Managing risk


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A brief and clear argumentation in favour of the personalisation approach in risk management procedures in large companies.
Taken from "Making better risk management decisions" by J. Birkinshaw and H. Jenkins.

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Managing risk

  1. 1. MANAGING RISK: A PERSONALISED APPROACH How companies should handle with difficult risk management decisions From the findings of Julian Birkinshaw and Huw Jenkins DAVIDE DI FAZIO
  2. 2. INDEX <ul><li>DEFINITION 3 </li></ul><ul><li>TYPES OF RISK 4 </li></ul><ul><li>THREE APPROACHES 5 </li></ul><ul><li>FORMALISATION 6 </li></ul><ul><li>EXTERNALISATION 7 </li></ul><ul><li>PERSONALISATION 8 </li></ul><ul><li>THE SOLUTION: A BALANCED SYSTEM 9 </li></ul><ul><li>PERSONALISATION IN RISK MANAGEMENT 10 </li></ul><ul><li>THREE SUPPORTING ELEMENTS 11 </li></ul><ul><li>HIGH-QUALITY INSIGHTS 12 </li></ul><ul><li>PERSONAL ACCOUNTABILITY 13 </li></ul><ul><li>C) SUPPORTIVE CULTURE 14 </li></ul><ul><li>CASE STUDY: CREDIT CRISIS 15-18 </li></ul>
  3. 3. DEFINITION <ul><li>RISK </li></ul><ul><li>THE POTENTIALLY NEGATIVE IMPACT RESULTING FROM A FUTURE EVENT </li></ul><ul><li>The entity of the risk connected with a certain event may be calculated with this general formula: </li></ul>Probability of event A happening X Scale of loss associated with event A
  4. 4. TYPES OF RISK <ul><li>There are two types of risk: </li></ul><ul><li>FALSE POSITIVE RISK </li></ul><ul><li>It is associated with investing in a potential business opportunity that finally does not transpire. </li></ul><ul><li>An oil and gas company which is extremely cautious about investing in new oilfields will probably avoid false positive mistakes, such as investing on wells that in the end turn out to be almost dry. </li></ul><ul><li>FALSE NEGATIVE RISK </li></ul><ul><li>It is associated with failing to act on an opportunity that actually did transpire. </li></ul><ul><li>That same oil and gas company will be probably more exposed to false negative mistakes, such as not investing on lucrative areas, thus leaving money on the table to its competitors. </li></ul><ul><li>The more one type of risk is minimised, the more the other type ends up occurring. </li></ul><ul><li>EFFECTIVE RISK MANAGEMENT IS ABOUT EVALUATING THE PROs AND THE CONs OF THESE TWO TYPES OF MISTAKES AND ADJUSTING DECISION-MAKING PROCESSES ACCORDINGLY. </li></ul>
  5. 5. THREE APPROACHES <ul><li>There are three different approaches to manage risk decisions: </li></ul><ul><li>1) FORMALISATION </li></ul><ul><li>2) EXTERNALISATION </li></ul><ul><li>3) PERSONALISATION </li></ul><ul><li>The first two are manifestations of bureaucracy; the third is the approach which should be re-introduced in risk management practises. </li></ul>
  6. 6. 1) FORMALISATION <ul><li>USING SYSTEM-WIDE PROCEDURES AND RULES TO EVALUATE AND ADJUDICATE ON WHAT RISKS ARE WORTH TAKING. </li></ul><ul><li>This approach can fail because it allows individual to detach themselves, legally and morally, from the system in which they were working: at least, with this approach risky decisions are taken, in some de-personalised way, by the firm’s management. </li></ul>
  7. 7. 2) EXTERNALISATION <ul><li>USING THE EXPERTISE AND SEAL OF APPROVAL PROVIDED BY THIRD PARTIES, SOME REQUIRED BY LAW (auditors, regulators), OTHERS OPTIONAL BUT WIDELY USED (credit ranking agencies). </li></ul><ul><li>Like Formalisation, this approach can fail too because it allows individual to detach themselves, legally and morally, from the system in which they were working: in addition, with this approach risky decisions are not even taken by the firm’s management, but are asked to third parties. </li></ul>
  8. 8. 3) PERSONALISATION <ul><li>PUSHING THE RESPONSIBILITY FOR EVALUATING AND MAKING A JUDGEMENT AROUND RISK TO THOSE INDIVIDUALS WHO ARE MAKING DECISIONS AND REQUIRING THEM TO LIVE WITH THE CONSEQUENCES OF THOSE DECISIONS. </li></ul><ul><li>Especially in large firms, this approach can be fruitful because it increases the management’s concern about their own decisions about risky business. </li></ul>
  10. 10. PERSONALISATION IN RISK MANAGEMENT <ul><li>THE PERSONALISATION APPROACH IN RISK MANAGEMENT APPLIES IN MANY DIFFERENT CONTEXTS: </li></ul><ul><li>Pharmaceutical industry – strong ethical norms and professional standards of the medical fraternity. Such shared accountability among medical professionals helps to minimise false positive risks. </li></ul><ul><li>Social services – case notes written in narrative form by social workers make it easier for different officials to quickly pick up relevant details of complex cases. </li></ul><ul><li>Policy procedures – an employee of any rank could call together a cross-force group to consolidate all the available information about an incident and make a call on how to react, thus quickly bringing to bear all the different views on an issue and reaching a thoughtful decision. </li></ul>
  11. 11. THREE SUPPORTING ELEMENTS <ul><li>HOW TO APPLY A PERSONALISATION APPROACH IN A LARGE ORGANISATION (which relies, by definition, on significant amounts of formal systems to get work done)? </li></ul><ul><li>There are three elements which are necessary for companies to implement a Personalisation approach within its risk management procedures: </li></ul><ul><li>HIGH-QUALITY INSIGHT </li></ul><ul><li>PERSONAL ACCOUNTABILITY </li></ul><ul><li>SUPPORTIVE CULTURE </li></ul>
  12. 12. A) HIGH-QUALITY INSIGHTS <ul><li>BUILDING A SYSTEM THAT PUTS THE RIGHT INFORMATION IN THE HANDS OF THOSE MAKING THE CALL AND THEN TRANSFORMING THAT INFORMATION INTO INSIGHT THROUGH DEEP EXPERIENCE. </li></ul><ul><li>Individuals who take decisions require: </li></ul><ul><li>Good quality information </li></ul><ul><li>Effective analytical tools </li></ul><ul><li>The competence to interpret this information </li></ul>
  13. 13. B) PERSONAL ACCOUNTABILITY <ul><li>BUILDING A SYSTEM IN WHICH PERSONAL ACCOUNTABILITY IS REWARDED AND IN WHICH THE INDIVIDUAL OR TEAM WITH THE HIGHEST-QUALITY INSIGHT IS ALSO THE ONE MAKING THE DECISION. </li></ul><ul><li>The top management of companies is not always the most appropriate level for many decisions to be made. Firms need to find mechanisms for pushing personal accountability down to those who are closest to the action without those at the top abrogating their overall responsibility for the decision being made on their watch. </li></ul>
  14. 14. C) SUPPORTIVE CULTURE <ul><li>BUILDING A SYSTEM WHICH SUPPORT THE PERSONALISATION APPROACH APPLYING THESE PRINCIPLES: </li></ul><ul><li>THE NEED FOR TRANSPARENCY: cultural values can be shared when there is a very clear purpose in which everyone can identify, and when it is reinforced through consistency of action; </li></ul><ul><li>THE REFUSAL OF SIMPLIFYING THE BIG PICTURE: employees should be encouraged to look across organisational borders to understand how their work has implications for others. </li></ul>
  15. 15. CASE STUDY: CREDIT CRISIS <ul><li>Managing risks in investment banking sector: the 2009 credit crisis </li></ul><ul><li>There are no simple ways for companies to avoid risks. However, the evidence suggests that some companies are better able to manage them than others. </li></ul><ul><li>The 2009 credit crisis illustrates this point very clearly: </li></ul><ul><li>Lehman Brothers and Bear Sterns were wiped out; </li></ul><ul><li>UBS , Citibank , Merrill Lynch and Royal Bank of Scotland were badly hit; </li></ul><ul><li>several other banks, such as Goldman Sachs and JPMorgan Chase sailed through unharmed. </li></ul><ul><li>What explains the very different fortunes of the winners and losers in this period of unprecedented turbulence? </li></ul><ul><li>Main errors </li></ul><ul><li>In the years leading up to the credit crisis, financial services companies focused unduly on the formalisation of risk management by developing multi-usage procedures, with many signatories, to evaluate what risks were worth taking. They also relied on externalisation of risk management to a large degree – the use of expertise and approval from outside parties such as auditors, regulators and credit-rating agencies. </li></ul>
  16. 16. CASE STUDY: CREDIT CRISIS <ul><li>A focused view </li></ul><ul><li>While there were certainly some notable failures among small players such as hedge funds, the major losses were borne disproportionately by the very large banks. This was partly because small financial services companies did not have the credit ratings or balance sheets to carry the so-called “super senior” tranches of the Collateralised Debt Obligation (CDOs) that ultimately got the big investment banks into trouble. But it was also partly because the decision makers were close to the action, highly knowledgeable, and personally accountable for the outcomes of their decisions. As one leading hedge fund executive commented “ We have robust informal systems, we communicate naturally and we develop our own views on what risks to take. We get a return on our judgement ”. </li></ul><ul><li>JPMorgan Chase , one of the least affected major companies, also had a highly cohesive top team that took ownership of its risk-management agenda. CEO Jamie Dimon and his team saw early warning signals (back in 2006) of the credit risk in mortgages and the market risk on CDOs: consequently, they reduced the bank’s level of exposure to mortgaged-backed securities. </li></ul><ul><li>Most of the large investment banks, in contrast, had hundreds of employees working in risk management, using procedures so carefully defined that well-intentioned managers could no longer see the forest for the trees. According to one report: “ The risk governance failings of the banks resulted from an over-reliance on low-level risk decisions in siloed business, product lines and trading desks that ignored how these exposures contributed to a firm’s overall risk profile ”. </li></ul><ul><li>The net result was that some of the investment banks ended up making false-positive and false-negative decisions. Not only did they steer clear of promising lines of business that other firms, such as hedge funds and private equity houses, grew into, they also made horrendous trading losses on some of the lines of business they chose to invest in. When a firm makes both types of error at the same time, it is a sure sign that the system is not working. </li></ul>
  17. 17. CASE STUDY: CREDIT CRISIS <ul><li>The Personalisation approach </li></ul><ul><li>Goldman Sachs , one of the best performers through the credit crisis, is frequently held up as the acme of personalisation. As the Financial Times reported: “ Employees at Goldman typically see themselves as being affiliated to the bank, not the business line, and there is a strong ethos of shared accountability ”. And in JPMorgan Chase , Jamie Dimon is known to have taken an active personal role in risk briefings. But Goldman Sachs and JPMorgan Chase are clearly exceptions: other firms in the sector relied, and continue to rely heavily, on bureaucratic approaches to risk management. </li></ul><ul><li>The three supporting elements of the Personalisation approach </li></ul><ul><li>A) High quality insight : the credit crisis provides abundant examples of failings in this element. Lloyds TSB ’s acquisition of HBOS , for example, was a massively risky decision made on the basis of very limited insight. While the board of Lloyds TSB was clearly under a lot of pressure from the Bank of England , its primary responsibility was to its shareholders – and it failed them. At a more micro level, studies have looked at the securitisation of mortgage loans in the run-up to the credit crisis: they show that, when loans were securitised and sold on to non-banks, the likelihood of default was far higher than when loans were sold to affiliates of the originator. The non-banks, in essence, lacked the high-quality insight to make the right judgements about the risks they were taking. </li></ul><ul><li>B) Personal accountability : often there is no link between the decisions taken and the rewards provided: for example, in the run-up to the credit crisis, many banks traded in risky securities to optimise revenue growth or short-term profits without giving due regard to the appropriate cost of capital or the long-term nature of these securities. It is now conventional wisdom among commentators that a key factor in the creation of the current financial crisis was this focus on short-term accounting profit and the use of highly geared incentives around it. </li></ul><ul><li>C) Supportive culture : one of the principles involves the need for transparency of purpose, a higher-order reason for the organisation to exist. Many investment banks such as Lehman Brothers and Bear Sterns had formal vision statements, but the credit crisis revealed that these were full of empty rhetoric. Transparency of purpose, instead, refers to visible and ongoing commitment to a set of non-financial objectives. </li></ul>
  18. 18. CASE STUDY: CREDIT CRISIS <ul><li>Conclusion: a balanced system </li></ul><ul><li>Personalisation should not be viewed as a substitute for the formalisation and externalisation of risk management – it must be a complementary approach. </li></ul><ul><li>Once again, Goldman Sachs is an interesting example. As a former partnership, there is a greater degree of personal accountability and ownership than in most other banks; but, according to CEO Lloyd Blankfein, “ risk and control functions need to be completely independent from the business units ”. Personalisation and formalisation at Goldman Sachs are the yin and the yang of effective internal decision making: they keep the organisation in harmony. </li></ul>