Reading: Risk management failures Flashcards
Nice sentences to use
A significant loss does not necessarily indicate a failure in risk management, as even with flawless risk management, large losses can still occur.
Risk management does not prevent losses. With good risk management, large losses can occur when those making the risk-taking decisions conclude that taking large, well- understood risks creates value for their organization
Collapse of LTCM
Long-term capital management a risk management failure?
LTCM is a company that handles hedge funds. Investors made good profits in the early years—20% in 1994 and 43% in 1995. But in 1998, after Russia defaulted on its debt, global financial markets went into turmoil, and LTCM suffered major losses. Before its downfall, LTCM had nearly $5 billion in capital and $100 billion in assets. By mid-September, LTCM had lost over $3.5 billion of its capital. Thankfully, the Bank of New York stepped in to help, injecting $3.65 billion into the fund.
Does a loss of more than 70% of capital represent a risk management failure? It is actually hard to answer these questions.
A decision to take a known risk may turn out poorly even though at the time it was made, the expectation was that taking the risk increased shareholder wealth and hence was the best interest of the shareholders.
Risk management failures
Identified risks can sometimes be inaccurately assessed, and certain risks might be overlooked, either due to their unknown nature or perceived insignificance.
Failure in communicating the risks to top management. - This may lead to delays or distortions in sharing important data with senior management.
Failure in monitoring and managing risks: Following the decision to accept specific risks, managers must actively manage them by identifying, mitigating, and hedging certain risks while rejecting others.
Fail to employ appropriate risk metrics.
Mismeasurement of known risks
Risk measurement performance can be a problem when assessments become subjective and reliance on historical data proves inadequate. For instance, why would a risk manager possess a better grasp of the likelihood of a real estate price decline than real estate experts?
Mismmeasured due to ignored risk
- ignore even when known
The information the firm had when making decisions - was it flawed, whether it was wrong? - somebody knows about the risk but it is not captured in risk models
Accounting for all risks is a difficult and costly task. - realisation of a truly unknown risk.
because these risk has trivially low probability. But had the firm managers known about them, their actions would have been different (building being hit by an asteroid is not one of them). They have to look for unknown risks.
Conclusions
Risk management failures can manifest in various ways, yet not every loss necessarily signifies such a failure. However, incorporating lessons learned from financial crises can enhance risk management practices. These crises occur with enough frequency to warrant careful modelling, prompting institutions to prioritise scenario analysis. This involves assessing the implications of crises on financial health and survival, a task not reliant on historical data alone. Economic analysis is crucial for evaluating the impact of liquidity withdrawal and common feedback effects during financial crises. Effective analysis should be ingrained in the firm’s culture and align with the strategic vision of top management.
