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Risk management was often ignored.

During the boom time, risk management was in many instances ignored. Now we know that this oversight has cost the world economy dearly. It can be argued that we would have been far better off today if we had paid more attention to this crucial business principle. Literally trillions of dollars have been written off by governments and institutions over the last two years. Due to a number of factors, including the National Credit Act, South Africa has managed to escape the global financial crisis relatively unscathed, writes Jurie van der Merwe.

There is no doubt that risk management systems played a part in causing the global financial crisis. For this reason, I would like to focus on risk management in this context.

Risk management should be a process of identification, analysis and either acceptance or mitigation of uncertainty in investment decision-making.

Essentially, risk management occurs anytime an investor or fund manager analyses and attempts to quantify the potential for losses in an investment and then takes the appropriate action (or inaction) given their investment objectives and risk tolerance. We all now know that if risk management had early on identified the risks correctly, much pain could have been avoided. It is interesting how an emotion such as greed can override reason.

In his book, Against the Gods: The Remarkable Story of Risk, Peter L. Bernstein explains how modern civilisation is largely distinguished by its successful efforts first to understand and then to control risk.

According to Bernstein, these efforts use tools of risk management that only became possible after the development of the mathematical subjects of probability and statistics.

Prior to the development of mathematical models to calculate it, risk-taking was simply gambling and the outcome could not be predicted. In essence, risk and the mastery thereof is a uniquely modern concept.

Perhaps there was reluctance in the development of risk theory because of the universal infatuation people have with the concept of luck: the concept that a person is put head-to-head with fate, no holds barred.

Beginning in the mid-1980s, the financial sector became a gigantic risk clearinghouse, as highly liquid markets for the transfer of all sorts of risk evolved.

Because companies could transfer risk that had previously been cushioned by equity, more equity was available to generate new business where they had a natural competitive advantage. Commercial banks, for example, could lay off interest rate risk and seek out additional depositors and creditors. More recently, they have laid off credit risk as well, further increasing their ability to grow.

Of course, when liquidity in the securitisation market dried up, the origination of debt diminished.

Risk management can mean different things to different people. A business owner can have a completely different view than an investment banker.

Different definitions of risk management also call for different types of tools and measures that can be used depending on the circumstances.

Proper risk management generally follows a process, which usually has a number of steps. The first step is to establish the context within which the risk management principles are to be implemented.

After establishing the context, the next step in the progress is to identify the potential risks. Risks are about events that, when triggered, cause problems.

Hence, risk identification can begin with the source of problems, or with the
problem itself.

Once the risks have been identified, they must then be assessed as to their potential severity of loss and to the probability of occurrence.

In the management of investments, risk measurement is a reflection of volatility in the price of an investment such as a share price. Volatility is then indicated by the standard deviation from the mean.

For the purposes of this article, the most widely accepted formula for risk quantification is:

Rate of occurrence x the impact of the event = risk

Once the risks have been identified and assessed, all techniques to manage the risk fall into one or more of these four major categories:

• Avoidance

• Reduction

• Transfer

• Retention

Data, computing power and mathematical models have been transforming many realms of management, from art to science.

But the global financial crises exposed the limitations of certain tools. In particular, the world saw the folly of the reliance by banks, insurance companies and other on financial models that assumed economic rationality, linearity, equilibrium and bell curve distributions.

As the recession unfolded, it became clear that the models had failed badly. As the models failed, many people began questioning the basis of economic theory as events appeared to take place randomly and not as planned or predicted.

Nassim Taleb investigates randomness in his provocative book, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets.

According to Taleb, “Corporations and financial institutions have recently created the strange position of risk manager, someone who is supposed to monitor the institution and verify that it is not too deeply involved in the business of playing Russian roulette...”

Is success simply a question of the lucky fool being in the right place at the right time? I think we should be sceptical in business, but should not dismiss all events as occurring randomly.

It would be bad to conclude that managers should go back to making decisions only on the basis of gut instinct.

The real lessons are that the tools need to incorporate more realistic visions of human behaviour – most likely by drawing on behavioural economics, becoming more dynamic, and integrating real-world feedback – and that business executives need to become better at using them.

Companies will, rightly, continue to seek ways to exploit the increasing amounts of data and computing power. As they do so, decision-makers in every industry must take responsibility for looking inside the black boxes that advanced quantitative tools often represent and understanding their functioning, assumptions and limitations.

Governments of developed countries were forced to bail out institutions.

These bailouts come with a price – more regulation!

The problem with regulation is that it is a form of risk discrimination. This discrimination disturbs the equilibrium of markets. In an efficient market, risk is allocated efficiently.

Massive government intervention has now taken place to pull us back from the precipice. Thankfully, there was collaboration between governments and the problem was tackled aggressively.

However, the world has changed forever.

The problems with catastrophes are that they are catastrophic because they are not expected and people do not know how to react to them. Generally, they are different from any catastrophes that might have occurred before.

Regulators and businesses will put in place risk management systems to prevent a similar catastrophe occurring again. The problem with these systems is that the catastrophe already has taken place and the next one will be different.

Is risk good or bad? It is probably not a case of being one or the other, but what you do not know can really hurt you.

Profitable business is not achievable without taking risk. When investors buy stocks, surgeons perform operations, engineers design bridges, entrepreneurs launch new businesses, astronauts explore the heavens, and politicians run for office, risk is their inescapable partner.

Yet, their actions reveal that risk today need not be feared: managing risk has become synonymous with challenge and opportunity.

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