Day: September 24, 2008

Lessons Learned from Crises in the Financial Markets: Impoved Regard for Risk Management Systems

The Director of the European Offices of the International Monetary Fund, Saleh M. Nsouli, recently gave an address that examined some of the lessons that can be learned from the crisis in today’s world financial market. In both the private and public sectors, Nsouli advises taking a harder look at the risk management sector.

For the private sector, Nsouli advises that risk analysis not be ignored, even when profits are up:

The governance structure of the risk management system needs to be improved in financial firms in which the incentives are biased toward returns rather than the risks involved in attaining them.

“Compensation schemes in many organizations focus on returns and, for the most part, ignore the risk taken to obtain such returns. The risk managers, because they are not profit centers and do not sell products or write trading tickets, tend to be ignored when profits are up. Indeed, many of them apparently did sound the alarm bells before the crisis set in and were often disregarded as too out-of-touch with new structural trends, though not all firms downplayed the advice of their risk managers. The key is to ensure that top management hears both sides at equal volume, choosing the risk-return combination which best represents the risk appetite of the firm.”

And in the public sector, Nsouli identifies shortcomings in risk management systems as a key lesson:

Supervisors and regulators need to have the incentives and resources to look hard and deep at possible flaws in the risk management systems of the institutions they oversee.

“Often, stress tests did not stress the right areas or not enough; funding liquidity risks received inadequate attention; and holistic views across credit, market, and funding risks were not emphasized in part because of the recent and constant attention on Basel II regulations, covering primarily credit risk.”

These lessons point to the centrality of risk management, whatever the state of the current market. At many failing banks, there are risk management specialists who have had a frustrating experience in the last few months. Hopefully lessons of this financial crisis will be taken to heart, and credence will be given to proper risk analysis even when profits are up.

2008 Palisade Risk & Decision Analysis Conference, New York City

To learn about the latest techniques in risk and decision analysis, and network with top-level consultants, industry practicioners and Palisade experts, consider the 2008 Risk & Decision Analysis Conference, November 13th and 14th in New York City.

» More about the Conference

What are Real Options?

Real options are the flexibilities that are inherent in general business or other decision situations. In general, a real option is present in any decision situation involving a decision-chance-decision sequence; the possibility to (at the second decision) select from a range of different decision possibilities after the occurrence of the chance event may alter the choice of the decision earlier on in the sequence (and/or increase its value). The extra value created by this flexibility is sometimes described as a real options value.

Real options analysis concerns itself with analysing such flexibilities. On some occasions it may be desired to value such flexibilities explicitly. On others, the valuation is not explicitly required and the analysis concerns itself mostly with making the correct decisions and planning risk response or mitigation actions. The topic has links to financial market options, as well as to traditional net present value analysis.

A more detailed description of this topic, with example models using Excel, @RISK (software for risk analysis using Monte Carlo simulation) and PrecisionTree (decision trees in Microsoft Excel) can be found in Chapter 5 of my book Financial Modelling in Practice (John Wiley & Sons, 2008. ISBN-13: 978-0470997444).

Dr. Michael Rees
Director of Training and Consulting