Fundamentals of Risk Management

Approaches to risk management
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The failure of the world banking system called into question the effectiveness of 
risk management activities in banks and, in particular, the effectiveness of opera-
tional risk management. One of the consequences of the world financial crisis is that 
the news reports now routinely state that: 1) risk is bad; and 2) risk management has 
failed. In fact, taking risk is essential for the success of organizations.
The statement that risk management has failed in banks is more difficult to
contradict. However, the reality is that it was not the failure of risk management 
principles that caused the banking crisis. It was the failure to correctly apply those 
principles. Many banks made two simultaneous mistakes:
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An accurate risk and reward analysis was not undertaken, so that banks 
made decisions on the basis of the rewards available, rather than taking
a more balanced view of the risks involved in seeking those higher rewards.
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Quantification of the level of risk involved was not accurate, because the 
banks were taking such a risk-aggressive approach that certain events were 
considered to be so unlikely that they could be ignored.
Detailed analysis of the banking crisis in 2008 is outside the scope of this text. 
However, it appears that the crisis was caused by the failure of two different sets of 
risk analysis models. Firstly, the banks had assumed that re-packaged debts, including 
sub-prime mortgages, would continue to be tradable commodities in the market, but 
this proved not to be the case.
Secondly, the banks assumed that short-term borrowing on the wholesale money 
markets would continue to be available. This short-term money is used by banks so 
that they can continue to lend money on a long-term basis, at a more profitable rate. 
The collapse of the wholesale money markets was not anticipated by the credit models 
used by most banks.