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The Mistakes Execs Make in Risk Mgt
- By Chris Uba
- Published October 13th, 2009
- Business School
- Unrated
THE ongoing crisis in the nation’s banking industry has been blamed on poor risk management practice. According to the present regime of the Central Bank of Nigeria (CBN) , the mess is largely the out come of complete disregard for risk management. For the banking sector to return to health, its operators must imbibe the culture of risk management . By risk management is meant the identification, assessment, and prioritisation of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events.
According to experts, risks can come from uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attacks from an adversary.
This week we shall be looking at the view of Nassim Taleb, Daniel Goldstein, and Mark Spitznagel in the current edition of Harvard Business Review. Here is their view: Black Swan events are almost impossible to predict. Instead of perpetuating the illusion that we can anticipate the future, risk management should try to reduce the impact of the threats we don’t understand.
We do not live in the world for which conventional risk-management textbooks prepare us. No forecasting model predicted the impact of the current economic crisis, and its consequences continue to take establishment economists and business academics by surprise. Moreover, as we all know, the crisis has been compounded by the banks’ so-called risk-management models, which increased their exposure to risk instead of limiting it and rendered the global economic system more fragile than ever.
Low-probability, high-impact events that are almost impossible to forecast—we call them Black Swan events—are increasingly dominating the environment. Because of the internet and globalisation, the world has become a complex system, made up of a tangled web of relationships and other interdependent factors. Complexity not only increases the incidence of Black Swan events but also makes forecasting even ordinary events impossible. All we can predict is that companies that ignore Black Swan events will go under.
Instead of trying to anticipate low-probability, high-impact events, we should reduce our vulnerability to them. Risk management, we believe, should be about lessening the impact of what we don’t understand—not a futile attempt to develop sophisticated techniques and stories that perpetuate our illusions of being able to understand and predict the social and economic environment.
To change the way we think about risk, we must avoid making six mistakes:
1. We think we can manage risk by predicting extreme events.
This is the worst error we make, for a couple of reasons. One, we have an abysmal record of predicting Black Swan events. Two, by focusing our attention on a few extreme scenarios, we neglect other possibilities. In the process, we become more vulnerable. It’s more effective to focus on the consequences—that is, to evaluate the possible impact of extreme events. Realizing this, energy companies have finally shifted from predicting when accidents in nuclear plants might happen to preparing for the eventualities.
In the same way, try to gauge how your company will be affected, compared with competitors, by dramatic changes in the environment. Will a small but unexpected fall in demand or supply affect your company a great deal? If so, it won’t be able to withstand sharp drops in orders, sudden rises in inventory, and so on.
In our private lives, we sometimes act in ways that allow us to absorb the impact of Black Swan events. We don’t try to calculate the odds that events will occur; we only worry about whether we can handle the consequences if they do. In addition, we readily buy insurance for health care, cars, houses, and so on. Does anyone buy a house and then check the cost of insuring it? You make your decision after taking into account the insurance costs. Yet in business we treat insurance as though it’s an option. It isn’t; companies must be prepared to tackle consequences and buy insurance to hedge their risks.
2. We are convinced that studying the past will help us manage risk.
Risk managers mistakenly use hindsight as foresight. Alas, research shows that past events don’t bear any relation to future shocks. World War I, the attacks of September 11, 2001—major events like those didn’t have predecessors. The same is true of price changes. Until the late 1980s, the worst decline in stock prices in a single day had been around 10 per cent . Yet prices tumbled by 23 per cent on October 19, 1987. Why then would anyone have expected a meltdown after that to be only as little as 23 per cent ? History fools many.
According to experts, risks can come from uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attacks from an adversary.
This week we shall be looking at the view of Nassim Taleb, Daniel Goldstein, and Mark Spitznagel in the current edition of Harvard Business Review. Here is their view: Black Swan events are almost impossible to predict. Instead of perpetuating the illusion that we can anticipate the future, risk management should try to reduce the impact of the threats we don’t understand.
We do not live in the world for which conventional risk-management textbooks prepare us. No forecasting model predicted the impact of the current economic crisis, and its consequences continue to take establishment economists and business academics by surprise. Moreover, as we all know, the crisis has been compounded by the banks’ so-called risk-management models, which increased their exposure to risk instead of limiting it and rendered the global economic system more fragile than ever.
Low-probability, high-impact events that are almost impossible to forecast—we call them Black Swan events—are increasingly dominating the environment. Because of the internet and globalisation, the world has become a complex system, made up of a tangled web of relationships and other interdependent factors. Complexity not only increases the incidence of Black Swan events but also makes forecasting even ordinary events impossible. All we can predict is that companies that ignore Black Swan events will go under.
Instead of trying to anticipate low-probability, high-impact events, we should reduce our vulnerability to them. Risk management, we believe, should be about lessening the impact of what we don’t understand—not a futile attempt to develop sophisticated techniques and stories that perpetuate our illusions of being able to understand and predict the social and economic environment.
To change the way we think about risk, we must avoid making six mistakes:
1. We think we can manage risk by predicting extreme events.
This is the worst error we make, for a couple of reasons. One, we have an abysmal record of predicting Black Swan events. Two, by focusing our attention on a few extreme scenarios, we neglect other possibilities. In the process, we become more vulnerable. It’s more effective to focus on the consequences—that is, to evaluate the possible impact of extreme events. Realizing this, energy companies have finally shifted from predicting when accidents in nuclear plants might happen to preparing for the eventualities.
In the same way, try to gauge how your company will be affected, compared with competitors, by dramatic changes in the environment. Will a small but unexpected fall in demand or supply affect your company a great deal? If so, it won’t be able to withstand sharp drops in orders, sudden rises in inventory, and so on.
In our private lives, we sometimes act in ways that allow us to absorb the impact of Black Swan events. We don’t try to calculate the odds that events will occur; we only worry about whether we can handle the consequences if they do. In addition, we readily buy insurance for health care, cars, houses, and so on. Does anyone buy a house and then check the cost of insuring it? You make your decision after taking into account the insurance costs. Yet in business we treat insurance as though it’s an option. It isn’t; companies must be prepared to tackle consequences and buy insurance to hedge their risks.
2. We are convinced that studying the past will help us manage risk.
Risk managers mistakenly use hindsight as foresight. Alas, research shows that past events don’t bear any relation to future shocks. World War I, the attacks of September 11, 2001—major events like those didn’t have predecessors. The same is true of price changes. Until the late 1980s, the worst decline in stock prices in a single day had been around 10 per cent . Yet prices tumbled by 23 per cent on October 19, 1987. Why then would anyone have expected a meltdown after that to be only as little as 23 per cent ? History fools many.
