High Risk Adjusted Returns and Risk Management – 10 Key ERM Questions from an Investor – The Answer Key (5)

Riskviews was once asked by an insurance sector equity analyst for 10 questions that they could ask company CEOs and CFOs about ERM.  Riskviews gave them 10 but they were trick questions.  Each one would take an hour to answer properly.  Not really what the analyst wanted.

Here they are:

  1. What is the firm’s risk profile?
  2. How much time does the board spend discussing risk with management each quarter?
  3. Who is responsible for risk management for the risk that has shown the largest percentage rise over the past year?
  4. What outside the box risks are of concern to management?
  5. What is driving the results that you are getting in the area with the highest risk adjusted returns?
  6. Describe a recent action taken to trim a risk position?
  7. How does management know that old risk management programs are still being followed?
  8. What were the largest positions held by company in excess of risk the limits in the last year?
  9. Where have your risk experts disagreed with your risk models in the past year?
  10. What are the areas where you see the firm being able to achieve better risk adjusted returns over the near term and long term?

They never come back and asked for the answer key.  Here it is:

5.  In the sub prime market prior to the crisis, investors were buying AAA securities but getting a little more yield.  Since they were AAA rated, the capital required was minimal.  So the return on equity could be attractive.  Unless you held that story up to the light and freely admitted that your bank profits were bolstered by exploiting the fact that the market and the regulators had different opinions of the creditworthiness of the sub prime securities.

So, if the banks had answered honestly, they would have been saying that their profits were coming from regulatory arbitrage.  There are only three possible outcomes from this situation.  First, the market could wise up and the excess profits would disappear.  Second, the regulators could wise up and suddenly the banks would find themselves needing lots more capital, and third, the market persists in its opinion of higher risk and it turns out the market is correct.  But since under this third option, the bank is playing the regulators for the fools, as the risks stay the same or grow ever larger, the banks take more and more advantage of the stupid regulators.  They pretend to their board that the bank is safe because they are holding the capital that the regulators require.  The banks takes more and more risk – the compulsion to grow and grow earnings in the face of the shrinking spreads for everything with “normal” risk is an immutable imperative that requires banks to multiply their risk.

So one of the possible reasons that Risk Adjusted Return is high is that the risk adjustment is based upon regulatory requirements – not on an actual assessment of risk.  And there are three possible outcomes of playing the regulatory arb game that are unfavorable.

Another reason for higher risk adjusted returns is a competitive advantage.  Investors should be happy to hear about a competitive advantage.  They should also do their own assessment about how permanent that advantage might be.

From the point of view of assessing an ERM system, the answer to this question should reveal how seriously that management takes the idea of risk management.  High and unexpected returns are as good a signal as any of higher risk.  In fact, in the financial markets, high returns are almost always a symptom of higher risk.

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