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Why does Risk Management Fail to Avoid

Crises?

SUBMITTED TO:
MR. MAHESH CHAUDHARY
ASSISTANT PROFESSOR OF MANAGEMENT

SUBMITTED BY:
ARMAAN GUPTA (15A027)
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TABLE OF CONTENTS

ACKNOWLEDGEMENTS...................................................................3

WHAT IS A FINANCIAL CRISIS?....4

......................................................................4

WHAT ARE THE CAUSES OF A FINANCIAL CRISIS?....4

....6
..................8

WHY DOES RISK MANAGEMENT FAIL TO AVOID FINANCIAL CRISIS?

5

COMPENSATION............................................................................... 6

COMPLEXITY. . .7

COMPETITION ..................................................7

CULTURE ....................................................................................... 8

COMMUNICATION ...................................................................8

CAPITAL REGIME.....................................................................9

SOLUTIONS...........................................................................10
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ACKNOWLEDGEMENTS
I deem it my utmost privilege to present project on “Why Risk Management Fails to Avoid
Crises?”

I would like to express my deepest gratitude to the Director, Dr Bimal N. Patel, Gujarat
National Law University, for granting this opportunity to research for which I shall remain
indebted forever.

At this juncture, I would like to express my deepest gratitude to Mr. Mahesh Chaudhary,
Assistant Professor of Management at the Gujarat National Law University for his immense
resourcefulness and precious guidance while preparing this paper.

In the end, I would also like to thank anyone who has directly or indirectly supported me
during this project.
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WHAT IS A FINANCIAL CRISIS?

A financial crisis is a situation in which the value of financial institutions or assets drops
rapidly. A financial crisis is often associated with a panic or a run on the banks, in which
investors sell off assets or withdraw money from savings accounts with the expectation that
the value of those assets will drop if they remain at a financial institution.1

WHAT ARE THE CAUSES OF A FINANCIAL CRISIS?

 The structure of an organisation and its associated systems of management. If the
structure of an organisation is too complex, with several interdependent processes, it
becomes more prone to events that may cause major loss or crises.
 The wrong perception of risk management by managers who are unable to understand
the risks being taken and the loss that could occur.
 The culture of an organisation, when it is too safe or too risky.
 Change in the organisational structure, which can cause attention to be diverted from
day to day risk or cause a rise in errors, fraud etc.
 Politics and powerplays within the organisation when certain departments or
individuals have a disproportionately large amount of power has a detrimental effect
on risk management.
 External social, political and economic factors.

Cultural
Culturaland
andHuman
HumanFactors Organisational Design and
Structure
Factors Trigger LOSS
Event

1
Investopedia

Economic and
Strategic Imperatives
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The causes of crises are usually multifaceted. No single factor can be pointed out for the
cause of a crisis. Usually the causes for a crisis develop over a long period and finally the
crisis occurs due to a trigger event.

WHY DOES RISK MANAGEMENT FAIL TO PREVENT

A FINANCIAL CRISIS?
There are several reasons for risk management failing to prevent a financial crisis. The six
C’s of a financial crisis are:

THE SIX CS

COMPENSA COMMUNIC
TION ATION

Cultural and Human Organisational Design and

Factors Structure

CULTURE COMPLEXIT
Y

Economic and
Strategic
Imperatives

COMPETITI CAPITAL
ON REGIME
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COMPENSATION
Poorly designed compensation arrangements can be a contributory factor to a crisis. Certain
arrangements that can cause such a crisis are:

 Incentive systems that encourage short-term, sales driven behaviour instead of

focusing on long term goals and growth of the organisation.
 Fixed salary/bonus arrangement, i.e. no reduction in either even when losses are
incurred, leading to decision makers having a financial stake in the decision they
make, leading to conflict of interest.
 Systems that fail to reinforce or contradict the standards of governance of certain
financial institutions
 Arrangements that do not incentivize managers enough to properly assess, monitor or
control risk.

In the above-mentioned cases, the compensation system or arrangement causes a moral

hazard problem, as a result of which managers are incentivized to expose shareholders to
excessive amount of risk. For example, if a manager is offered bonus if he is able to achieve
an unrealistic amount of sales, the manager is incentivized to take more risk than is
appropriate to attain more sales, or if the salary of a manager is fixed regardless of whether
the company is in loss or earning profit, it creates no incentive for the manager to work to
reduce the risk of the company.

If a certain type of behaviour is incentivized, that behaviour will be followed. One must be
cautious while deciding compensation schemes and ensure that the risk being taken is not
excessive just for the sake of compensation. In order to solve the moral hazard problem, the
compensation arrangement of certain financial institutions must be redesigned. The
arrangement must be such that compensation is earned on the basis of considered risk taking
that balances the interests of all major stakeholders.
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COMPLEXITY
Complexity is another factor that can lead to the failure of risk management. Financial
services involve various complex process like assessing the credit worthiness of a borrower,
the risk factor of a prospective insurance policyholder or the value of intangible assets. There
are various risk factors that must be considered which are volatile in nature and difficult to
pinpoint. Furthermore, the interrelatedness of many activities, risks and institutions creates
the perfect environment for unforeseen correlations and extreme events.

Thus, it is not a surprise that in such a complex world, major crises occur from time to time.
There even exists a theory that states that in such complexity, a crisis is inevitable. However,
crises can occur more frequently when institutions fail to manage complexities of their risk
exposures in an effective and efficient manner.

Being involved in complex activities, managers sometimes forget the basic rules or principles
that can help reduce the associated risk exposures, thereby exposing their organisations to a
higher amount of risk and consequently, crisis.

COMPETITION
Competitive pressure can also lead to the failure of risk management. Sometimes real
economic pressures cause institutions to take hasty management decisions, allowing the way
for a crisis. Competition also causes institutions to take short cuts in their risk management
activities, to save time and money, but leaving them exposed to errors and frauds that may
causes a great increase in the chance of loss.

While trying to differentiate from the competition or find the cheapest way to make a
product, managers sometimes forget to provide for possible losses that may occur while
looking for such a way.
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CULTURE
Cultural weaknesses play a major role in causing crises. Crisis prone organisations have
cultures that are very different to crisis avoiding organisations. Crisis prone organisations are
self-inflated and narcissistic, whereby managers care only about themselves and the
organisations. However, crisis avoiding organisations are much more outward looking and
consider the needs of all stakeholder groups.

The existence of factors like greed, short-termism, tendency to copy others etc. in the
organisation’s culture are definite indicators of a crisis prone organisation. These factors
don’t exist only at the individual level, but may exist industry wide, inter-firm and intra- firm
as well.

For example, at the industry wide level, greed may exist if there is a strong belief that nothing
can go wrong and that there will be infinite boom in the industry. This can leave an entire
industry prone to a very big crisis.

A prudent and conservative culture can avoid significant losses compared to an aggressive,
sales and market share oriented culture. Concentrating on long term growth instead of short
term growth can also avoid crisis.

It is important to remember that an overly conservative approach to management can reduce

profitability and innovation in the organisation. A balance must be maintained. A risk-aware
culture must be promoted where risks can be discussed openly without fear.
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COMMUNICATION
The main problems in communication are:

 The wrong data being communicated to the wrong people

 Data not being understood by the people receiving it.

Managers sometimes fail to present meaningful information. They make mistakes while
filtering relevant and irrelevant information. There are a lot of barriers to effective
communication. Sometimes technical terms may not be understood in the correct sense by
low level employees. Other times important information may not reach the top management
in time. There might be informational inaccuracy or an imbalance of information between
managers, which may cause a lot of confusion and errors. Too much information or too less
information may be provided to managers.

The top management may withhold information from managers causing them to take the
wrong decisions for the organisation. All these problems cause issues in decision making and
may leave an organisation exposed to excessive risk, and a crisis.

CAPITAL REGIME
The capital regime itself may sometimes fail, due to poor regulation or policy decisions. This
leads to proof performance for banks, building, societies and investment firms. If too many
flaws exist in the Capital regime, it may cause a major system wide event.
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SOLUTIONS
IMPROVING RISK CULTURES:

The management of financial organisations need to be more aware of risk and prepared for it
as well so that they can act in an effective and efficient manner when exposed to excessive
amounts of risk.

Extreme events need to be assessed and controlled in an improved manner and the advice and
judgement of experts must be taken into consideration.

Blame cultures should be avoided so that managers can report not only actual losses but
concerns regarding future potential losses.

In order to achieve the above-mentioned goals, experienced staff should be retained, risk
management objectives must be communicated in training and induction programmes,
internal placements or cross department team building projects must be designed to break
down barriers.

REDESIGNING COMPENSATION ARRANGEMENTS:

Instead of short term bonuses, longer term bonuses must be given, as a shorter term would
lead to risk seeking behaviour as the staff wouldn’t be likely to incur loss from the
consequences of actions with short term bonuses.

Compensation arrangements must be aligned with an institution’s risk management and

governance policies. Managers should not only be incentivized to consider the institution’s
risk when making business decisions but also assess and report on the risk in a timely and
efficient manner.

Learning from Outside the Financial Services Sector:

This can be done through various methods like stress testing and scenario analysis and this
must be implemented, in order to realize reaction to worst case scenarios and extreme
situations and set up mechanisms to take care of them.

IMPROVING INTERNAL CONTROL:

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Risk Reporting: The timeliness and quality of risk reports must be improved. Management
information should become more accurate and speedy by the use of various indicators.

Educating and involving board directors in risk management decision making: Each director
must be well aware and educated about what the organisation does and the things involved in
doing it. The creation of a board risk committee to provide a forum within which non-
executive directors can review and challenge reports and decisions is another way to involve
directors in decision making.

Enhancing the status of the risk function and Chief Risk Officer: Risk management must be
given a stronger and louder voice so that risk issues can be given proper consideration by
senior management and boards.