The new Black Swan – II

A genesis of the modern Risk Management

Risk as we know as a subject today is a singularly monolithic structure, with deep interconnections to branches/sub-branches that commingle. This makes the study of Risk singularly fascinating. One, as a serious student of Risk, can ‘view’ it as a complex monolith; while it can be considered as a ‘polylithic’ given that numerous blocks make up the Risk superstructure, and those blocks have their own distinct features and dimensions, if not individuality. An example will make it clear.

In almost all textbooks, and there are many, Risk is generally defined as the ‘deviation from the expected returns’. Now this is a vague definition in my opinion. What is an expected return? What deviation are we talking about? What makes those deviations acceptable? Who sets those expectations that make a certain category (categories) of ‘risk(s)’ acceptable? What is the true identifier of such deviations that differentiates something between ‘risk’ and uncertainty? Is there any ‘X’ factor that can identify an uncertainty, or uncertainties, with a mathematical accuracy?…….

These are only a few, just a few, questions that can overwhelm your mind as you embark upon the journey to understand, and study, Risk. The topic, as a discipline, is layered with multiple dimensions, simple and not so simple, that need to be properly studied, and understood in order to appreciate the complexity and elegance that it offers.

As I mentioned in my first article, through this space we intend to study the systematic proliferation, and measurement of, Financial Risk. Financial Risk, naturally, refers to the question I just asked above. It is the endeavor of firms to maximize returns. In order to do that, they have to enhance value of the firm by effectively achieving financial disciplines and operational excellence, coupled with prudent risk management practices. Please note here, I have NOT mentioned risk elimination anywhere. Reason being, it’s not possible!

We thus get one angle of Risk here. The most prominent angle, that it is something integral to business (or even human lives!) and without assuming risk, a business cannot grow. Why is it that a business cannot but assume risks? What is that peculiar element that asks for such a compelling decision? The answer is far simple than understanding the true nature of the building blocks that make up for the monolith we started the discussion with. By definition business operates (and grows, like any other being) in an environment of change. Change is continuous, it’s not static or constant. So anything continuous, having a future path, would be laced with uncertainty. The moment we operate in an environment of uncertainty, risk is born. So, we can safely say that risk is in-built in the structural formation of uncertainty. It’s a linear by product of the great uncertainty!

In life we face a multitude of uncertainties. Like, education, job, political uprisings, diseases (the present Coronavirus situation makes it even more compelling), study and career progressions, wars and their consequences, economic downturns, etc. to name a few. Please note amid these uncertainties, we, as humans, grow. Do you feel all these uncertainties are measurable? You may know that as a good student you will get a campus placement, but do not know your career path! Reason being it’s dependent on a host of factors beyond your control. Similarly about income, or life expectancies. What we do with these uncertainties? Well, a no brainer reply is, we buy insurance and start saving from an early age. We ‘plan’ things so that we face rainy days with less discomfort. Isn’t that an act of risk management in general? You measure certain things (standard example is that you are going to live for 80 years, or work till 55 starting at the age of 23), using a probabilistic approach in life, you forecast certain targets and see to it that you stay closer to the target. You got it right! This is what risk management calls for at its most fundamental. Measure something which is apparently futuristic. Make estimations. Use past data, but try to forecast using a balanced approach of caution and risk appetite (I will expand this term much broadly at a later stage). Always know that if you cannot quantify anything, you cannot measure. If you cannot measure anything, you cannot manage anything. Period.

The systematic study of risk, financial risk for our purpose, would begin from this fundamental principle of quantification of a future event that would have an impact on the business financials. If we want to double our profit targets, what we need to do other than (say) investing a certain sum of money? In what time frame we would ‘likely’ to achieve that target? A scaling up of operations into multiple geographical areas would lead to an ascension of sectoral risks. How do we minimize that impact? What is going to be our funding or capital investment pattern? Did we study the impact of the equity or debt funding? Did we properly estimate the ‘leverage ratios’ or ‘efficient operating or financial leverage’? Did we properly study the Regulatory environment and the impacts of certain actions we are undertaking? What is the right ‘cost-benefit’ of certain decisions? Does the firm possess a ‘risk appetite’ statement that clearly and unambiguously elaborate and explain all assumed and to be assumed risks? What methodologies are adopted to measure the numbers arrived at? Are they consistent, forward looking and reasonably accurate? What level of ‘exposures’ are expected as the firm moves in a significantly uncharted territory due to ambitious expansionist plans? There are so many questions, other than these, that one can ask. Put together in a systematic and systemic way, they form the ‘genesis’ of risk. Each block is unique, yet the sum total is the large picture that needs to be looked at. Going forward, we will unravel these blocks one by one, and observe what lies beneath!

Sherlock Holmes very famously said: We see my dear Watson, we do not observe!!

As a serious student, and practitioner, of risk you need to observe!