There are many flavors of Risk Management. Each flavor of risk manager believes that they are addressing the Real World.
- Bank risk managers believe that the world consists of exactly three sorts of risk: Market, Credit and Operational. They believe that because that is the way that banks are organized. At one time, if you hired a person who was a banking risk manager to manage your risks, their first step would be to organize the into those three buckets.
- Insurance Risk Managers believe that a company’s insurable risks – liability, E&O, D&O, Workers Comp, Property, Auto Liability – are the real risks of a firm. As insurance risk managers have expanded into ERM, they have adapted their approach, but not in a way that could, for instance, help at all with the Credit and Market risk of a bank.
- Auditor Risk Managers believe that there are hundreds of risks worth attention in any significant organization. Their approach to risk is often to start at the bottom and ask the lowest level supervisors. Their risk management is an extension of their audit work. Consistent with the famous Guilliani broken windows approach to crime. However, this approach to risk often leads to confusion about priorities and they sometimes find it difficult to take their massive risk registers to top management and the board.
- Insurer Risk Managers are focused on statistical models of risk and have a hard time imagining dealing with risks that are not easily modeled such as operational and strategic risks. The new statistical risk managers often clash with the traditional risk managers (aka the underwriters) whose risk management takes the form of judgment based selection and pricing processes.
- Trading Desk Risk Managers are focused on the degree to which any traders exceed their limits. These risk managers have evolved into the ultimate risk takers of their organizations because they are called upon to sometime approve breaches when they can be talked into agreeing with the trader about the likelihood of a risk paying off. Their effectiveness is viewed by comparing the number of days that the firm’s losses exceed the frequency predicted by the risk models.
So what is Real World Risk?
Start with this…
Top Causes of death
- Heart disease
- lower respiratory infections
- chronic obstructive lung disease
- Lung cancers
Earthquakes, floods and Hurricanes are featured as the largest insured losses. (Source III)
Financial Market risk seems much smaller. When viewed in terms of losses from trading, the largest trading loss is significantly smaller than the 10th largest natural disaster. (Source Wikipedia)
The largest financial market loss is the Global Financial Crisis of 2008 – 2009. One observer estimates the total losses to be in the range of $750B to $2000B. During the Great Depression, the stock market dropped by 89% over several years, far outstripping the 50% drop in 2009. But some argue that every large drop in the stock market is preceded by an unrealistic run up in the value of stocks, so that some of the “value” lost was actually not value at all.
If your neighbor offers you $100M for your house but withdraws the offer before you can sell it to him and then you subsequently sell the house for $250k, did you lose $99.75M? Of course not. But if you are the stock market and for one day you trade at 25 time earnings and six months later you trade at 12 times earnings, was that a real loss for any investors who neither bought or sold at those two instants?
So what are Real World Risks?