Risk Management Challenges

Abrupt levels of variability 

It must be understood that Risk management is not the process of controlling and reducing the expected loss. It is process of managing the unexpected levels of variability in financial outcome for a business.

Given confidence in the way a business assesses and measures the unexpected loss levels associated with its various activities, accumulates sufficient capital or deploys risk management techniques, disseminates communications with stakeholders; even conservative business can incur significant risk quite rationally.

 Correlation Risk

Real-estate linked loans are often secured with real estate collateral, the real estate collateral looses the value as and when default rate raises. So the 'recovery rate risk' on any defaulted loan is itself closely correlated with the 'default rate risk'. The two risk factors acting together can sometimes force losses abruptly skyward. In this regard, risk that are lumpy and are driven by risk factors that under certain circumstances can become linked together, we can predict that at certain times high 'unexpected loss' will be realized. We can try to estimate how bad this problem is by looking at the historical severity of these events in relation to any risk factors that we define and then examining the prevalence of these risk factors in the particular portfolio under examination.

Moving away from an over dependence on historical-statistical treatment of risk

Risk managers have realigned their focus on scenario analysis and stress testing, after Global Financial Crisis (207-2008). Risk managers examines the outcome as consequence of adverse scenario or stress on a firm (or portfolio). The scenario may be chosen not on the basis of statistical evidence, but instead simply because it is both plausible and suitably severe.

However it is not fair to remove the statistical portion of the risk management entirely. So in a more robust form of scenario analysis, the firm will need to examine how a change in a given macroeconomic factor leads (e.g labor supply) to a change in a given risk factor (e.g probability of default of a security).

The Risk Management Process

(Figure 1) Risk Management Process

Risk management is identification, assessment and prioritization of risk.

Identification - It identifies the risk so that staffs at the operation are aware of potential problems. It is important to not only identify the risk as early as possible but also to repeate the identification process frequently.

Measure and estimate risk exposure - Risk management process involves measuring risk and estimating risk exposure that developed during risk identification, into a consistent form. These measures and estimates are then used to make decisions around accessing the costs and benefits of risk management. The cost and benefit analysis then enables operations to commit resources (instruments and facilitates) to manage the most important risks.

Form a risk mitigation - Risk management process involves taking information from risk analysis and using it to either formulate strategies, avoid, transfer, mitigate or keep the risk.

Evaluate Performance, controlling and learning - Risk management evaluates and monitors the status of specific risks and the progress in their respective action plans. Evaluating performance includes monitoring the probability, impact, exposure, and other measures of risk for changes that could alter priority or risk plans and ultimately the availability of the service. Risk reporting ensures that the operations staff, service manager, and other stakeholders are aware of the status of top risks and the plans to manage them.