The risks of risk management

Risk management involves systematically identifying and evaluating risks as well as managing the response to the risks that have been identified. It is usually performed by specialised employees within a company and has become increasingly important since the 2008 financial crisis. Since the 1990s, the influence of risk management has grown gradually, in particular in financial companies, due to a rise in the number of legal and regulatory requirements. The financial crisis, in turn, triggered a growing internal acceptance of risk management within companies.

Nevertheless, the task of risk managers is practically impossible, particularly in the area of finance. On the one hand, their companies have to make money, which they can only do by taking risks. On the other hand, it is a risk manager’s job to limit or reduce these risks. And in doing so, he incurs costs or even prevents business from being generated, which tends to annoy the operational managers. And this tendency to prevent business can have a fatal economic impact, as the latest discussion about the credit crunch in southern Europe has revealed. When banks do not issue a sufficient amount of loans, they prevent the economy from rebounding.

In comparison to other industries, this conflict of interests has much more serious implications in the area of modern finance as the risks are often more abstract and are also situated in the distant future. Risk management is particularly difficult for complex financial products, as identifying and analysing their risks is particularly challenging. In addition, this complexity can also tempt creators of financial products into hiding risks or passing them on to unsuspecting investors. These days performance incentives are mainly given for meeting sales targets. They therefore reward short-term success, which makes the marketing of products with non-transparent risks a very appealing option for providers of financial services.

Experience has shown that risk managers come under pressure to throw caution to the wind when competitors start taking risks and aggressively sweep the market. There is therefore a fundamental tendency towards procyclical behaviour in risk management, a phenomenon that was particularly clear before the last financial crisis. It is a known fact that some banks relaxed their rules regarding risks between 2004 and 2007.

In addition, the supervisory authorities focus in particular on risk managers. They serve as agents who are responsible for ensuring that state regulations are met by delivering data and implementing provisions, but have no influence on what is regulated and in which form.

When things go well, risk managers are the party poopers who stand in the way of economic success; when things go badly, they are the ones who failed to warn everyone in good time beforehand. So by definition risk managers are wrong, no matter what happens. We can therefore understand why they tend to retreat behind a battery of formal rules governing risk control. This also explains the popularity of mathematical models and bureaucratisation, which has resulted in slavish application of red tape in risk management. Although they restrict their own scope for economic judgement, in case of doubt they can also resort to seemingly objective figures or regulations for justification.

For instance, a parliamentary inquiry in Great Britain investigated the collapse of the HBOS Bank in 2008 and criticised the bank’s risk management for being very strongly oriented to formal procedures and for not monitoring contents and assessing risks sufficiently. This bureaucratisation has been caused by the growing amount of regulation and the reporting requirements imposed by the supervisory authorities.

Michael Power of the London School of Economics has conducted several analyses exploring this development in risk management, which has resulted in the growing inability of analysts to identify new, unknown problems. In his work he has shown how the increasingly stringent formal requirements imposed on risk management have put the industry under considerable pressure to quantify their analyses. So although it is impossible to determine when uncertain events will occur, they are forced into a mathematical calculation, which incorrectly give the impression that they are measurable and, as a result, controllable.

However, it is not only the permanent pressure to justify themselves that makes risk managers retreat behind the pseudo-precision of figures. In modern society, we have a fundamental tendency towards greatly simplifying complex matters by reducing them to catchy key words or indicators. Many top managers or asset management clients do not want to be bothered by complex explanations. Concise reports are needed as a basis for decision-making; questions require clear answers – even if there aren’t any.

Mathematical risk indicators such as “Value at Risk” (VaR) and the hedging strategies based on them meet this need. This is probably the reason why “Value at Risk” has maintained its popularity in spite of its obvious failure (just like in 1998 after producing heavy losses during the debt crisis in the emerging markets). And mathematical hedging strategies also continue to be successfully marketed, even though they cannot function in a complex and uncertain world on a long-term basis. They can only deliver accurate results if the assumptions they are based on are correct. In a fast-changing marketplace, these assumptions can sometimes change drastically overnight.

In the risk management of investing, the liquidity risk is still one of the most frequently underestimated risks, because it cannot be measured with the standard quantitative approaches. Moreover, it has developed into a genuine fund killer. In the area of open-ended real estate funds, for example redemptions have repeatedly forced funds into selling at poor conditions. This in turn has negatively impacted their performance, leading to further redemptions. The most spectacular collapse of a hedge fund to date, that of the LTCM fund in 1998, was significantly accelerated by the sudden deterioration of the liquidity situation of numerous investments.

The fundamental conflict between achieving short-term profits and assessing long-term risks is particularly clear with regard to liquidity risk. The performance of asset mangers is measured on an ongoing basis. Customers generally favour the asset managers who succeed in generating the best results in a short period of time. They are not particularly interested in knowing whether the investment manager’s success is due to chance, to expertise or to the fact that he has taken greater risks. Portfolio managers experiencing falling rankings come under pressure to enhance their performance. One way of achieving this is to take greater risks. It is especially applicable when risks can be hidden.

Risk control is predominantly based on indicators that are calculated using volatilities, which makes it easier for portfolio managers to take liquidity risks without being detected. Illiquid shares often seem to be less volatile because they are traded less and therefore appear to be less risky than shares that are traded frequently. As a rule their performance correlates less strongly with the performance of other shares, so they appear to improve risk diversification. Some fund managers may be tempted to influence the prices of illiquid shares to enhance their own performance. If something goes wrong, however, it becomes virtually impossible to sell these illiquid shares due to their low trading volumes without pushing the prices down. This can have a lasting adverse effect on performance.

The liquidity risk is also often ignored because it is relatively obvious that it prevents business. The most simple form of risk management – holding liquidity or investing in very liquid assets – compromises performance and may therefore result in a loss of clients. As long as the clients of fund managers cannot tell whether the performance of their investments is based on a high degree of risk-taking or on the expertise of their portfolio managers, an attempt to reduce risks will automatically result in commercial problems for a financial product. And this makes risk management a farce.

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Welcome to the weblog of Karl-Heinz Thielmann, fund manager, financial analyst, economist and dedicated long-term investor.

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