Risk Management Wisdom

From Open Risk Manual

Risk Management Wisdom


  • Identifying, quantifying and managing complexity is one of the least developed areas in financial riskmanagement
  • In the financial universe there are no isolated systems: personal, corporate and country risks interlinked in a correlation web
  • The web of financial contracts and interdependencies is complicated but finite. in due course it can be understood and tamed
  • Financial risk model complexity and quality are not necessarily correlated. But complexity is also in the eye of the beholder

Risk Quantification

  • Applying quantitative models to financial phenomena is subject to severe misspecification, whether intentional or unintentional
  • When there is no empirical basis to support risk assessment the fallback is polling expert opinion. Human experts will use analogy
  • Scenario analysis is a basic building block for a probabilistic approach to risk
  • Diversification versus model risk are the two key phenomena relevant for managing portfolio risks
  • In a crisis, all correlations go to one. Except this phenomenon concerns market expectations and prices and actual events might be less correlated
  • Some risks can be usefully decomposed into a probability of occurrence and a severity of occurrence. Others have a continuous range
  • Risk is about the deviation /uncertainty around expectation. A bad outcome expectation with little remaining uncertainty is not risky
  • Risk is not linear. Robust ratings need log-scale: 10%, 1%, 0.1% hence limited in number. Alphabet soup not a good risk metaphor
  • Credit risk analysis looks at the 1) ability and 2) willingness of an entity to fulfill its contracts. It gets messier very fast
  • All risk models built on past experience. some may contain an element of truth about the future

More Wisdom

  • After the simplest binary, risk on / off choice, next step up in risk management complexity is the traffic light system: green, orange, red
  • First recorded incident of bank risk concentration: Florentine banks' Bardi and Peruzzi sovereign exposure to King Edward III
  • Regulation is supposed to prevent financial crises. the track record seems not good but we don't really know a world without it
  • Financial crises are recurring economic phenomena where prevailing contractual arrangements / designs get severely challenged
  • Risk insurance can remove risk but does create new risks (exposure to the insurance provider and other residual risks)
  • There is risk and there is the perception of risk. The two are only loosely correlated and perception is generally more volatile
  • One of the simplest and most effective forms of risk management is risk avoidance (also termed zero risk appetite)
  • Operational risks definitely scale with the size and complexity of the organization but the precise law is not easy to establish
  • There is no physical law to prevent even the deepest, most active, market to become illiquid
  • All forms of financial risk are subordinate to sovereign risk

See Also