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A CRITICAL ANALYSIS ON RISK MANAGEMENT
Muhammad Babur Farrukh 7441932 12/21/2012
RISK MANAGEMENT AND CORPORATE GOVERNANCE According to Dejan Tosev (2012). but also due to its critical importance in Corporate Governance and as a whole. while the second represents “opportunity”. the key to successful risk management is a good strategy. The Chinese symbol for risk consists of two symbols. or what is commonly referred to as “risk management. which means “to dare”. DEFINITION The word “risk” derives itself from the Italian word risicare. planning and implementation of measures at the earliest. Risk evaluation and management tools are difficult to 1 . implying that risk is a strategic combination of vulnerability and opportunity. journals.” is a concept that dates back thousands of years to when early visionaries tried to understand risk. However. it’s a cog alright. while weighing the consequences of what they deemed as unmanageable. and had never seriously contemplated any risk assessment. and case studies. manage aspects of risk that were manageable. 2007).A CRITICAL ANALYSIS ON RISK MANAGEMENT 2012 CRITICAL ANALYSIS ON RISK MANAGEMENT “Why is it that so many of the important things are also the most boring?” Ashleigh Brilliant (A well known author) INTRODUCTION The reason for me choosing “Risk Management” is. two opposite sides of a coin (Bernstein. Managing risk. but one of the vital ones. too often it is discovered that boards were satisfied with minimal formal procedures of accountability. initially. When companies fail. 1996). believed that risk was only applicable to natural disasters that dampened the financial security and future of the company but the bursting of the global economic bubble became an eye opener. one fine distinction has become clear. the first representing “danger”. as I read through several articles. possessed little information regarding internal controls. Theorists. not only because it is amongst the most fundamental duties for the board of any company to perform (Thomas Clarke. My perception regarding risk management was that it was one of the cogs that were needed to turn in order for a machine to function properly. after which risk management has been taken to another level of understanding.
The conclusion can be elucidated as.. This objective can be in conflict with the other. in absence of. The second argument stated that the value of the options portfolio will decline if shares fall in value since the possibility of utilising those options will also lessen. Even with a committee comprising of leading in the related fields (Healy and Palepu. would be able to double check the risks and their mitigations. The meeting. when they hold stock options. they are open to it when it comes to firm’s value. 2003). executives who got compensated with stock options would be prone to attempt fewer risk management activities as compared to those who were not (Dionne and Triki. but the pragmatic conclusion cited above confirm the supremacy of preferences amidst managers and the source of conflict of interest between executives and shareholders. when it comes to their own capital. A theoretical counter-argument was put forward by Carpenter (2000) where he stated that holding options had 2 ramifications for the wealth of executives. According to the minutes (link provided) recorded by Enron at the audit committee meeting. therefore. Tufano (1996) and Dionne and Garand (2003) examined that. But it can also serve to boost the well-being of directors. the financial worth of the executives’ share options increases with the volatility of firm’s value or its shares. 2001). another study shows that firms most active in hedging against risks are those that have the largest number of external directors on their board (Borokhorich et al. Such results raise questions regarding the configuration of RMC1 selected by boards. particularly when these directors are compensated with stock options (Smith and Stulz. since conventional risk management 1 Risk Management Committee 2 . since some of them might also be holding options.A CRITICAL ANALYSIS ON RISK MANAGEMENT 2012 use and monitor since they require one to have a firm grasp of mathematics and statistics. it is presumed to be quite hard for committee members. 2003 came up with the same conclusion). there were 9 issues at hand. two of which were related to risk management. 1985). still have an inconclusive affiliation between options and risk management. specially designed course. in the North American gold mining industry. lasted only 85 minutes. Finally. Therefore. The first was the one reported above: The wealth of managers is directly proportional to the volatility of options. 2001. Even if managers are unwilling to taking risks. A well known fact is that one of the main goals of risk management is to maximize the firm’s value or shares. This is a crucial inquiry. the chances of all the proposals being discussed comprehensively were extremely remote. We. however.
A CRITICAL ANALYSIS ON RISK MANAGEMENT 2012 codes must be recognised and surveyed by the BoD2’s. associated to RE3 and RM4. time and again. Business risk. People risk. Disaster Risk (Fig 1). The abandonment of risk management in the Fig 2 (The learning board model) 2 3 Board of Director Risk Evaluation 4 Risk Management 3 . Risk Management: Australia/New Zealand Standard. highlights four key risk areas in a business. RISK MANAGEMENT AND THE WORLDCOM FIASCO The report. & Dionne. It is not conspicuous that simply moderating the composition of the audit committee will suffice to diminish possible conflicts of interest in the future. The directors should hold no options to purchase the firm’s shares. 2003). The RMC should also be constituted of capable and independent directors. particularly in firms with a committee dedicated to these assignments (Blanchard. G. Fig 1(Key risk areas in a firm) Risk exists at all stages of a business cycle (Fig 2). Legislative risk. D. but in good times companies often become more relaxed about potential risks as confidence grows.
there is a 99% chance that our portfolio won’t lose more than $50 million (Nocera. with earnings effectively depleting. 1995). weekly. retiring. 1996). Long range appraisal of risks and check up of management’s plans for governing risks seemed non-existent in. conventional telephony or data markets. VaR. which was developed by the scientists and mathematicians of JPMorgan in the early 1990s. However. both. It was widely 4 . World in the seismic 2001-2002 accounting frauds. the board failed. aspects related to risk became more perplexing and needed to be looked at in depth. RISK MANAGEMENT (VaR) AND THE LEHMAN BROTHERS CATASTROPHY What is VaR? Value at risk or as it is commonly known. it may have cons as well. and preservation of maximum investment programs. with them. Surveys conducted by Smithson (1996) and Bodnar et al (1996) indicate that approximately 60-80% of large US firms have some sort of financial risk management policies in place. As the financial and accounting manoeuvres of companies became complex and fraudulent. Substantial contributions by Smith and Stuiz (1985). in understanding risks the firm was facing and in designing commensurable risk control arrangements. Liquidity risks amplified as the firm’s debt load increase. 2009). There was no evidence that the board investigated how these stupendous debts had been amassed by the firm in acquisitions. there has been very little debate on it. These debates have been discussed in detail and popularized by David Shimko’s and Charles Smithson’s monthly pieces in Risk Magazine. it means that over the course of the next week. Risk Management provides benefits. 1995 and Mello and Parsons. Scharfstein and Stein (1993. their respective board of directors became more detached and ignorant about the finances of the companies they were supposedly supervising. networks or commission plans. If we have $50 million of Value at Risk. costs of bankruptcy. Bottom line. is a mathematical model. 1994) have shown that there are potential gains from risk management. Froot. Breedon (2003) revealed that as WorldCom made purchase upon purchase. and later Lehmann Brothers in the year 2008. Control risks also heightened exponentially as new firms were acquired. ultimately. decrement of expected deadweight. Corporate managers have began to actively embrace the concept of risk management. minimization of tax payments.A CRITICAL ANALYSIS ON RISK MANAGEMENT 2012 euphoria of apparently easy money making was the characteristic board approach that led to the downfall of corporations such as Enron. with management failing to integrate systems. like. Stuiz (1984. Although. VaR is easier to understand if one follows the example Nocera (2009) provided. miserably. apart from transaction costs and sometimes some important implementation details of executing risk management (Miller. 1990.
which was the biggest cataclysm that might be expected from holding the security (Crouhy.50 on the dollar. With all of its benefits. which appraised the instability of the trading’s and holding’s of the firm. accumulating their leveraged position past the lowest point on the risk scale. traders and MD’s. The Risk Management Department. Cudmore. both the subprime and Delta bonds were viewed exhibits a different picture of how risk was evaluated and the results of that appraisal. They saw the Delta bond market as volatile while the CDO market was experiencing no volatility what-so-ever making it virtually riskless (McDonald and Robinson. they failed to use common sense and see the signs that the bubble was about to be deflated and burst. According to McDonald and Robinson (2009). only to acquire more so as to pay back the first one (Alman. The criticism of the RMD was that. some MD’s5 were of the opinion that it couldn’t perceive a risk if it bit them (McDonald and Robinson. The Delta positions. Lehman had acquired these securities in the hope of them being worth $0. The significance of how. the Risk Management Department followed the suggestions of Value at Risk (VaR). though. Lehman were holding. In the meantime. Volatility was imperative in turbulent markets. 2009). however. the subprime mortgage crash had begun to feel its first crack. caused concern with the Risk Department. 2009). R & McVeigh. as it was higher according to their computations. The Lehman Brothers Even though they had an RM department. Galai and Mark. it would affect VaR immensely. These amounts kept on growing (McDonald and Robinson. in addition to its assets. VaR was a composition of numerous variables. it had its limitations as well. 2009). because if it was much higher. saw the trend taking shape and advised on lowering back on positions. leverage and volatility (Nocera. Researchers. which stated that the CDO’s6 were safe. comprising of assortment. something. had begun to see the cracks grow in the subprime market. 2009). with Delta Airlines filing for bankruptcy. Lehmann brothers got to know the hard way as it was one of the major reasons why they collapsed. being the most reasonable measure to take. The borrowed funds were used to acquire yet more mortgages to cut 5 6 Managing Director Collateralized Debt Obligations 5 .A CRITICAL ANALYSIS ON RISK MANAGEMENT 2012 approved by many firms since it could was applicable to most of the asset classes and also measure individual and firm wide risks. According to VaR the greed of more returns made Lehman keep on purchasing with borrowed capital. 2009). 2006). VaR. followed VaR’s suggestions. R. alike. to the dot. instead of using common sense and put their faith in the statistical formula. Lehman. kept borrowing money in the short term.
there were other examples of management’s wayward attitude towards risk management (Appendix).A CRITICAL ANALYSIS ON RISK MANAGEMENT 2012 up and package into CDOs. Fig 3 The figure shows how Lehman’s risk policy grew more and more reckless through the 2007-08 periods. in the 3rd and 4th quarters of 2007. 2010). soon became impossible. It also shows that Lehman Brothers exceeded their own risk boundary. Risk appetite was the firm’s estimate of the amount it could lose without risking employee remuneration or shareholder returns (Delaney. to be disposed before the initial credit became due. 6 . 2010). According to Delaney’s (2010) analysis. These however. solving them by raising the limit on the risk and not reducing the risk (Delaney. leaving Lehman in a huge financial liability.
significant losses in the organization”. the risk management department and the tools they utilize along with failure to accommodate governing standards are some of the innumerable perspectives compile up to play a dominant role in a firms failure. All risks cannot be predicted. overleveraging themselves while not being able to sustain the minimal capital required. with good management is to metamorphose those ambiguities to certainties. that is. the cooperation of BOD’s and senior management. As Tošev (2012) puts it.Corporate Governance in a Global Context. What we can do is. The overall culture of the company. Lehman Brothers looked to have stuttered in most of these regards. HBO681 . research for the course. R.A CRITICAL ANALYSIS ON RISK MANAGEMENT 2012 Lehman Brothers saw risk management as only a PR tool and did not realise its importance for a company running on a limited resources in a crashing market. the entirety of them is still uncertainties. R & McVeigh. a higher count of independent directors. (Alman. 2009) 7 . I was also able to learn that constitution of the BoD’s has a large influence on the risk management schemes of a firm. Some that are. Its misusage was far more detrimental than all the other bloopers that they made. would increase the number of risk hedging activities tackled by them. within a firm. “Poor attitude to risk management can lead to a miscarriage of the desired state. must be good. depending heavily on risk tools in seclusion. and this analysis I have been able to understand that the very institute of risk management. Cudmore. CONCLUSION During various discussions.
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Madelyn Antoncic. When Chief Risk Officer. to determine compensation. giving minimal attention to risk factors while setting compensation. resisted an increase in the firm’s risk appetite in 2007. Lehman Brothers replaced her with CFO. someone who had no risk management experience at all. such as return on risk equity. They were rewarding their employees based upon revenue. in spite of the fact that managers were supposed to use risk-weighted metrics. Rick O’Meara.A CRITICAL ANALYSIS ON RISK MANAGEMENT 2012 APPENDIX They overlooked some of the largest risks from its risk usage calculation until June 2008 and did not revise its stress testing to address the evolving business strategy that they had implemented. 10 .