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Risk Management in the Business Process by David R. KoenigThis weblog looks to promote the use of risk management as an enhancement to the business decision making process. It is the author's belief that risk management can only realize its full potential when it has become ingrained as a normal part of every business decision. October 24, 2008 Books to Help With Understanding the Crisis and to Make Things BetterIn past posts I've talked about various elements of psychology, behavioral finance and complexity as they can be applied to risk management and our organizations. Risk is the change in value of a system or "thing". Value can go up or down. A risk event is the event that drives that change in value. Risk management, then, is the process of shaping how the system or "thing" changes in value in response to a risk event, but in a manner more to your liking. Much of the success of risk management depends on how people perceive things, whether it be their worth today, or the uncertainty about their worth in the future. Successful risk management also depends on an understanding of how people interact in social systems and how the elements of complex systems interact to determine value. In this particular environment, I find the lessons which I have learned from various books that address these areas to be quite on point. So, if you are looking for some reading that might not be on your normal list, here are four books to get you going on a new way of thinking about risk and risk management: The Social Amplification of Risk The Perception of Risk Origin of Wealth: Evolution, Complexity, and the Radical Remaking of Economics Complex Adaptive Systems: An Introduction to Computational Models of Social Life The texts above have helped to solidify the foundation for how I think about risk management and governance. The ultimate goal of these two disciplines is to allow our organizations to better attain their objectives, be they wealth creation, stakeholder service or both. The challenge facing each of us is to be willing to look at our work and our analysis from a different perspective and then to change that which can be done better.
Posted by David Koenig at 02:32 PM | Comments (4) April 24, 2008 Integrated Risk Management - A Spectacular VideoThis blog is focused on integration of risk management into the business process. To highlight different ways in which this can happen, I try to find angles that we typically don't consider as risk managers. This week, I was introduced to an amazing integration of risk management into a "business". The associated output is visual, realized through a combination of the "CEO's" creativity and the way in which the company's risk manager's work fits seemlessly into the production. Continue reading "Integrated Risk Management - A Spectacular Video" Posted by David Koenig at 08:01 PM | Comments (3) March 20, 2008 Survey Results: Is Fair-Value Accounting Exacerbating the Credit Contraction?This week, the Financial Times asked at the end of their Tuesday opinion piece whether some elements of Basel II that are contributing to pro-cyclicality of the credit cycle and elements of fair-value accounting should temporarily be suspended. Today it was reported that the Financial Services Authority (FSA) in the UK has held 'round table' meetings with banks and leading auditors to discuss fair value accounting as part of its analysis of valuation techniques in the current market turmoil. Last week we invited a group of professionals involved in risk management to share their opinions about fair-value accounting and whether it has contributed to the current credit contraction. Results follow. Continue reading "Survey Results: Is Fair-Value Accounting Exacerbating the Credit Contraction?" Posted by David Koenig at 11:53 PM | Comments (3) February 29, 2008 Chapter 31 - Aligning Compensation Systems with Risk Management ObjectivesThis week, Fed Governor Randall Kroszner called on the financial sector to develop industry-wide guidelines for compensation that would better align individual incentives with the long-term interests of the firms they work for (see article). "Aligning Compensation Systems with Risk Management Objectives" is a chapter that I wrote in 2006 for Michael Ong's book Risk Management: A Modern Perspective. Click on the link to download the chapter in PDF format. I also have a brief article on "Generalized Problems with Metric-Based Incentive Plans" which you can download by clicking on the link as well. Design and review of compensation schemes does not typically fall under the oversight of risk management areas. But, given the numerous case studies of how miscommunication and mis-alignment of incentives have led to loss, it is clear that they should. I hope that the risk profession will take up the challenge from the Fed and lead the movement towards better designed programs. Feel free to contact me if you'd like to discuss further. Posted by David Koenig at 04:31 AM | Comments (0) February 21, 2008 Blame the Pension Fund "Animals" for Excessive Risk-Taking Behavior?At the recent PRMIA Credit Forum in New York, one slide from an early morning presentation leaped off of the screen. The slide depicted the number of issuers coming to the marketplace at below investment grade. In 2000, less than 100 Single-B issuers came to market. In 2007, that number had grown to nearly 250. In 2000, slightly more than half of the issuers were below investment grade. By 2007, the figure was 82%. At the same time, the number of issuers who were able to come to market increased by 56 percent. Said another presenter, "10 years ago, most of these firms could never have issued". So, what gives today that allows firms of sub-investment grade credit the ability to come to market? The answer may come from "animalistic behavior" in pension funds. Continue reading "Blame the Pension Fund "Animals" for Excessive Risk-Taking Behavior?" Posted by David Koenig at 02:26 PM | Comments (0) February 05, 2008 Pro-cyclicality (the flip side)While Basel II is generally seen by industry practitioners as having been a positive contributor to the risk management of banks and the stabilty of financial systems (see PRMIA Survey), the nagging worry that most have had is that the use of market-sensitive credit models would lead to an exacerbation of credit cycles. This may be coming to fruition in terms of credit restrictions and some would argue that this is just the flip-side of the easy credit terms the same models allowed when volatility was low and stock prices were increasing. As the Bloomberg headlines says today MBIA, Ambac Downgrades May Lead to Bank Rating Cuts, S&P Says. Changes in credit ratings or market prices that drive Merton-type credit models will no doubt be affecting factors like collateral and lines of credit and general liquidity to banks and other affected financial service firms. See my previous posting on the Social Amplification of Risk to see how the human response to risk events can cause the same kind of impact. Is this just the beginning of the regulation-based contribution? Could the economic downturn be exacerbated even further by the pro-cyclicality of Basel II? Does this kind of approach prohibit banks from making opportunistic lending when other credit providers do not face the same restrictions? Please share your comments. Posted by David Koenig at 11:25 AM | Comments (1) January 31, 2008 Call for Papers: The Blind Spots of Risk ManagementThe Blind Spots of Risk Management - A Special Issue of the Journal of Risk Management in Financial Institutions Over the past 20 years, the field of financial risk management has grown and advanced at an incredible pace. Oftentimes, an industry or profession that experiences this degree of expansion doesn't have time to reflect on whether the paths it has taken are truly the best paths or whether key elements or key assumptions are relied upon inappropriately or disproportionately to their true value. An insularity or self-assuredness may prevent us from examining other sectors or similar disciplines for better practices. This special issue of the Journal asks financial risk managers to reflect on the state of the practice and to identify the places in which we might be missing something. The assumption is not that the risk management profession is broken or even badly off course. Rather, the intent of this special issue is to put a focus on new areas that help us strengthen what we have already built and to become aware of our potential blind spots. Continue reading "Call for Papers: The Blind Spots of Risk Management" Posted by David Koenig at 02:53 PM | Comments (2) January 21, 2008 Watching the Social Amplification of Risk LiveIn the late 1980's, a framework for understanding how the human response to risk events could contribute to the amplification or attenuation of a risk event was conceived under the Social Amplification of Risk Framework or SARF. What we are seeing in the financial markets today is a dramatic playing out of this framework, rippling from the sub-prime losses that initiated the crisis. Can it be stopped? Continue reading "Watching the Social Amplification of Risk Live" Posted by David Koenig at 02:54 PM | Comments (0) December 04, 2007 The Impact of Outside Monitoring on CEO IncentivesAn interesting paper from the New York Fed was released last week that studies and conveys evidence confirming two hypoteheses regarding CEO incentives and risk-taking at banks: that the pay-for-performance sensitivity of bank CEO compensation: (1) decreases with the total leverage ratio and The understanding of human behavior via incentives, especially among highly-influential and/or highly-compensated employees is critical to any enterprise risk management program and to board governance. I hope that you find this paper to be of interest. Posted by David Koenig at 10:57 AM | Comments (0) November 13, 2007 Call for Papers: Innovations in Risk ManagementSpecial Issue on: "New Advances of Risk Management in Services" Guest Editors: In recent years, risk management has attracted a great deal of attention from both researchers and practitioners. Typical financial hedging contracts have been used in the area of operation services by a growing number of operations management researchers. Risk creates lots of opportunity to make profits. Complexity and uncertainty in many practical problems require new methods and tools to handle. Risk management can be used as a tool for greater rewards, not just control against losses. This special issue seeks to provide a platform for exchanging new ideas and to bring together state-of-the-art research from different perspectives. It focuses on real problems and opportunities that are being experienced in industry, and looks for papers that describe helpful, relevant research, or that reflect on the current state and identify new research directions. Continue reading "Call for Papers: Innovations in Risk Management" Posted by David Koenig at 10:21 AM | Comments (1) October 17, 2007 Proper Incentives for CEOs: Improper Framing Increases Volatility, Reduces Expected OutcomeIn a recent New York Times article, new research supporting the importance of properly framed incentive structures was highlighted. In brief, the story cites research by Wm. Gerard Sanders of Brigham Young University and Donald C. Hambrick of Penn State that shows companies which incent CEOs heavily with options, particularly ones without downside risk, are not necessarily getting the best performance from their CEOs. Posted by David Koenig at 05:34 PM | Comments (0) August 16, 2007 No Shock - The Lessons are Repeated at DellNews today that Dell is restating earnings after apparent efforts by sales people to manipulate numbers to achieve goals. According to the story: * "employees... manipulate[d] financial results in order to reach desired levels of growth" (see Darley's Law) It's time to put an end to metrics-based incentives that don't have a discretionary override or these stories will be repeated over and over again. Posted by David Koenig at 05:12 PM | Comments (0) June 13, 2007 "The Numbers" - Looking for a Future HeadlineA few weeks ago I sat on an airplane flying home and started a conversation with the person sitting next to me. It always surprises me how often I connect with someone who has a tie to or an interesting story about risk management. This flight was no different. But, my guess is that the risk management story in this case is one that we will read about someday in the future. Continue reading ""The Numbers" - Looking for a Future Headline" Posted by David Koenig at 09:29 PM | Comments (2) December 04, 2006 More Evidence on the Impact of Long-term Pay for PerformanceThis week there was lots of coverage of the Watson Wyatt study supporting the link between long-term realizable pay (at risk pay) and company performance. You can read the Watson Wyatt Press Release for summary information or access the study by clicking here (fee or subscription required). "Directors and shareholders will be pleased that the results show that companies with a well-designed incentive program are only paying for the performance they get," said Ira Kay, global director of executive compensation consulting at Watson Wyatt. Continue reading "More Evidence on the Impact of Long-term Pay for Performance" Posted by David Koenig at 08:09 PM | Comments (2) November 07, 2006 Reinventing Pay for PerformanceIt's good to see a growing focus at the Board level and in industry press on reinventing the methods by which employees are compensated. There is no risk management policy or governance structure that can overwhelm mis-formed or mis-framed incentive schemes. The reverse is not true. CFO Europe has a good article on efforts at Lloyds TSB, but, alas, the reliance in these programs, while long-term focused, still seems too heavily metric-based. Princeton psychologist John Darley coined "Darley's Law" when he said “The more any quantitative performance measure is used to determine a group or an individual's rewards and punishments, the more subject it will be to corruption pressures and the more apt it will be to distort and corrupt the action patterns and thoughts of the group or individual it is intended to monitor.” Darley’s Law is a good warning to organizations that employ overly objective incentive systems and likewise to those who pursue risk management as primarily a control tool or quantitative science. Humans are quite adept at manipulating rules to personal benefit. What we must do is to determine how much owner-like behavior we want from employees, structure the incentive program accordingly (including the risk of loss) and ensure that most, if not all, incentive compensation remains "discretionary". Then the checks and balances can be on the method by which discretion is employed. I welcome your comments.... Posted by David Koenig at 06:00 PM | Comments (1) |
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- to understand how risk events lead to changes in value that far exceed first order effects and how to manage them
- to understand how people process information and react to risk
- an accessible introduction to complexity science and how it is going to change economics, finance and risk management forever
- a slightly more technical introduction to how complex adaptive systems work