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6. Risk……
Risk is therefore primarily concerned with evaluating potential losses.
There two concepts used in this regard
Loss frequency
Loss severity
These concepts are particularly useful in helping a firm to rank loss exposures according to their relative importance.
In addition, the relative frequency and severity of each loss exposure needs to be estimated so that an appropriate technique or a combination of techniques can be selected to treat the loss exposure.
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7. ……….
Regardless of the approach is used for measuring severity, it must seek to determine the maximum possible loss and the maximum probable loss.
The maximum possible loss is the worst loss that could possibly occur to the firm during its lifetime.
On the other hand, the maximum probable loss is the worst loss that is likely to happen to a firm
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8. When faced with risk…… An organisation may do one of the following;
1. Avoid the risk
2. Accept the risk
3. Treat or control the risk, or
4. Transfer the risk to another party
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9. Risk Management Risk management starts with three basic questions
1. What can go wrong
2. What will be done to prevent risk
3. What will be done in the event that risk
materializes
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10. Defining Risk Management
Definition of risk management: the practice of defining the risk level a firm or financial company desires, identifying the risk level it currently has, and using derivatives or other financial instruments to adjust the actual risk level to the desired risk level.
Note:
it has to be Identifiable and insurable risks
Not necessarily to insure against risk, firms can take on higher risk (which is not sound risk management).
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11. Risk Management
Risk Management is the process of measuring or assessing the actual or potential adverse implications of a business operation
* Risk management is an inherent part of everyday life both for businesses and individuals
* It is a systematic way of thinking about all possible risks before they occur
* It helps an organisation to set up strategies to deal with potential risks
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12. Risk Appetite & Risk Culture
Risks are not always seen in the same way. Some argue that risk appetite and risk culture largely shape the understanding of the nature of risk management in a firm.
Risk appetite is the amount of risk an organisation is willing to accept in pursuit of profit or value. It is directly related to a firm's strategy and may be expressed as the acceptable balance between growth, return and risk.
This is the set of shared attitudes, values and practices that characterise how an entity considers risk in its daily activities. Risk culture is mainly derived from an analysis of organisational practices, namely rewards or sanctions for risk taking or risk avoiding behaviour.
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13. RISK MANAGEMENT IN PERSPECTIVE
Important to note that:
FIs are of different sizes and
undertake varied business activities,
There can be no single optimal risk management structure for all.
This fact notwithstanding, all FIs need to have structure designed to identify, measure, manage and control the risks
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14. Liberalization of economies towards market economy Deregulation
FIs ARE INCREASINGLY EXPOSED TO RISKS DUE TO EXTERNAL AND INTERNAL ENVIRONMENTAL CHANGES
KEY DRIVERS OF CHANGE
Liberalization of economies towards market economy
Deregulation
Globalization and Cross border dealings
Increased sophistication of bank products
Changes in Information Communication and Technology (ICT)
Changes in Balance Sheet Management
ALL THESE IMPACT ON FIs’ CAPITAL AND EARNINGS
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15. RISK MANAGEMENT ARCHITECTURE
Risk management is a practice with process, methods and tools for managing risk in a business and /or industry.
It provides a disciplined environment for proactive decision making
Assess continuously what could go wrong (risks)
Determine which risks are important to deal with and
Implement strategies to deal with those risks
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16. Why Practice Risk Management
The driving force for Risk Management
Firms practice risk management for several reasons:
Interest rates, exchange rates and stock prices are more volatile today than in the past.
Significant losses incurred by firms that did not practice risk management
Improvements in information technology
Favorable regulatory environment
Sometimes we call this activity financial risk management
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17. Benefits of Risk Management
What are the benefits of risk management, in light of the Modigliani-Miller principle that corporate financial decisions provide no value because shareholders can execute these transactions themselves?
Firms can practice risk management more effectively.
There may tax advantages from the progressive tax system.
Risk management reduces bankruptcy costs.
Managers are trying to reduce their own risk.
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18. Benefits Continued
By protecting a firm’s cash flow, it increases the likelihood that the firm will generate enough cash to allow it to engage in profitable investments.
Some firms use risk management as speculative tools.
Some firms believe that there are arbitrage opportunities in the financial markets.
Note: The desire to lower risk is not a sufficient reason to practice risk management
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19. Risk Management Risks can be:
Avoided by not assuming the risk or otherwise eliminating the hazard associated with the activity
Reduced by taking preventative action, e.g., sprinklers to reduce fire damages or other action to reduce the probability of loss
Retained/Accepted
Transferred using insurance or derivatives
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20. Risk Management Speculative risks
Stulz, R. M. (1996). "Rethinking Risk Management." Journal of Applied Corporate Finance 9(3): 8-24.
risk management is viewed as variance minimization in most academic circles
risk management may be viewed as the “elimination of costly lower-tail outcomes” or equivalently risk management is the purchase of out of the money put options
Note that this approach does suggest that only those firms with bankruptcy risk need to actively manage risk.
This approach also provides an intuitive connection with capital structure theory.
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21. Risk Management Process
Risk assessment
Identification of organizational risks
Frequency and severity
Risk control
Avoid
Reduce
Transfer
Risk finance
Self-finance
(Re)insurance
Alternative Risk Transfer
Administration
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22. Risk Assessment
A firm should make every attempt to assess its risks within the context of both the external and internal operating environment.
This is a useful process as it assists in understanding the key drivers of the risks the firm may face in its every day operations.
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23. Risk Identification
The objective of risk identification is to determine the risks that may affect the firm and document their characteristics.
Risk identification may be done through various stakeholders to the firm as well as external experts
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24. Tools & Techniques for Risk Identification
1. Documentation reviews
This can be done by conducting a structured review of previous documentation and reports of the firm.
This is in order to ascertain whether there are any historical issues likely to influence the nature and direction of risks faced by the firm.
2. Information gathering techniques
Several methods of information gathering can be used in risk identification.
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25. Cont’d These include: Brainstorming
probably the most used risk identification technique. The goal is to compile a comprehensive list of risks that can be addressed later in the risk analysis processes.
It usually consists of a multidisciplinary set of experts.
Under the leadership of a facilitator, they generate ideas about a firm's risks.
The process proceeds without interruption and without any expression of judgment or criticism of ideas and without regard to one's position in the organisation.
Sources of risk are identified in broad scope and discussed by the whole team.
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26. Cont’d
Risks are then categorised by type and their definitions sharpened.
Brainstorming can be mire effective where participants prepare in advance and the facilitator develops some risks in advance and the meeting is structured by operational activity and risk category.
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27. Delphi Technique
This is a method by which consensus of experts can be reached on risk.
Experts are identified but participate anonymously.
Delphi technique helps reduce bias and minimises the influence of any one person on the outcome. A facilitator uses a questionnaire to solicit ideas about the important risks facing the firm and responses are submitted and put into risk categories.
The risks are then circulated for expert review. Consensus on major risks is reached after a few rounds of this process.
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28. Information Gathering
1. Interviews
Risks can be identified by interviews with experienced and skilled experts within the firm.
The appropriate individuals are selected and briefed. The interviewees identify risks based on their experience in their respective operational areas and any other sources they find useful.
2. SWOT Analysis: ensures examination of risks from each of the SWOT perspectives to increase the scope of risks considered
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29. Cont’d
3. Checklist
It is also useful for organisations to develop checklists of risks based on information collected from past activities.
This could include loss event data etc. The checklist is a quick way of identifying potential risks and should not be considered as complete.
It should factor the possibility of other risks emerging and being addressed.
4. Assumptions Analysis
There is also need to consider the underlying assumptions and scenarios used in the various operational activities of the firm.
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30. Cont’d
Assumptions analysis is a technique that explores the accuracy of the assumptions.
It identifies risks relating to the firm arising from inaccurate, inconsistent and incomplete assumptions.
This is a useful technique given the role of that assumptions play in the planning process of any firm.
5. Diagramming technique
Cause and effect diagrams useful for identifying causes of risk.
System or process flowcharts show how various elements of a system interrelate and the mechanism of causation.
Similarly, influence diagrams provide a graphical representation of a problem showing causal influences, time ordering of events and other relationships among variables and outcomes
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