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The rise of financial risk management.

OVER THE PAST decade, risk managers have witnessed both a greater acceptance of their discipline as well as a greater willingness on the part of companies to employ the term "risk management." In the banking and finance industry, however, these attitudinal changes have contributed to a situation where the manager of pure risk has gotten lost among the hordes of financial risk managers. What makes this situation prevalent here as opposed to other industries is the fact that the management of financial risk, alternatively known as market, balance sheet, speculative or, more generically, business risk, is the financial community's stock and trade.

Almost all traditional risk managers of operations and contractual risks, like William J. Kelly, senior vice president of risk management at Morgan Guaranty Trust Co. of New York, will get involved in financial risk management, but "only to the extent that there are insurance vehicles for these business risks such as credit insurance." Mr. Kelly will also get involved in contractual issues such as those related to lending and collateral for a new funding program. But that is about as far into the profit-generating area of the bank's activities his position takes him.

It is at this juncture that the company's other risk manager - the financial risk manager - takes over. It is this risk manager that must contend with interest rate risk (the risk that interest rates will rise and reduce the market value of an investment), credit risk (the risk that a borrower will be unable to make interest or principal payments in a timely manner), currency risk (the risk that the value of one's currency will rise or fall relative to another before payment is made), liquidity risk (the risk of having difficulty in liquidating an investment position without taking a significant discount from current market value) and market risk (the risk that it may be necessary to liquidate a position during a down period due to general market pressures). Financial risk management is perhaps the most volatile branch of the discipline, which is one reason why it tends not to be insurable.

Should the traditional risk manager be dealing with such financial issues or only those activities geared towards mitigating or eliminating what has been traditionally viewed as hazard, event or pure risk, such as physical damage, products liability or maybe even criminal activity? Or, as Dr. William R. Feldhaus, associate professor of risk management and insurance at Georgia State University puts it, "Should one manage positive, as well as negative, risk?" Dr. Feldhaus notes that at present, most universities and colleges limit the notion of risk management to the pure risk delineated in the traditional text books, allowing for professors to provide minor variation amongst their lectures.

Few, if any, would argue that the risk manager should become a specialist in all forms of the discipline, not even H. Felix Kloman, principal and vice president at Tillinghast, who advocates perhaps the broadest view of what a risk manager's job should entail. Mr. Kloman believes that the interrelationship between all four branches of risk management- operational, legal, political and financialnecessitates "an entirely new risk management function that would be on par with a chief strategy officer or a chief executive officer."

To illustrate his point, Mr. Kloman presents a scenario involving Philip Morris's reaction to the recent U,S. Supreme Court ruling opening up tobacco companies to an untold number of claims. "The risk manager there probably will look at the claims. But what the risk manager should be doing is questioning whether or not it makes sense to remain in this business at all." He adds, however, that currently "there are only a small handful of individuals who have the mandate to practice strategic risk management. But I believe this is the direction we are moving in."

Use and Abuse

DUE TO CHANGING government regulations, tax laws and heightened economic uncertainty stemming from the volatile 1970s, this past decade witnessed expanding responsibility for the financial risk manager and an extraordinary flurry of financial market innovations. This in turn spawned new techniques for hedging - locking in prices to improve budget forecasting and profit predictability - and the increased usage of derivative instruments for managing financial risk. Derivative instruments (a form of "side bet") are securities that firms buy or sell to protect against adverse fluctuations m, for example, interest rates, exchange rates or commodity prices.

Several types of derivatives at a risk manager's disposal include: traded options, which give the firm the right (without the obligation) to buy or sell a commodity or financial asset at an agreed upon price at some future time within a stated period; futures contracts, which are orders that are placed in advance on organized exchanges to buy or sell an asset or commodity upon date of delivery; forward contracts, which are custom-made futures contracts not traded on an organized exchange; and swaps, which are arrangements whereby two companies lend to each other on different terms, the most common being in different currencies (currency swap) or one at a fixed rate and the other at a floating rate (interest rate swap). With techniques such as hedging and instruments such as derivatives becoming more sophisticated and more commonplace, the classic model of risk management is becoming passe.

Given the media's increased use of these terms and the recent proclamation in the business periodical American Banker that "risk management" (in a reference to financial risk) is becoming "one of the banking industry's hottest topics," managers of traditional risk in the financial community are starting to sense confusion over what is a risk manager. At Bankers Trust Co. in New York, where the mainstay of the business is risk management in the financial sense (e.g., structuring derivative products and hedges to help clients manage risk), Douglas G. Hoffman, senior vice president for corporate risk and insurance services, has encountered plenty of confusion. Not only does his company manage financial risk for its clients, but it also has to manage its own financial and pure risk needs.

Strategic Involvement

WHERE DOES Bankers Trust draw the line? "In a peripheral way, our department gets involved in financial risk management, particularly in consideration of financial disasters," Mr. Hoffman reports. For example, if for some reason the payments and exchange systems collapsed, as could happen during a power outage like the one that blacked out Wall Street a few years back, his department would look into the root causes. From there the business continuity implications and contingency planning would be addressed.

In this industry, even the technologies for managing pure and speculative risks are starting to overlap. According to consultant Edith Lichota, a former senior vice president and risk manager at Irving Trust Co. and now president of Lichota & Associates Inc. in Norwalk, Connecticut, some institutions have applied traditional risk management methodologies to non-traditional exposures. But the development of this situation usually depends upon the levels of interest and influence the risk manager has with senior management. More specifically, Ms. Lichota feels that the risk manager must have "a sufficiently high profile in the management structure so that he or she is recognized as a resource."

When he was brought on board at Bankers Trust, Mr. Hoffman looked at the various financial risk models that the other departments were utilizing to analyze the myriad speculative risks and found himself asking, "Why don't we quantify event risks with these models also?" Part of the answer was that it is very difficult. But by showing initiative and asking the question, his group was given the latitude to interface with the other departments and carve out their own niche.

Mr. Hoffman's high-level position at Bankers Trust, where he is in charge of corporate risk management and strategic planning, in so far as it concerns insurance, is unique, however. "In a world of confusion where everybody is taking the name risk management," he points out, "we were able to latch on to a small section that was logical for us and has worked out well for our group."

Which Way Do We Go?

PEOPLE LIKE Mr. Kloman and Mr. Hoffman find that today, the traditional risk manager in the banking and finance industry has in most cases been relegated by upper management to concentrate solely on the insurance buying and risk financing aspects of the function. As a result, many risk managers fail to play a key role in the organization's strategic planning by no longer performing risk assessment (especially of uninsurable loss exposures) and risk control.

Dr. Feldhaus concurs with Mr. Kloman that risk managers should be more active in the decision-making process. He adds that in such strategic moves as those involving mergers and acquisitions, "companies tend to avoid looking at the downside risks. Involving the risk manager would be a healthy thing for organizations." Similarly, consultant Ms. Lichota has found that "the sooner a risk manager provides input the better off the company is, and things tend to move along a lot more smoothly."

But one factor that may work against the risk manager's development, no matter in what branch he or she is involved, is specialization. In most instances, Mr. Kloman notes, risk managers "revel in their specialty to such an extent that they don't think strategically; they think tactically." Another problem is that today's risk managers lack sufficient training or even the interest to rise to the top of the organization.

It is for these reasons that Mr. Kloman believes that some 75 percent to 85 percent of risk managers will not be able to make the transition to the strategic or holistic risk management approach he envisions taking hold in the next decade. They will become known solely as specialists in their particular areas of concentration.

What has been recognized by all parties, however, is that the scope of the traditional risk manager, by necessity, has broadened. "The function is much more challenging than 10 years ago," Dr. Feldhaus claims. The only certainty left regarding the discipline is that it will remain in flux into the 21 st century.
COPYRIGHT 1992 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Author:Kurland, Orin M.
Publication:Risk Management
Date:Sep 1, 1992
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