Risk Management

Thomas Wolke

• Publisher: De Gruyter Oldenbourg
• Year: 2017
• eBook ISBN: 9783110432459
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Finanzwesen

This book is the English edition of the German third edition, which has proven to be a standard work on the subject of risk management. The English edition extends the scope of use to the English-language bachelor's and master's degree courses in economics and for potential use (especially as a reference work) in the professional practice of risk management. The subject of the book is company-wide risk management based on the Value at Risk concept. This includes quantitative and qualitative risk measurement, risk analysis based on the RoRaC and various management tools for risk control. Other topics covered are the peculiarities of the various risk types, e.g. risk management of the effects of climate change, the global financial crisis and risk reporting. The book is rounded off by a comprehensive case study, in which all aspects are summarized. The volume is thus an indispensable standard work for students and practitioners.

1Fundamentals

It is not necessary to emphasize the importance of risk management in view of the daily media information about the consequences of the worldwide financial crisis, company bankruptcies, and other emergencies. In the news coverage about risk, central concepts are often interpreted and applied in different ways. What follows is an overview of the different types of risk and a process-oriented description of risk management. Risk identification and an overview of the different types of risk will round off the fundamentals of risk management.

1.1The definition and reasons for risk management

There is no unified definition of risk concepts applied in the business literature. The word “risk” derives from the early Italian risicare, which means “to dare”. A relatively commonly used definition of risk is based on possible damage or the potential loss of a net asset position, with no potential gains to offset it. The neglect of potential gain is especially important because in further concepts, for example the RoRaC concept (see Section 2.6), the measurement of returns is separate and occurs independently of the risk measurement. There must be sharp distinctions between risk and return, otherwise it’s possible for the same profit to be considered more than once, which could lead to inconclusive results.

In business decision theory, the concept of risk is based on knowledge of probabilities or probability distributions regarding uncertain future events.

Risk management includes the company-wide measurement and supervision of all business risk.

In particular, consideration of the synergies between different risks, the so-called diversification effect, represents an important distinction between the treatment of individual risks and of combined risks.

The term risk controlling, often used in both practice and theory in this context, is substantively distinct from risk management. In the following material, risk controlling is viewed as a component of risk management which supports the planning and steering of the company. From this perspective, risk controlling fulfills a strong organizational and oversight role. By contrast, risk management revolves around the concrete implementation of provisions for risk measurement and risk steering. Risk controlling is one part of the process-oriented description of risk management (see Section 1.2).

The reasons for risk management are manifold and complex. Ever since the 2008 financial crisis there has been a mutual consensus about the necessity of a functioning business risk management strategy. Since the grounds for pursuing risk management have an effect on the way it is conducted, the reasons will be described and elucidated. The effects of the financial crisis on risk management will be handled in more detail in Section 4.4. The reasons can be divided into three categories:

–Legal framework

–Economic reasons

–Technological advances

Legal framework include first of all the respective national laws and regulations. For example, the following legislation applies in Germany: The German Act on Corporate Control and Transparency (KonTraG) from 27 April 1998, which expands the duty of care required from companies and stipulates disclosure of the business risks in the management report. The Corporate Governance Code contains non-legally-binding recommendations for risk management. The Risk Limitation Act of 12 August 2008 regulates the disclosure requirements of major company shareholders (financial investments) and is supposed to make company acquisitions by investors more transparent. The Commercial Code (Handelsgesetzbuch/HGB) and the German Accounting Standard (Deutscher Rechnungslegungsstandard/DRS) describe the most important laws regulating German reporting.

In America the Dodd-Frank Act constitutes an important legal framework in response to the financial market crisis. The goal of the Dodd-Frank Act is to promote stability of the financial market as well as increase responsibility and transparency in the US financial system. The US GAAP (Generally Accepted Accounting Principles) regulate, among other things, risk reporting for US companies.

However, there are also international laws and regulations that form a legal basis for risk management. For banks Basel III sets out the current and future international legal framework for structuring risk management. For the insurance industry, Solvency II is the corresponding counterpart to Basel III. Descriptions of industry-specific features will be omitted here and elsewhere in this book in favour of more generally accessible accounts. The IFRS 9 (International Financial Reporting Standards) applies to external risk reporting from 2018. The contents of the IFRS 9 as it applies to external risk reporting will be explored in more detail in Section 6.4 and with regard to the financial crisis in Section 4.4. The application of international laws depends on how they are integrated into national law and often represents a long process. Thus the USA has not so far adopted Basel III. The greatest alignment between national and international law being observed at the moment is with the IFRS, although the differences between the US-GAAP and the IFRS are also evident here.

Over the course of the financial crisis, numerous laws and regulations have been passed in the last few years which have especially changed the legal framework for banks and financial markets. Basel III is one example mentioned here and other pertinent laws and regulations are discussed in Section 4.4. The effects of the financial crisis on risk management for non-banking institutions will also be further clarified there.

The economic reasons for risk management lie basically in the strongly increasing globalization of the financial markets and the introduction of new financial products (especially in the area of derivatives). The launch of the Euro in combination with inadequate regulation of these new products was one cause of the financial crisis and therefore a reason to pursue risk management. In Section 4.4.2 these developments will be considered more closely in the context of market failure.

Finally, there is technological advances, primarily the quicker spread of information through digital media and the Internet. But also, businesses now make products that become obsolete faster, thus shortening the product cycle and increasing the product risks. As a result, the commodities and goods markets also grow faster due to the technological advances in spreading information and accompanying globalization. The result of the increasing globalization and shortened product cycles are seen in the numerous bankruptcies of the past years and not least also in the financial crisis.

The concept of risk management and the reasons for pursuing risk management are summarized in Figure 1.1.

Fig. 1.1: Definitions and reasons for risk management

1.2Risk management as a process

Starting from the concept of “risk management” as defined in Section 1.1, the topic of risk management will now be systematized. There are different criteria for doing this. One of the classifications that is used most often in the literature considers risk management as a process, i. e., as a sequence of events in time (dynamic). Risk management is a dynamic process and not a one-time event (static). The schematic representation of risk management processes shown in Figure 1.2 is often found in the current literature in this or slightly modified form (based on the classic management process). The structure of this book is oriented to this schema, so that the process-oriented perspective provides a red thread to lead the reader through the individual chapters.

Fig. 1.2: The risk management process

Economic risks in the sense of the above definition (see Figure 1.2) will be included in the scope of risk identification. There are a number of different approaches for this purpose, which depend on the special features of the business and its organizational structures. Generalizations are simply not possible, yet there are different instruments that can be deployed. For a complete compilation of all risks see Section 1.3, where a systematization of business risk types (for example, market risks) can be found.

After risk identification comes risk measurement and the accompanying assessments or risk analysis. In the context of risk measurement it is then useful to distinguish between quantitative and qualitative measurement procedures. Quantitative measurement is largely about key figures (for example volatility), whose calculation is based on existing observable prices, rates and other market data (Sections 2.1 to 2.4). For many risks, however, such market data are not available, for numerous reasons. In these cases, qualitative measurement techniques are used (see Section 2.5). In the second chapter, fundamental functions of the different key indicators...

Table of contents

• Cover
• Title Page
• Copyright
• Foreword
• Table of content
• List of Figures
• List of Tables
• List of Abbreviations
• List of Symbols
• 1 Fundamentals
• 2 Risk measurement and risk analysis
• 3 Risk control
• 4 Financial risks
• 5 Performance risks
• 6 Risk controlling
• 7 Profit-risk-based company management using a case study
• List of References
• Glossary
• Index