Measuring Risks

What gets measured gets managed.

Measuring risks is the second of the eight ERM Fundamental Practices.

There are many, many ways to measure risks.  For the most part, they give information about different aspects of the risks.  Some basic types of measures include:

  • Transaction Flows, measuring counts or dollar flows of risk transactions
  • mean Expected Loss
  • Standard deviation of loss
  • Expected loss at a particular confidence interval (also known as VaR or Value at Risk)
  • Average expected loss beyond a certain confidence interval (also known as TVaR, Expected Shortfall, and other names)

So you needs to think about what you want from a risk measure.  Here are some criteria of a GOOD RISK MEASURE:

1. Timely – if you do not get the information about risk in time, the information is potentially entertaining or educational, but not useful.

2. Accurately distinguishes broad degrees of riskiness within the broad risk class – allowing you to discern whether one choice is riskier than another.

3. Not too expensive or time intensive to produce – the information needs to be more valuable than the cost of the process that produces it, either in dollars or opportunity cost based on the time it uses up.

4. Understood by all who must use – some will spend lots of time making sure that they have a risk measure that is the theoretical BEST.  But the improvements from intellectual purity may come with a large trade-off in the ability of a broad audience to understand.  And if people in power do not understand something, there are few who will really rely on it when their career’s are at stake in an extreme risk situation.

5. Actionable – the risk measure must be able to point to a possible action.   Otherwise, it just presents management with a difficult and unpleasant puzzle that needs to be solved.  And risk is often not a presenting problem, but a possible problem, so it is easier always to defer actions that are unclearly indicated.

If you can set up your risk measurement systems so that you can satisfy all five of those criteria, then you can feel pretty good. Your risk management system is well served.

But some do not stop there.  They look for EXCELLENT RISK MEASURES.  Those are measures that in addition to satisfying the five criteria above:

6. Can help to identify changes to risk quality – this is the Achilles heel of the risk measurement process.  The deterioration of the key riskiness of the individual risks.  Without this ability, it is possible for a tightly managed risk portfolio to fail unexpectedly because the measures gradually drifted away from the actual underlying riskiness of the portfolio of risks.

7. Provides information that is consistent across different Broad Classes of Risk – this would allow a firm to actually do Risk Steering.  And to more quantitatively assess their Diversification.  So this quality is needed to support two of the four key ERM Strategies and is also needed to  apply an enterprise view to Risk Trading and Loss Controlling.

8. For most sensitive risks will pinpoint variations in risk levels – this is the characteristic that brings a risk measure to the ultimate level of actionability.  This is the information that risk managers who are seeking to drive their risk measurement down to the transaction level should be seeking to achieve.  However, it is very important to know the actual accuracy of the risk measure in these situations.  When the standard error is much larger than the differences in risk between similar transaction then process has gone ahead of substance.

 

 

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